6-1
Chapter 6—Accounting Quality
MULTIPLE CHOICE
1. All of the following are true regarding a high quality balance sheet except:
a.
It should portray the economic resources that can be reasonably expected to generate
future economic benefits.
b.
It should provide a complete and fair portrayal of all of the firm’s obligations at a point in
time, including the present value of long-term liabilities for future payments.
c.
It should minimize measurement error and bias.
d.
It should be optimistic in terms of accounting numbers.
2. Firms’ choices and estimates within U.S. GAAP or IFRS should be determined by all of the following
except:
a.
firms’ underlying economic circumstances.
b.
conditions in the company’s industry.
c.
the company’s competitive strategy.
d.
accelerated management efforts to meet earnings projections.
3. Examples of poor earnings quality that hinder the forecasting of expected future earnings include all of
the following except:
a.
Earnings dominated by a substantial one-time gains from the sale of real estate tangential
to the firm’s operations.
b.
Reporting a large expense from a warehouse fire that was not covered by insurance.
c.
A local government corrects a processing error and a firm receives an unexpected rebate
on property taxes previously paid.
d.
The company adds equipment that reduces carbon emissions in response to EPA
requirements and increases production efficiency.
4. The best measure of a firm’s sustainable income is
a.
net income.
b.
income from continuing operations.
c.
income before extraordinary items.
d.
income before extraordinary item and change in accounting principle.
5. On the income statement, income from discontinued operations is shown
a.
as an accounting principle change.
b.
without any income tax effect.
c.
as a separate section of income from continuing operations.
d.
net of taxes after income from continuing operations.
6. Users of financial statements should consider which of the following when evaluating the quality of
accounting information?
a.
Economic faithfulness of accounting measurements and classifications.
b.
Reliability of the measurements.
c.
Reasonableness of the estimates made in applying GAAP or IFRS.
d.
All of these should be considered.
7. Income or loss from discontinued operations would best be regarded by an analyst as:
a.
sustainable earnings.
b.
impairments.
c.
transitory earnings.
d.
permanent earnings.
8. Which one of the following is an example of sustainable earnings?
a.
A gain from corporate restructuring.
b.
A loss from debt retirement.
c.
A settlement paid by the company for a class action suit.
d.
Earnings from repeat customers.
9. As transitory components become a more important part of a firm’s reported earnings, the
reported earnings
a.
are more quality enhanced.
b.
become a more reliable indicator of sustainable cash flows.
c.
are a less reliable indicator of sustainable cash flows.
d.
are a more reliable indicator of fundamental value.
10. The assessment of earnings quality is best accomplished through the use of which one of the
following?
a.
Balance sheet and cash flow statement.
b.
Single-step financial statements.
c.
Single-step income statement, balance sheet, and cash flow statement.
d.
Multi-step income statement, balance sheet, and cash flow statement.
11. Under new accounting standards passed in 2006 firms must report changes in accounting principle in
the current and prior years as if the new accounting principle had been applied all along. The rationale
for this change was
a.
using the same accounting principle in current and prior periods enhances the information
content of reported earnings in forecasting future earnings.
b.
conservatism.
c.
comparability.
d.
materiality.
6-3
12. During July2013 Ralston Company decides to dispose of one of its subsidiaries which qualifies for
accounting as a discontinued operation. At the July2013 measurement date Ralston Company
estimates that it will report net income of $300,0000 dollars from the measurement date until the
disposal date which is expected to be in April 2014 In addition, Ralston estimates that it will lose
100,000 on the sale of the segment. How much gain or loss on discontinued operations will Ralston
report in its 2012 income statement (net of income taxes)?
a.
$200,000 gain
b.
$0
c.
$100,000 loss
d.
$300,000 loss
13. During July 2012 Ralston Company decides to dispose of one of its subsidiaries which qualifies for
accounting as a discontinued operation. At the July 2012 measurement date Ralston Company
estimates that it will report net losses of $1,500,000 dollars from the measurement date until the
disposal date which is expected to be in April 2013. In addition, Ralston estimates that it will lose
$300,000 on the sale of the segment. How much gain or loss on discontinued operations will Ralston
report in its 2012 income statement (net of income taxes)?
a.
$1,500,000 loss
b.
$0
c.
$1,800,000 loss
d.
$300,000 loss
14. Which of the following does not describe an extraordinary gain or loss?
a.
infrequent in occurrence
b.
peripheral to the company’s core business
c.
unusual in nature
d.
material in amount
15. Which of the following items is consistent with earnings not being informative about current
performance but are informative about future earnings?
a.
The firm recognizes an unexpected gain
b.
The firm recognizes a fair value gain on a financial asset as a result of a favorable move in
interest rates.
c.
The firm recognizes additional expenses this period due to pre-opening costs associated
with new stores.
d.
The firm experiences a large jump in sales and earnings as a result of successful research
and development of new products.
16. Which of the following items is consistent with earnings being informative about current performance
but not informative about future earnings?
a.
The firm recognizes an unexpected gain
b.
The firm recognizes a fair value gain on a financial asset as a result of a favorable move in
interest rates.
c.
The firm recognizes additional expenses this period due to pre-opening costs associated
with new stores.
d.
The firm experiences a large jump in sales and earnings as a result of successful research
and development of new products.
6-4
17. Which of the following items is consistent with earnings being informative about current performance
and informing the analyst that level of current earnings is sustainable?
a.
The firm recognizes an unexpected gain
b.
The firm recognizes a fair value gain on a financial asset as a result of a favorable move in
interest rates.
c.
The firm recognizes additional expenses this period due to pre-opening costs associated
with new stores.
d.
The firm experiences a large jump in sales and earnings as a result of successful research
and development of new products.
18. Which of the following items is consistent with earnings being informative about current performance
and informing the analyst that level of current earnings are not sustainable?
a.
The firm recognizes an unexpected gain
b.
The firm recognizes a fair value gain on a financial asset as a result of a favorable move in
interest rates.
c.
The firm recognizes additional expenses this period due to pre-opening costs associated
with new stores.
d.
The firm experiences a large jump in sales and earnings as a result of successful research
and development of new products.
19. In a restructuring it is possible that managers may use the opportunity to write down assets that do not
even relate directly to the restructuring action. Why might a manager decide to write down an asset
that is not included in the restructuring action?
a.
The manager is practicing conservatism.
b.
The write down relieves future periods of depreciation expense, which increases cash
flows.
c.
Normally the stock market reacts positively to restructuring and the greater the amount the
better.
d.
The write down relieves future periods of depreciation expense, which increases earnings.
20. When a company makes a change in an estimate that it has used in its financial statements, it should
account for the change by
a.
retroactively restating all prior financial statements
b.
treat the change as a cumulative effect change in accounting estimate
c.
spread the effect of the change over the current and future periods
d.
companies are not allowed to make changes to estimates
21. Many times a financial analyst may decide to make adjustments to the financial statements in order to
make the statements more useful. Which of the following would not require an adjustment to the
financial statement?
a.
A company signs a new contract with a customer.
b.
A delivery company incurs a loss from disposition of used delivery trucks.
c.
A company changes the useful life of its equipment from 5 years to 8 years.
d.
A company incurs a charge related restructuring its operations.
22. Which of the following is not considered a motive to manage earnings?
a.
To create optimal manager compensation payments.
b.
To create optimal job security for senior management.
c.
To create optimal measures of assets and liabilities for balance sheet purposes.
d.
To manage reported earnings in order to reduce industry-specific actions.
23. One definition of earnings management is that it occurs when managers use
a.
judgment in financial reporting to alter financial reports to mislead stakeholder.
b.
an accounting method that is inconsistent with other industry members.
c.
more conservative accounting estimates than other companies.
d.
pro forma accounting results as opposed to GAAP results.
24. The Orbus company has a 30,000 unrealized gain and a 10,000 unrealized loss. Where would Orbus
company report these transactions?
a.
only in non-current assets and liabilities.
b.
in stockholders’ equity.
c.
other comprehensive income
d.
on the balance sheet as a current asset
25. Firm’s choices and estimates within U.S. GAAP should be determined by
a.
how the industry operates.
b.
the firm’s underlying economic circumstances.
c.
SEC interpretations regarding specific choices.
d.
the firm’s auditor.
26. Earnings that are high quality would
a.
be informative about current performance and provide information about the long-run
sustainability of profits.
b.
be informative about past performance and provide information about the long-run
sustainability of profits.
c.
be informative about current performance and provide information about the long-run
sustainability of assets.
d.
be informative about past performance and provide information about the long-run
sustainability of assets and liabilities.
27. When evaluating the quality of accounting information, an analyst should consider all of the following
except:
a.
reliability of the measurements made
b.
adequacy of disclosures
c.
comparability of estimates
d.
economic faithfulness of the measurements made
28. Which of the following are characteristics of an extraordinary item?
a.
Unusual in nature
b.
Infrequent in occurrence
c.
Material in amount
d.
All of the above
29. How is a disposal of a segment of the business reported?
a.
separately stated item on the income statement
b.
balance sheet
c.
statement of cash flows
d.
statement of retained earnings
30. Accounting information should provide a fair and complete representation about a number of a firm’s
characteristics. Which of the following is not one of those characteristics?
a.
risk
b.
position
c.
performance
d.
conservatism
COMPLETION
1. Accounting information should be a fair and complete representation of the firm’s economic
____________________, ____________________, and ____________________.
2. Accounting information should provide relevant information to forecast the firm’s expected future
earnings and _________________________.
3. Quality accounting information seeks to maximize relevance and economic faithfulness, subject to the
constraints of the ____________________ of the measurements.
4. Quality accounting information should be informative as to both the
__________________________________________________ of the current period’s earnings and the
long-run sustainability of profits.
5. The _________________________ is the date on which a firm commits itself to a formal plan to
dispose of a business segment.
6. A ____________________ of operations differs from a discontinuation of operations because the firm
continues to operate in the business segment.
7. A change in the useful life of an asset is treated as a _____________
8. Gains and losses differ from revenues and expenses in that they are produced by
____________________ activities.
9. When evaluating the quality of accounting information the user should consider the reasonableness of
the ____________________ made in applying GAAP.
10. When evaluating the quality of accounting information the user should consider the
____________________ of the measurements made.
11. When evaluating the quality of accounting information the user should consider the
____________________ of the firm’s disclosures.
12. When evaluating the quality of accounting information the user should consider the
_____________________________________________ of the measurements made.
6-8
13. Earnings are informative if they signal the portion of current period’s due to a new product and the
additional earnings in the future as a result of the ____________________ of this new earnings
stream.
14. On the income statement the disposal of a segment of a business should be shown _________ .
15. An extraordinary gain or loss is unusual in nature,
_____________________________________________, and material in amount.
16. Under current GAAP unrealized gains and losses from four balance sheet items are reported in
___________________________________________________________________________.
17. Some firms attempt to maximize the amount of restructuring charge in a particular year, analysts refer
to this as the _________________________ approach.
18. U.S. GAAP requires that changes in estimates be accounted for by recognizing the effect
________________________________________ period(s).
19. ____________________ represents the concept of being able to compare financial statement data
across years for any particular firm.
SHORT ANSWER
6-9
1. Banks Corp. reported net income of $595,000 in 2012. During 2012 Banks reported a loss of $87,435
from a peripheral activity. The loss was included as part of income from continuing operations.
Assuming that the loss is a one-time event and that Banks has an effective tax rate of 35% calculate
Banks’ adjusted net income. Show all of your calculations for credit.
In addition, discuss why analysts might make an adjustment of this type.
Income before tax (X – .35X = $396,923)
Net Income
2. Creighton Corp., a textile manufacturer, reported net income of $258,000 in 2012. During 2012
Creighton reported a gain of $29,800 from the sale of three used delivery trucks. The gain was
included as part of income from continuing operations. Assuming that the gain is a one-time event and
that Creighton has an effective tax rate of 35% calculate Creighton’s adjusted net income. Show all of
your calculations for credit.
In addition, discuss why analysts might make an adjustment of this type.
3. First Bank recognized an extraordinary loss from the settlement of a lawsuit with Fifth Street Bank
that it had impeded on a processing patent. The extraordinary loss was in the amount of $4,250,000
and First Bank Corporation has an effective tax rate of 35%. First Bank paid the settlement
immediately and recognized the tax benefit as a receivable to offset the current period’s taxes.
Instructions:
a.
b.
Income before tax (X – .35X=$595,000)
Net Income
6-10
Analytical Framework:
Shareholders’ Equity
Entry
Assets
=
Liabilities
+
CC
+
AOCI
+
RE
that active markets exist to indicate the amount of the value changes.
current period.
The unrealized gains or losses have no immediate cash flow effect.
asset or liability is not traded in an active market.
4. Many times an analyst will have to make judgments as to whether to include unrealized gains and
losses when assessing earnings persistence and predicting future profitability. Discuss the case for and
the case against including unrealized gains and losses as part of sustainable earnings when examining
earnings persistence and future profitability.
5. Healy and Wahlen state that one type of earnings management occurs when managers use judgement
in financial reporting to alter financial reports in order to mislead some stakeholder about the
economic performance of the company. Earnings management is a consequence of a judgement by
management which results in lower economic information content of the financial reports.
Discuss five motives that encourage managers to practice earnings management.
Entry
=
Liabilities
+
CC
+
AOCI
+
6-11
6. Healy and Wahlen state that one type of earnings management occurs when managers use judgement
in financial reporting to alter financial reports in order to mislead some stakeholder about the
economic performance of the company. Earnings management is a consequence of a judgement by
management which results in lower economic information content of the financial reports.
Discuss four reasons that discourage managers from practicing earnings management.
7. Achieving comparability in financial reporting is important to the analysis of multinational firms.
However, the data from the reconciliation of foreign firms financial statement to U.S. GAAP must be
carefully interpreted. What types of things complicate the analysis of multinational firms?
8. A company may try to paint a favorable picture of itself by accelerating the timing of revenues or
estimating the collectible amounts too aggressively. In these cases the quality of accounting
information declines because it does not represent the company’s true economic condition and may
not be sustainable. List four conditions which might suggest that a company is recognizing revenues
too early?
6-12
2.
9. Many users of financial statements believe that the quality of accounting information for intangible
assets is low because firms seldom report intangible asset resources on the balance sheet. However,
from the perspective of accounting quality what are arguments in favor of expensing most intangibles
and not recording them on the balance sheet?
10. Penny Corp. manufactures telecommunication equipment and has been profitable each year for the
past ten years. During 2014 the company saw its core market decline sharply when a competitor
introduced a significant new product technology. In response to the decline in business Penny Corp.
announced a major restructuring of its operations. The restructuring plan which would be implemented
in 2010 would involve the following changes (all of the charges are material):
a.
Severance payments to reduce work force
$ 9 million
b.
Write-down of inventory
$13 million
c.
Penalty payment for termination of lease on manufacturing facility
$ 6 million
d.
Write-down of equipment associated with manufacturing facility
$12 million
Total 2010 restructuring charge
$40 million
Penny Corp. has never previously restructured its operations and believes that it can return to
profitability within two years based on its current research and development activity.
Required:
1.
Discuss whether or not you would eliminate the restructuring charge from the 2010 income
statement of Penny Corp. when using earnings to forecast future profitability.
2.
Penny Corp.’s restructuring charges cover a wide range of different cost categories, identify
those that entail a cash payment and those that do not require a cash payment. For those
charges not requiring a cash payment how would they be treated in the Statement of Cash
Flows?
1.
1.
Large and volatile amounts of uncollectible accounts receivable.
2.
Unusually large amounts of returned goods.
3.
Excessive warranty expenditures.
4.
A significant increase in days accounts receivable are outstanding.
PROBLEM
1. On September 1, 2012, Ramos Inc. approved a plan to dispose of a segment of its business. Ramos
expected that the sale would occur on March 31, 2013, at an estimated gain of $375,500. The segment
had actual and estimated operating profits (losses as follows):
Realized loss from 1/1/12 to 8/31/12
$200,000
Realized loss from 9/1/12 to 12/31/12
(135,000
Expected profit from 1/1/13 to 3/31/13
475,000
Assume a marginal tax rate of 35%
Required:
A)In its 2012 income statement, what should Ramos report as profit or loss from discontinued
operations (net of tax effects)?
B) Calculate the amount of income that should be shown on the 2013 income statement as a result of
the operating profit and the gain on disposal (net of tax)
2. Motor Corporation’s income statements for the years ended December 31, 2012 and 2011 included the
following information before adjustments:
2012
2011
Operating income
$900,000
$600,000
Gain on sale of division
450,000
—0——
$1,350,000
$600,000
Provision for income taxes
(405,000)
(180,000)
Net income
$945,000
$420,000
On January 1, 2012, Motor Corporation agreed to sell the assets and product line of one of its
operating divisions for $1,600,000. The sale was consummated on December 31, 2012, and it resulted
in a gain on disposition of $450,000. This division’s pre–tax net losses were $320,000 in 2012 an
$250,000 in 2011. The income tax rate for both years was 30%.
Required:
Starting with operating income (before tax), prepare revised comparative income statements for 2012
and 2011 showing appropriate details for gain (loss) from discontinued operations.
3. On November 15, 2012, Jacobs Co. sold a segment of its business for $2,750,000. The net book value
of the segment at the time of its disposal was $3,000,000. Jacobs had pretax operating income of
$1,750,000 for 2012 which included $380,000 earned by the discontinued segment prior to its
disposal. Assume Jacobs’ tax rate is 30%.
Required:
Prepare a partial income statement for Jacobs Co. beginning with pretax income from continuing
operations.
4. On July 15, 2009 Time Services decided to sell its agricultural business and focus on its landscape
equipment business. The sale of the agricultural business qualifies for discontinued operations
accounting treatment. On November 11, 2009 Time Services signs a firm contract to sell the
agricultural business to Acme Inc. on March 10, 2010. For each of the situations listed discuss how
Time Services would report the discontinued operations in its December 31, 2009 income statement.
(You may disregard tax issues with respect to the sale.)
Situation 1: For the period January 1, 2009 to July 15, 2009 Time Services reports that the agricultural
business lost $3.2M. From July 16, 2009 to November 11, 2009 Time Services reports that the
agricultural business loses an addition $1.4 million dollars. At the end of the 2009 Time estimates that
it will lose an additional $800,000 on the sale of the agricultural business when it is finally completed
in 2010.
Situation 2: For the period January 1, 2009 to July 15, 2009 Time Services reports that the agricultural
business had a profit of $1.5M. From July 16, 2009 to November 11th, 2009 Time Services reports
that the net income from the agricultural business was $600,000 dollars. At the end of the 2009 Time
estimates that the sale of the agricultural business will result in a gain of $1.7 million dollars when it is
finally completed in 2010.
Situation 3: For the period January 1, 2009 to July 15, 2009 Time Services reports that the agricultural
business lost $3.2M. From July 16, 2009 to November 11th, 2009 Time Services reports that the
agricultural business loses an addition $1 million dollars. However, at the end of the 2009 Time
estimates that the sale of the agricultural business will result in a gain of $1.3 million dollars when it is
finally completed in 2010.
6-17
5. Mattel, Inc. designs, manufactures and markets various toy products worldwide through sales to
retailers and directly to consumers. Among the company’s many products are Barbie, GI Joe, and
American Girls. Below is an income statement for Mattel for years 2002, 2001 and 2000. Notes to the
financial statements reveal the following information.
1.
Discontinued Operations – In 1999 Mattel merged with Learning Company, with Mattel
being the surviving company. The Learning Company, which produced consumer
software, represented a separate line of business for Mattel. In 2000 Mattel’s Board of
Directors committed to dispose of the Learning Company and its consumer software
operations. In 2000 the Learning Company was reported as a discontinued operation and
the company was sold to Gores Technology on October 18, 2000.
In 2002 Mattel received a contractual payment from Gores Technology based on the sale of assets of
Learning Company and other liquidation events.
2.
Accounting Change – In 2001 Mattel changed the manner in which it accounted for
derivative instruments consistent with the issuance of SFAS No. 133 Accounting for
Derivative Instruments and hedging Activities. The change resulted in Mattel recording a
one-time adjustment of $12 million.
3.
Accounting Change – In 2002 the FASB issued SFAS No. 142 Goodwill and Other
Intangible Assets. The standard requires that management estimate the value of its
goodwill and, if necessary, record an impairment charge. Consistent with SFAS No. 142
Mattel recorded a one-time adjustment of $252.2 million, net of tax, as the cumulative
effect of the change in accounting principle.
Mattel, Inc.
Selected Income Statement data
Fiscal year end
12/31/2002
12/31/2001
12/31/2000
(amounts in thousands of dollars)
Net sales
$4,885,340
$4,687,924
$4,565,489
Cost of Goods Sold
(2,524,353)
(2,538,990)
(2,572,247)
Gross profit
2,360,987
2,148,934
1,993,242
Selling and Administrative Expenses
(1,602,846)
(1,507,793)
(1,560,157)
Amortization of Goodwill
0
(46,121)
(46,561)
Non-operating income/expense
(22,747)
(9,878)
(8,121)
Interest expense
(113,897)
(155,132)
(152,979)
Income from Continuing Operations
before Income Taxes
621,497
430,010
225,424
Provision for income taxes
(166,455)
(119,090)
(55,247)
Income from Continuing Operations
455,042
310,920
170,177
Gain (Loss) from Discontinued Oper., net of tax
27,253
(601,146)
Income (Loss) before Cumulative Effect of
Change in Accounting Principles
482,295
310,920
(430,969)
Year Ended 2009
Income from Discontinued Operations
Net Loss of Discontinued Business
Estimated Gain on Disposal of Discontinued Business
$ 0
Loss from Discontinued Business
Cumulative Effect of Change in Accounting
Principles, net of tax
(252,194)
(12,001)
0
Net Income (Loss)
$230,101
$298,919
($430,969)
Required:
a.
Discuss whether or not you would adjust for each of the following items when using
earnings to forecast the future profitability of Mattel:
(1)
Discontinuance of the Consumer Software operations.
(2)
The change in accounting for derivative instruments.
(3)
The change in accounting for goodwill and other intangible assets.
b.
Indicate the adjustment you would make to Mattel’s net income for each of the items in
part a.
c.
Prepare a common size income statement for 2002, 2001, 2000 for Mattel.
d.
Repeat part c after making the income statement adjustments in part b.
e.
Assess the changes in profitability of Mattel during the three-year period.
more major issue might be examining the strategy with respect to Mattel’s decision to
purchase the Learning Company and so quickly dispose of the operations.
profitability and risk ratios.
adjusted net income becomes what is originally reported as “income from continuing
operations”.
c.
Common size financial statements