57. Information about a company’s executive compensation practices can be found in a
company’s
a. annual report.
b. form 10-K.
c. proxy statement.
d. form 10-Q.
58. A decrease in market-wide interest rates will result in a/an
a. increase in the cost of equity capital.
b. decrease in the cost of equity capital.
c. increase in the cost of debt.
d. decrease in the demand for fixed-rate bond investments.
59. Compensation incentives that motivate and reward executives for three to seven years of
growth and prosperity are called
a. base salaries.
b. short-term incentives.
c. long-term incentives.
d. executive compensation packages.
60. Which of the following is not an accurate statement regarding the compensation committee?
a. It selects the performance metrics used.
b. It may adjust a calculated award up or down at its discretion.
c. It is comprised of both internal and external directors.
d. It selects the annual or multiyear performance goals.
61. Stock options
a. have value only if the market price of the stock declines.
b. have value only if the market price of the stock rises.
c. are taxed at ordinary rates.
d. do not qualify for favorable tax treatment.
62. An award of stock that is not transferable or subject to forfeiture for a period of years is
called
a. phantom stock.
b. treasury stock.
c. restricted stock.
d. preferred stock.
63. Most executive compensation plans link bonus awards to one or more
a. non-accounting based performance measures.
b. accounting-based performance measures.
c. marketing-based performance measures.
d. management-based performance measures.
64. The widespread use of accounting-based incentives for executive compensation is
controversial for which one of the following reasons?
a. earnings growth does not automatically increase shareholder value.
b. accounting-based incentive plans can encourage managers to adopt a long-term business
focus.
c. executives cannot use their discretion over the accounting policies.
d. managers do not have accounting flexibility.
65. Several studies show that incoming CEOs have an incentive to
a. increase earnings in the year of the executive change as well as in years subsequent to the
change.
b. decrease earnings in the year of executive change and increase earnings in the next year.
c. decrease earnings for a few years after taking over to establish a low “bonus baseline.”
d. take actions that will make his/her predecessor look incompetent thus validating the board’s
decision to change CEOs.
66. Which statement best describes stock options?
a. Stock options are not an expense on the company’s profit and loss statement.
b. Stock options obligate the holder to purchase shares at a stated price.
c. Stock options give the holder the right to purchase shares at a stated price.
d. Stock options have been replaced by restricted stock.
67. Managers believe it is important to meet earnings benchmarks. When a number of
executives were asked—within the parameters of GAAP—which choices your company might
make to hit an earnings target, the most popular choice was to
a. decrease discretionary spending.
b. alter accrual assumptions (such as allowances).
c. postpone taking an accounting charge.
d. draw down on reserves previously set aside.
68. A clawback provision in an employment contract
a. requires managers to become more conservative in their business decision-making.
b. requires managers to respond to compensation committee requests for information .
c. requires managers to return bonuses received in the event of a financial statement restatement.
d. requires managers to refrain from making discretionary accruals.
69. With respect to executive pay, which of the following is not correct?
a. The proportion of pay “at risk” falls off steeply for executives on lower rungs of the
corporate ladder.
b. Top executive bonus opportunities have a maximum payout of 200%.
c. Most executive compensation packages involve a base salary, an annual incentive, and a
long-term incentive.
d. Long-term incentives are designed to counterbalance the inherently short-term orientation
of other incentives.
70. Research has shown that research and development expenditures during the years
immediately prior to a CEO’s retirement tend to
a. increase by a large amount.
b. increase by a small amount.
c. decline.
d. show no change.
71. Compensation plans should
a. not link incentive plans to financial performance.
b. not be based on long-term business goals.
c. align shareholders’ incentives with the objectives of managers.
d. align managers’ incentives with the objectives of shareholders.
72. Long-term incentive components of executive compensation plans should include stock
options
a. to enhance the short-term focus of executives.
b. to mitigate the short-term focus of executives.
c. to mitigate the long-term focus of executives.
d. to encourage better performance by low-level staff.
73. With respect to executive compensation, which statement is not valid?
a. Compensation packages are designed to minimize conflicts of interest.
b. Stock returns are the best way to align managers’ and owners’ interests since management’s
actions control the share price in both the short and long term.
c. Executive compensation components are generally linked to stock returns and/or financial
performance measures.
d. Use of accounting earnings should not be used due to its reliance on valuations that involve
subjectivity and judgments.
74. A compensation committee should be comprised of
a. the CEO and the CFO of the company.
b. the CEO of the company and the outside attorney.
c. members of the Board of Directors who are also officers of the company.
d. members of the Board of Directors who are outside (non-management) directors.
75. Regulatory accounting principles are important to those outside the regulatory agencies
because
a. GAAP may allow reporting for assets and liabilities consistent with the way in which
regulators establish rates.
b. GAAP does not allow reporting for assets and liabilities consistent with the way in which
regulators establish rates.
c. regulatory accounting principles are not compatible with GAAP.
d. the SEC requires them.
76. Banks that fail to comply with regulations, including the failure to maintain an adequate
capital adequacy ratio, face
a. higher costs.
b. lower costs.
c. mergers and expansion of services.
d. incarceration of officers.
77. The use of a bank manager’s discretion in the timing and amount of loan loss provisions and
loan charge-offs can falsely understate the losses and
a. decrease net income.
b. decrease bank obligations.
c. improve the bank’s debt adequacy ratio.
d. improve the bank’s capital adequacy ratio.
78. In the banking industry, the ratio of investor capital/gross assets, as defined by RAP, is the
a. capital asset ratio.
b. capital adequacy ratio.
c. gross asset ratio.
d. indirect capital ratio.
79. A bank’s estimated bad debt expense associated with its loan receivables is the
a. loan loss provision.
b. loan charge-offs.
c. allowance for loans.
d. accumulated loan loss.
80. In the utilities industry, rate formulas are established to allow the utilities to set total allowed
revenues to recover
a. only the administrative costs of operations.
b. only the operating costs associated with operations.
c. all operating costs, depreciation, taxes, and a fair return on invested capital.
d. all operating costs other than depreciation and taxes, and a fair return on invested capital.
81. In the utilities industry, image advertising and customer safety advertising are
a. both paid for by customers.
b. both paid for by shareholders.
c. both treated as operating expenses under RAP.
d. both treated as operating expenses under GAAP.
82. Rate regulation provides incentives for public utility managers to
a. artificially decrease the asset base.
b. artificially increase the asset base.
c. artificially decrease operating expenses.
d. artificially decrease taxes.
83. IRS regulations govern the
a. computation of net income for GAAP.
b. computation of net income for tax purposes.
c. computation of gross profit for GAAP.
d. computation of net income for the SEC.
84. Regulatory Accounting Principles (RAP) can be used
a. to set the prices customers may be charged.
b. as a basis for supervisory action.
c. as a source of statistical information.
d. to determine the amount of dividend to be paid.
85. Which of the following does not properly represent the relation of tax and GAAP
accounting?
a. Companies using FIFO for financial statements prefer FIFO for tax purposes because FIFO
results in a lower taxable income.
b. GAAP and tax depreciation expense will rarely be equal.
c. If LIFO is used for inventory valuation for taxes, LIFO must also be used for GAAP
financial reporting.
d. The accounting methods used for tax are permitted to differ from GAAP rules.
86. Which of the following statements does not reflect the provisions of ASU 2016-01 related to
fair value measurement?
a. It requires minority-passive equity investments (generally less than 20% ownership) to be
measured at fair value with changes in fair value recognized in net income, unless there is no
readily determinable fair value.
b. It simplifies the impairment assessment of equity investments that do not have readily
determinable fair values.
c. It requires an entity applying the fair value option to its own liabilities to recognize in net
income the change in fair value attributable to the entity’s creditworthiness.
d. It requires an entity applying the fair value option to its own liabilities to recognize in other
comprehensive income (not net income) the change in fair value attributable to the entity’s
creditworthiness.
87. Which of the following did not contribute to the 2008 financial meltdown?
a. the packaging/bundling of traditional mortgages to be sold as investments.
b. the speculative bubble related to housing demand drove up prices which proved to be
unsustainable.
c. an increase in traditional 30 year mortgages.
d. the issuance of high-risk/subprime mortgage loans.
88. Banking regulators have a powerful weapon to encourage compliance with minimum capital
guidelines as they can compel a noncomplying bank to do any or all of the following except
a. require the bank to increase the number of outside directors on its board.
b. require the bank to submit a plan describing how and when its capital will be increased.
c. subject the bank to more frequent examinations by the regulator.
d. deny a request to merge, open new branches, or expand services.
89. The prevalence of stock options in executive pay packages
a. eliminates managers’ incentives to engage in short-term earnings management.
b. is frowned upon by the SEC.
c. may actually contribute to, rather than moderate, managers’ short-term focus.
d. has been widely cited as the main cause of the financial system meltdown that occurred in
2008.
90. Managers cater to Wall Street (i.e., try to meet earnings benchmarks) for which of the
following reasons?
a. To build credibility with the capital market
b. To maintain or increase the firm’s stock price
c. To build the external reputation of management
d. All of these are reasons managers cite for meeting earnings benchmarks.
91. When faced with falling short of a desired earnings target, financial executives reportedly
might consider any of the following actions except
a. prematurely taking an accounting charge.
b. providing incentives for customers to buy more product this quarter.
c. decreasing discretionary spending.
d. delaying the start of a new project.
92. Which of the following does not represent the impact of changes in EPS on the stock price?
a. Small differences in reported EPS to expected EPS will not affect the stock price.
b. Penny differences in EPS matter a lot to investors.
c. Management makes accounting choices to get to an EPS number rather than EPS being a
random result around analyst’s expectations.
d. It is better to be $.01 over EPS target than at or $.01 below the target.
93. Which of the following is an accounting strategy most likely used by management to meet
EPS guidance?
a. postpone taking an accounting charge.
b. draw down accounting reserves.
c. delay R&D expense to the next quarter or year.
d. alter assumptions such as those relating to the allowance for doubtful accounts.
Essay and Computational Questions
[QUESTION]
94. Explain the difference between affirmative and negative debt covenants and provide two
examples of each.
[QUESTION]
95. Why do loan agreements often contain covenants tied to accounting numbers? Are there any
disadvantages to this common practice?
[QUESTION]
96. On October 31, 2018, Sterling Construction Company entered into a credit agreement with
Comerica Bank. The following appeared among the agreement’s financial covenants:
“Commencing with the fiscal quarter ending December 31, 2018, maintain as of the end of each
fiscal quarter a Fixed Charge Coverage Ratio of not less than 1.25 to 1.00.” The credit
agreement also contained a “definitions” section where this item was listed: “ ‘Fixed Charge
Coverage Ratio’ shall mean as of any date of determination a ratio the numerator of which is
EBITDA for the Applicable Measuring Period, minus cash taxes and cash tax distributions with
respect to such period and the denominator of which is the sum of Current Maturities of Long
Term Debt plus interest paid during the trailing twelve month period, plus twenty-five percent
(25%) of the daily average total non-amortizing debt during the trailing twelve month period.”
Required:
a. What is a minimum fixed charge coverage ratio and what purpose does it serve in the
company’s loan agreements?
b. Why is it necessary for the loan agreement to precisely define “Fixed Charge Coverage
Ratio?”
97. Sam Jones is the president of Apollo Finance, a payday lender. The company’s proxy
statement contains the following description of Mr. Jones’ pay package.
Mr. Jones is eligible for an annual incentive bonus equal to 1% of Net Income of the company
and is eligible for an additional bonus based upon annual increases in EPS only after earnings
exceed 15% over the prior year. The additional bonus is determined as follows:
EPS Growth
Additional Bonus
EPS increases up to 14.9%
$0
EPS increases of 15.0% to 24.9%
2% of the earnings increase from the prior year
EPS increases of 25.0% to 34.9%
3% of the earnings increase from the prior year
EPS increases above 35.0%
4% of the earnings increase from the prior year
Assume no change in the number of shares of outstanding stock during the year.
Required:
a. Suppose that Apollo Finance had $75 million of Net Income for the year. How much of a
bonus would Mr. Jones receive if the EPS increase for the year was 12%?
b. Suppose that Apollo Finance had $75 million of Net Income for the year. How much of a
bonus would Mr. Jones receive if the EPS increase for the year was 28%?
98. Duke Power & Light just spent $10 million to repair one of its electrical grid substations that
was heavily damaged by a lightning strike. The loss was not insured.
Required:
Why would a utility ask the public service commission for approval to treat the $10 million as an
asset for rate-making purposes rather than as an allowed expense?
[QUESTION]
99. Define the term “minimum capital requirements” and explain why banks and insurance
companies are required by regulators to maintain such capital minimums.
100. Firms may meet earnings benchmarks via operational excellence or by taking real actions
to maintain accounting appearances. Explain why the latter approach may be detrimental to a
firm’s stockholders.