978-0077862213 Chapter 7 Solution Manual Part 1

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Chapter 7 Discussion Questions

1. In Arthur Levitt’s speech that was referred to in the opening quote he also said: “…I

fear that we are witnessing an erosion in the quality of earnings, and therefore, the

quality of financial reporting. Managing may be giving way to manipulation;

Integrity may be losing out to illusion.” Explain what you think Levitt meant by this

statement. What role do financial analysts’ earnings expectations play in the quality

of earnings?

The financial reporting process becomes unreliable when corporate managers, auditors, and

analysts all work together to deceive the investing public. The reason for the auditing process is

to independently verify that the financial statements present fairly financial position and results

Financial analysts’ report projected earnings expectations for the market. Shareholders act on

such expectations, and if they are not the results can be a loss of share value and difficulty

2. Relevance and faithful representation are the qualitative characteristics of useful

information under SFAC 8. Evaluate these characteristics from an ethical

perspective. That is, how does ethical reasoning enter into making determinations

about the relevance and faithful representation of financial information?

Relevance relates to the usefulness of the information and whether all necessary information has

been made available for stakeholders to be able to make informed decisions. Faithful

representation addresses the honesty and integrity of the information. Is it biased or slanted to be

Accounting reports should reflect the accurate, reliable and verifiable financial position including

debt, cash flow and company performance. Relevance and representational faithfulness can be

3. Evaluate earnings management from a utilitarian perspective. Can earnings

management be an ethical practice? Discuss why or why not.

From a utilitarian perspective, the market, shareholders, investors, and other stakeholders want a

company to be profitable over the long-run. Quarterly financial reporting introduces variability

into earnings and other trends. Earnings management can smooth the short term earnings and

have little effect on the long-term earnings. Accrual accounting is a form of earnings

management for the short-term. Examples of accrual accounting that manage earnings in the

Ask the students about a product recall. How should this be accounted for? If companies could

Earnings management may be considered unethical from a virtue perspective if, when earnings

do not meet financial analysts’ earnings expectations or goals established for earnings, the

Earnings management may either ignore or not adequately consider the rights of the investors

and creditors to receive accurate, reliable and transparent financial statements. Earnings

4. Evaluate the following statements from an ethical perspective:

“Earnings management in a narrow sense is the behavior of management to play

with the discretionary accrual component to determine high or low earnings.”

“Earnings are potentially managed, because financial accounting standards still

provide alternative methods.”

The statements reflect that earnings management is a means to an end, that being increasing

earnings. The methods of managing earnings may either be ethical or unethical. Using ethical

means would led to staying in the middle of the continuum as Needles noted (and that was

Accounting allows for alternative ways to record transactions. If the choices are designed to best

reflect the financial results within the context of GAAP, then the techniques used are acceptable.

5. Comment on the statement that materiality is in the eye of the beholder. How does

this statement relate to the discussion in the chapter of how to gauge materiality in

assessing financial statement restatements? Is materiality inconsistent with the

notion of representational faithfulness?

One of the definitions of materiality is that it is the amount that would cause an investor to

change his mind about investing in a company. Normally, a rule of thumb for materiality is the

amount that would change a net income to a loss or vice versa, or 5% of revenue. However,

many investors have their own definition. Ask students what their definition of materiality is. A

student in class said that materiality is the amount of money that he would not care about if his

check book was out of balance (i.e., $1). One student claimed that it was the amount that

In late 2008, the SEC Final Report of the Advisory Committee on Improvements to Financial

Reporting recommended moving away from the professional judgment and “reasonable person”

6. Needles talks about the use of a continuum ranging from questionable or highly

conservative to fraud to assess the amount to be recorded from for an estimated

expense. Discuss his concept of a continuum and the choices within a range from an

ethical perspective. That is, how might a decision about the selection of one or

another amount in the continuum relate to it being an ethical position to take?

In Needles’s continuum, a neutral treatment is in the middle of the continuum reflecting the mid-

ground between high and low misstatements of GAAP. The continuum shows a highly

conservative amount on one end and fraudulent on the other. This continuum may be thought of

as a road with the two extremes being the curbs on either side of the road. The idea is to stay

7. Explain how the quality of corporate governance, risk management, and compliance

systems is critical in controlling financial restatement risk within organizations.

Restatements of financial statements are necessary when it is determined that a previous

statement contains a material inaccuracy. The need to restate financial figures can result from

accounting errors, noncompliance with GAAP, fraud, misrepresentation or a simple clerical error.

Internal controls or compliance systems of the company should be designed to address the issues

of accounting errors, simple clerical errors and to some extent the compliance with GAAP. The

8. In 2010 LinkedIn reported trade payable obligations totaling $10.8 million in other

accrued expenses within accrued liabilities instead of accounts payable. In 2011,

note 2 in the 10-K financial statements described the use of accrued liabilities

instead of accounts payable as a classification. Do you believe LinkedIn’s accounting

qualifies as a financial shenanigan? Why or why not?

Accounts payable is a liability account; normally it is considered a current liability or payable in

one year or less. Using the term “liabilities” instead of “payable” does not rise to a financial

The most important point is accounts payable denote trade amounts so the readers believes these

liabilities occurred as a result of purchase and other operating decisions. Accrued liabilities are

seen as adjustments to expenses to conform to the matching principle. While the use of the

9. Comment on the statement that what a company’s income statement reveals is

interesting but what it conceals is vital.

Here are some examples of where the earnings on the income statement revealed information but

 Revenue Gross-Up: Revenue Gross-Up is a practice that many internet firms used in the early

part of this decade. The companies would report the entire sales price a customer paid at their

site when in reality the companies kept only a small percentage of the amount they collected.

 Right to Return. When a company sells a product to another company and the contract gives

the company buying the product a right to return it, the selling company may have a financial

accounting duty not to recognize the revenue from the sale of the product until the right to return

 Related Service Agreements. Related service agreements may cause revenue recognition

problems. So for example, if a computer system is sold on a bundled basis at $125 million at the

time of installation and $25 million/yr for each of the three years of service, then the company

 Sale of Franchises. When a franchisor collects a high front-end fee in return for exclusive

rights to a territory the franchisers may book the fee as revenue. However, this practice could

make the growth rate in early years look spectacular but significantly drop in later years. Jiffy

10. Maines and Wahlen state in their research paper on the reliability of accounting

information: “Accrual estimates require judgment and discretion, which some firms

under certain incentive conditions will exploit to report non-neutral accruals

estimates within GAAP. Accounting standards can enhance the information in

accrual estimates by linking them to the underlying economic constructs they

portray.” Explain what the authors meant by this statement with respect to the

possible existence of earnings management.

The authors note that accrual estimates may be skewed under the right circumstances. These

accruals can be adjusted up or down to reflect desired results (earnings management) rather than

The authors note go further to note that accounting standards could be enhanced by tying the

estimates to the underlying economic constructs they portray. This is what is desired from a

representational faithfulness perspective. For example, in accounting for leases if one of four

capital lease criteria exist (i.e., transfer of ownership to lessee, bargain purchase option, lease