74) Spinning is the practice of
A) investment banks allowing executives of potential client companies to buy underpriced initial
public offerings of other companies’ securities.
B) investment bank analysts providing misleading information about a company to encourage
more investors to purchase the company’s securities.
C) accounting firms encouraging its audit clients to also purchase its management advisory
services.
D) credit rating agencies providing higher ratings on a company’s securities in order to develop a
long-term relationship with the company.
75) Investment banks are guilty of conflict of interest when they
A) pressure their analysts to produce research favorable to their client firms.
B) permit executives of client firms to alter analysts’ research on their firms.
C) prohibit analysts from making negative or controversial comments about client firms.
D) all of the above.
76) Investment banks serve two client groups,
A) home buyers and mortgage lenders.
B) people saving for retirement and pension funds.
C) issuers of securities and investors in those securities.
D) mutual funds and investors with relatively small amounts to invest.
77) Auditors attempt to reduce information asymmetry between a firm’s managers and its
A) customers.
B) owners.
C) employees.
D) competitors.
78) Conflicts of interest in the Arthur Andersen accounting firm intensified when ________
became the firm’s largest source of profits and large clients pressured ________ office managers
to give favorable audits.
A) consulting; regional
B) consulting; national
C) auditing; regional
D) auditing; national
79) The potential conflict of interest when a single accounting firm provides both auditing and
consulting services is that the firm can
A) charge higher fees to its audit clients and lower fees for its consulting services so it can
expand its consulting business.
B) charge higher fees to its consulting clients and lower fees for its audit services so it can
expand its auditing business.
C) provide unjustifiably favorable audit reviews for firms that are large clients for its consulting
services.
D) pressure its clients into paying high fees for both auditing and consulting services.
80) The conflict of interest in credit-rating agencies arises because ________ pay to have
securities rated and, as a result, the agencies‘ ratings may be biased ________.
A) security issuers; downward
B) security issuers; upward
C) investors; downward
D) regulators; upward
81) During the 2007-2009 financial crisis, housing prices began to fall and subprime mortgages
began to default. Which of the following statements is true about the rating of subprime
mortgage products?
A) The rating agencies were way ahead of the market, giving many of the subprime products
junk ratings from the start.
B) Rating agencies were not involved. Subprime mortgages could not be structured, by law.
C) Many AAA-rated subprime products had to be downgraded over and over again until they
reached junk status.
D) None of the above are true.
82) Since firms issuing new securities pay to have these securities rated, the credit-rating
agencies have incentive to ________ to attract more business.
A) give favorable ratings
B) give impartial ratings
C) lower the fees they charge
D) practice spinning
83) The Sarbanes-Oxley Act of 2002 dealt with conflicts of interest in
A) investment banks.
B) accounting firms.
C) credit-rating agencies.
D) all of the above.
84) The Global Legal Settlement of 2002 dealt with conflicts of interest in
A) accounting firms.
B) investment banks.
C) credit-rating agencies.
D) all of the above.
85) Which of the following provisions of legislation to deal with conflicts of interest does not
increase the flow of information in financial markets?
A) Requiring a firm’s chief officers to certify its financial statements and other disclosures
B) Requiring investment banks to make their analysts’ recommendations public
C) Requiring disclosure of off-balance-sheet transactions
D) Increasing resources available to the Securities and Exchange Commission to supervise
financial markets
86) The Global Legal Settlement includes what key element?
A) It directly reduces conflicts of interest.
B) It provides incentives for investment banks to not exploit conflicts of interest.
C) It has measures to improve the quality for information in financial markets.
D) All of the above.
87) China is in an early state of development, with a per capita income that is still less than
________, one-fifth of the per capita income in the United States.
A) $5,000
B) $10,000
C) $25,000
D) $50,000
1) American businesses get more funds from direct financing than from indirect financing.
2) American businesses use stock to finance about 10 percent of their external financing.
3) One reason why indirect financing is used is to minimize adverse selection problems.
4) Issuing marketable securities is the primary way businesses finance their operations.
5) Because of the adverse selection problem, lenders may refuse loans to individuals with low
net worth.
6) The concept of adverse selection helps to explain why indirect finance is more important than
direct finance as a source of business finance.
7) The problem of adverse selection helps to explain why direct finance is more important than
indirect finance as a source of business finance.
8) The concept of adverse selection helps explain why collateral is an important feature of many
debt contracts.
9) One way of describing the solution that high net worth provides to the moral hazard problem
is to say that it makes debt contracts incentive compatible.
10) Net worth is the difference between a firm’s assets and its liabilities.
11) Economies of scale means that the percentage return on a financial transaction rises as the
size of the transaction rises.
12) Agency theory focuses on how government agencies regulate financial intermediaries and
markets.
13) The principal-agent problem is an example of the adverse selection problem that can result
from asymmetric information.
14) The financial system is one of the most heavily regulated sectors of the economy.
15) Collateralized debt is also called secured debt.
16) Most legal work in the U.S. involves the writing and enforcement of contracts, not
ambulance chasing, criminal law, and frivolous lawsuits.
17) The Sarbanes-Oxley Act of 2002 was passed in response to scandals in the investment
banking industry.
18) The Sarbanes-Oxley Act of 2002 provides for oversight of accounting firms but makes no
provisions for increasing the flow of information to financial markets.
19) The Sarbanes-Oxley Act of 2002 and the Global Legal Settlement of 2002 both have the
potential to reduce economies of scope.
20) The Global Legal Settlement of 2002 arose out of a lawsuit brought by New York Attorney
General Eliot Spitzer against the ten largest investment banks.
21) The Sarbanes-Oxley Act of 2002 established a Public Company Accounting Oversight Board
(PCAOB), overseen by the SEC, to supervise accounting firms and ensure that audits are
independent and controlled for quality.
22) Due to criticisms of rating agencies following the default of many subprime products, the
SEC prohibited credit rating agencies from structuring the same products that they rate.
23) China is in an early state of development, with a per capita income that is still less than
$10,000, one-fifth of the per capita income in the United States.
1) What are economies of scale in financial transactions? How can financial intermediaries
2) How does the U.S. differ from other countries with respect to the source of funding for
3) Explain how the “lemons” problem could cause financial markets to fail.
4) Distinguish between adverse selection and moral hazard.
5) What facts about financial structure can be explained by adverse selection?
6) What facts about financial structure can be explained by moral hazard?
7) What factors usually cause an increase in moral hazard?
8) What factors usually cause an increase in adverse selection?
9) What is the principal-agent problem?
10) What is the free-rider problem? Describe some situations that this problem creates.
11) The U.S. has more lawyers per capita than any other country in the world. It is also among
12) Why should we be concerned about conflicts of interest in the financial services industry?
13) What conflicts of interest can arise in investment banking?
14) What conflicts of interest can arise in accounting firms?
15) What conflicts of interest can arise in credit-rating agencies?
16) Evaluate the major provisions of Sarbanes-Oxley and the Global Legal Settlement as
17) What issues do critics cite when discussing why Sarbanes-Oxley has led to a decline in U.S.
capital markets?