23) Recognizing revenue that belongs in future accounting periods is the type of manipulation
where management maximizes its earnings to meet analysts’ expectations.
24) The big bath theory is the type of manipulation where management maximizes a current loss
to get rid of expenses that belong on future income statements.
25) Higher than usual earnings implies the company may be recognizing revenues early.
26) Higher than usual expenses may indicate a company is manipulating earnings using big bath
charges.
27) Lower than usual expenses may indicate a company is manipulating earnings using big bath
charges.
28) A lower than usual allowance for uncollectible accounts may indicate a company is
manipulating earnings using big bath charges.
29) A higher than usual allowance for uncollectible accounts may indicate a company is
manipulating earnings using a cookie jar reserve.
30) A higher than usual estimated warranty liability may indicate a company is manipulating
earnings using a cookie jar reserve.
31) Put an X in the appropriate box to identify each of the following as overstating, understating
or not affecting earnings per share.
Overstating
Understating
Not affecting
a. Recording revenue expenditures as
capital expenditures
b. Depreciating long-term assets over
unusually short useful lives
c. Overstating the allowance for
uncollectible accounts
d. Reporting a current asset as a long-
term asset
e. Writing-off long-term assets even
though the assets are not impaired
f. Overstating warranty payable
Overstating
Understating
Not affecting
a. Recording revenue expenditures as
capital expenditures
b. Depreciating long-term assets over
unusually short useful lives
c. Overstating the allowance for
uncollectible accounts
term asset
e. Writing-off long-term assets even
though the assets are not impaired
f. Overstating warranty payable
32) Put an X in the appropriate box to identify each of the following as overstating, understating
or not affecting earnings per share.
Overstating
Understating
Not affecting
a. Recording capital expenditures as
expenses
b. Depreciating long-term assets over
unusually long useful lives
c. Understating the allowance for
uncollectible accounts
d. Reporting a long-term liability as a
current liability
e. Understating warranty payable
33) What effect will purchasing treasury stock have on earnings per share? Is it ethical for
management to repurchase the company’s own shares?
Overstating
Understating
Not affecting
a. Recording capital expenditures as
expenses
b. Depreciating long-term assets over
unusually long useful lives
c. Understating the allowance for
uncollectible accounts
d. Reporting a long-term liability as a
current liability
e. Understating warranty payable
34) The management of Krupt, Inc. decided to buy back 30% of the shares of stock outstanding.
What effect would this have on the company’s earnings per share? Why would management want
to do this? Is this ethical?
35) The management of Snake, Inc. was having a bad year and decided to include numerous big
bath charges in an already bad year. What effect would this have on the company’s earnings per
share this year? What effect would this have on future years’ earnings per share? Is this ethical?
36) The management of Snake, Inc. was having a banner year and decided to increase the
amount of allowances and reserves for the sake of future years. What effect would this have on
the company’s earnings per share this year? What effect would this have on future years’ earnings
per share? What is this kind of manipulation called? Is this ethical?
37) List two ways management may manipulate its revenue recognition and describe the effect
each manipulation will have on the company’s current earnings per share and the following year’s
earning per share. Is this ethical?
38) Team Instructions: Divide the class into teams of three or four people. Each team member
should work the following problem separately outside of class. Then give the students time in
class to compare answers with their teammates and put together a final correct copy of the
problem. Each team should turn in only one copy of the problem for grading, along with a copy
of the annual report that it used. All team members will receive the same grade.
Provide students with copies of real merchandising companies’ annual reports, or give students
the Web addresses of real merchandising companies and ask them to print out and submit the
annual reports. All team members should work with the same company’s annual report.
Answer the following questions using the annual report assigned to your team:
1. What is the name of your company?
2. Which of the notes to the financial statements describes the company’s revenue recognition
policy?
3. Does anything seem unusual about the company’s revenue recognition policy? If yes, describe
it.
4. Perform a horizontal analysis for your company’s revenue, using the earliest year shown as the
base year.
Current year Prior year Earliest year
Base year
5. Does the amount of revenue reported seem unusually high or unusually low in any of these
years? If yes, which one?
6. Calculate total operating expenses as a percentage of sales for each of the three years shown.
Current year Prior year Earliest year
7. Does the amount of total operating expense seem unusually high or unusually low in any of
these years? If yes, which one?
8. Does your company report any non-operating gains or losses? If yes, describe them.
9. Calculate net income as a percentage of sales for each of the three years shown.
Current year Prior year Earliest year
10. Does the amount of net income seem unusually high or unusually low in any of these years?
If yes, which one?
11. Calculate accounts receivable as a percentage of sales for the current year.
12. Calculate accounts receivable as a percentage of sales for the prior year.
13. Does accounts receivable as a percentage of sales seem consistent for the two years?
14. Which of the notes to the financial statements describes the method your company uses to
value its inventory?
15. Does your company use LIFO?
16. Describe how the choice of LIFO in a time of rising prices affects the quality of a company’s
earnings.
17. Does the company have any treasury stock?
18. Did the company purchase any treasury stock during the most recent year?
19. Which of the notes to the financial statements describes your company’s purchase of treasury
stock?
20. Does your company seem to have a legitimate reason for repurchasing its own stock? What is
the reason?
21. What effect does purchasing treasury stock have on a company’s earnings per share? Why?
22. Look in the management discussion and analysis portion of your annual report to find
management’s comments about “Forward-looking information and risk factors.” (If you aren’t
sure that you have found the right pages, ask your instructor for help.) Does your company seem
to operate in a particularly risky environment?
23. Describe the relationship between risk and quality of earnings.
39) Match each of the following items with the appropriate description or example. Each item
should be used only once.
a. earnings per share
b. quality of earnings
c. big bath charges
d. cookie jar reserves
e. improper revenue recognition
_____ 1. how well a reported earnings number communicates actual performance of the
company
_____ 2. overstatement of sales
_____ 3. overstatement of allowance for uncollectible accounts
_____ 4. net income divided by the weighted average number of outstanding shares of (common)
stock
_____ 5. wrote-off as much as possible in a bad year
Learning Objective 11-4
1) Which of the following is evidence of a company’s positive ethical climate?
A) The company controller leaves work after lunch every Friday to play golf with his friends.
B) The company president has a framed motto on his desk that says: “Winning isn’t the most
important thing, it’s the only thing.”
C) The company’s annual audit is performed by a firm of independent CPAs which has a purely
business relationship with the company.
D) To ensure the statements are prepared properly, the company pays its external auditors extra
to prepare its financial statements as well as audit them.
2) Which of the following is evidence of a company’s positive ethical climate?
A) The company president’s brother-in-law is the company’s biggest supplier.
B) The company president has a very, very close personal relationship with his secretary.
C) The aunt of the company president manages the CPA firm that performs the company’s
annual audit.
D) The company’s executives require all new employees to attend an ethics workshop.
3) Which of the following is evidence of a company’s positive ethical climate?
A) X Company has a written ethics policy, which all new employees are required to sign.
B) Y Company’s president has been indicted for fraud, but the case has not yet gone to trial. In
the meantime, it is business as usual.
C) Z Company skipped its annual audit this year because it was too expensive.
D) To ensure the statements are prepared properly, the company pays its external auditors extra
to prepare its financial statements as well as audit them.
4) Which of the following is evidence of a company’s positive ethical climate?
A) Alpha Company’s chief financial officer has a degree in drivers’ education.
B) Beta Company has a hotline where anonymous callers can leave information about any
fraudulent activity in Beta Company.
C) Gamma Company provides free health insurance only for employees who earn more than
$100,000 a year. Hourly workers are not eligible for company health insurance even if they are
willing to pay for it themselves. This saves the company a lot of money in employee benefits.
D) To ensure the statements are prepared properly, the company pays its external auditors extra
to prepare its financial statements as well as audit them.
5) Corporate governance ________.
A) is required by the SEC in accordance with the 1933 and 1934 securities acts
B) is the process carried out by the board of directors to provide direction and oversight on
behalf of the stakeholders
C) is a new concept that arose as a result of the accounting scandals in the early 2000s
D) prevents fraud and ensures financial statements are prepared in accordance with GAAP
6) Which of the following is NOT one of the lessons learned from the business failures of the
early 2000s?
A) Top management should set the ethical climate of a firm.
B) Overreliance on earnings per share may encourage fraudulent behavior.
C) External auditors should get to know top management well, both personally and
professionally, so that they have a strong working relationship.
D) Executive compensations linked to stock performance may result in fraudulent activity.
7) The ethical climate of a company is determined by the external auditors.
8) The ethical climate of a company is determined by the board of governors.
9) The ethical climate of a company is determined by the tone at the top.
10) Corporate governance eliminates the need for internal controls.
11) Describe some of the lessons learned from the business failures of the past decade.
Learning Objective 11-5
1) Which of the following is a new requirement imposed by the SOX Act?
A) The CFO must be part of the audit committee.
B) The external auditors have stronger rules regarding auditor independence.
C) Management is required to have a representative on the board of directors.
D) Public companies must have at least one representative of the external auditors as a member
of its board of directors.
2) Who is responsible for a company’s internal controls?
A) the CEO and CFO
B) the board of directors
C) the external auditors
D) the PCAOB
3) Who must attest to the accuracy of a company’s report on its internal controls?
A) the CEO and CFO
B) the board of directors
C) the external auditors
D) the PCAOB
4) Who is ultimately responsible for the accuracy of a company’s financial statements?
A) management
B) the board of directors
C) the external auditors
D) the PCAOB
5) Who must swear that they have reviewed a company’s financial statements and that, based on
their knowledge, the report does not contain any false statements and does not omit any
significant facts?
A) the CEO and CFO
B) the board of directors
C) the external auditors
D) the PCAOB
6) What is whistle-blowing?
A) an announcement that the financial statements might be issued late this year
B) an employee disclosure of suspected fraud within a company
C) a warning from the SEC to management that a company’s annual report is inadequate
D) an announcement that this year’s earnings will not meet analysts’ expectations
7) Which of the following is a new requirement imposed by the SOX Act?
A) Management must report on the effectiveness of its internal control system.
B) The external auditors are required to provide consulting services.
C) The external auditors are required to prepare and audit the financial statements.
D) Executive compensations are no longer allowed to be linked to earnings.
8) Who are elected by the shareholders to represent the interest of the shareholders?
A) management
B) the board of directors
C) the external auditors
D) the PCAOB
9) Who are elected by the shareholders to make decisions on major company policies, such as
dividend payments?
A) management
B) the board of directors
C) the external auditors
D) the PCAOB
10) Who created the Sarbanes-Oxley Act (SOX)?
A) the SEC
B) the PCAOB
C) the United States Congress
D) the IRS
11) All accounting firms that audit publicly traded companies must register with the ________
and follow its rules.
A) American Institute of Certified Public Accountants
B) PCAOB
C) United States Congress
D) Internal Revenue Service
12) The audit committee is part of ________.
A) management
B) the board of directors