Chapter 6-Earnings Management: Multiple Choice

Chapter 6—Earnings Management
MULTIPLE CHOICE
1. A Company showed a large restructuring charge on its income statement in 2014 and has experienced
a constantly rising earnings trend since that time. This would most nearly represent an example of
a. cookie jar reserves.
b. big bath accounting.
c. creative acquisition accounting.
d. using immaterial transactions to increase reported earnings to meet analysts' expectations.
ANS: B PTS: 1 DIF: Medium OBJ: LO 2
TOP: AICPA FN-Reporting MSC: AACSB Analytic
2. The cost of capital is defined as the

a. simple average of the interest rates of all debt outstanding.
b. simple average of the cost of debt and equity.
c. weighted average of the interest rates of all debt outstanding.
d. weighted average of the cost of debt and equity.
ANS: D PTS: 1 DIF: Easy OBJ: LO 5
TOP: AICPA FN-Measurement MSC: AACSB Reflective Thinking
3. Which of the following is true?

a. Cash flow data is superior to earnings under the accrual basis in predicting long-term
performance of an entity.
b. Earnings under the accrual basis is superior to cash flow data in predicting short-term
c. Earnings under the accrual basis is superior to cash flow data in predicting long-term
d. Cash flow data is superior to earnings under the accrual basis in predicting both short- and
long-term performance of an entity.
ANS: C PTS: 1 DIF: Medium OBJ: LO 2
TOP: AICPA FN-Measurement MSC: AACSB Analytic
4. Which of the following organizations has recommended that entities provide a reconciliation to GAAP
net income whenever reporting proforma numbers?
a. Auditing Standards Board
b. Financial Executives International
c. Financial Accounting Standards Board
d. Accounting Standards Executive Committee
ANS: B PTS: 1 DIF: Easy OBJ: LO 2
TOP: AICPA FN-Reporting MSC: AACSB Reflective Thinking
5. Which of the following is the SEC authorized by Congress to do?
I. Monitor the standard-setting process of the FASB

II. Set accounting standards
III. Investigate and punish cases of deceptive financial reporting
a. Only III
b. I and III
c. I and II
d. I, II, and III
ANS: D PTS: 1 DIF: Medium OBJ: LO 5
6. "Purchased in-process research and development" is typically associated with

a. creative acquisition accounting.
b. cookie jar reserves.
c. proforma earnings amounts.
d. big bath accounting.
ANS: A PTS: 1 DIF: Easy OBJ: LO 2
7. Which of the following is typically associated with cookie jar reserves?

a. Purchased in-process research and development
b. Recognizing very high bad debt expense when earnings are high
c. Recognizing revenue when a contract is signed prior to delivery of goods or performance
of services
d. Proforma earnings
8. Which of the following earnings management techniques is frequently associated with start-up
companies?
a. Recording immaterial adjustments that cause earnings to meet analysts' expectations.
b. Recording extremely high warranty expense when earnings are high.
c. Recognizing revenue when a contract is signed and before goods are delivered or services
are provided.
d. Expensing purchased in-process research and development.
9. Which of the following items of the earnings management continuum is in the correct order?
a. Strategic matching, change in methods or estimates with full disclosure, non-GAAP
accounting
b. Change in methods or estimates with little or no disclosure, non-GAAP accounting,
fictitious transactions
c. Strategic matching, change in methods or estimates with little of no disclosure, fictitious
transactions
d. Change in methods or estimates with full disclosure, non-GAAP accounting, fictitious
transactions
10. Which of the following typically is NOT associated with a change in estimate for accounting
purposes?
a. Return on pension fund
b. Useful life of a depreciable asset
c. Bad debt expense
d. Change in calculating depreciation from straight-line to sum-of-the-years'-digit
11. Most companies that engage in earnings management typically do NOT go beyond which of the
following activities on the earnings management continuum?
a. Strategic matching
b. Change in methods or estimates with full disclosure
c. Change in methods or estimates with little or no disclosure
d. Non-GAAP accounting
ANS: A PTS: 1 DIF: Easy OBJ: LO 2
12. Earnings management through strategic matching is best exemplified by

a. changing the useful life of a depreciable asset.
b. timing transactions such that large one-time gains and losses occur in the same quarter.
c. changing the interest rate used in accounting for leases without describing the change in
the notes to the financial statements.
d. capitalizing as assets expenditures that have no future economic benefit.
13. Recording as an asset expenditures that have no future economic benefit is an example of
a. strategic matching.
b. change in methods or estimates with full disclosure.
c. a fictitious transaction.
d. non-GAAP accounting.
14. Which of the following accounts would NOT be affected if a company failed to report returns of
merchandise sold?
a. Sales returns
b. Sales allowances
c. Cost of goods sold
d. Inventory
15. Deferring the recognition of revenue for which the earnings process is complete is an example of
a. "big bath" accounting.
b. a "cookie jar" reserve.
c. a change in an accounting estimate.
d. strategic matching.
16. Which of the following typically involves the use of non-GAAP accounting?
a. Strategic matching
b. A change in accounting estimate that is fully disclosed
c. Proforma earnings
d. A change in accounting principle that is fully disclosed
17. Excluding some revenues, expenses, gains, losses from the earnings figure calculated using generally
accepted accounting principles is an example of
a. income smoothing.
b. "big bath" accounting.
c. a "cookie jar" reserve.
d. proforma earnings.
18. Excessive earnings management typically begins as a result of

a. a regulatory investigation.
b. pressure to meet the expectations of stakeholders.
c. a downturn in business.
d. a violation of generally accepted accounting principles.
ANS: C PTS: 1 DIF: Easy OBJ: LO 4
19. The GAAP Oval best represents the

a. fact that only one true earnings number exists.
b. flexibility managers have within GAAP to report one earnings number from among many
possibilities.
c. philosophy that earnings management within limits is ethical.
d. fact that GAAP is not subject to interpretation.
20. Which of the following regarding the weighted-average cost of capital is true?
a. The tax effect of preferred stock dividends should be included in the calculation of
weighted-average cost of capital.
b. The tax effect of common stock dividends should be included in the calculation of
c. The tax effect of debt should be included in the calculation of the weighted-average cost of
capital.
d. Taxes do not affect the weighted-average cost of capital.
21. Which of the following is true regarding the weighted-average cost of capital?
a. The book value of the components of capital should always be used to calculate the
b. A company may have two weighted-average costs of capital if the firm's capital structure
is so large that new common stock must be sold.
c. The cost of common equity is lower than the cost of retained earnings.
d. The cost of preferred stock is adjusted for the tax deduction associated with preferred
dividends.
22. Which of the following services offered by investment firms have some states declared to be
incompatible with generating forecasts of company earnings?
1. Assisting a firm in an initial public offering in determining a preliminary offering price.

2. Assisting a firm in an initial public offering in determining the number of shares to be
sold.
3. Agreeing to buy the entire issue of stock in an initial public offering and reselling the
stock to investors.
4. Agreeing to put forth the firm's best effort to sell the entire issue of stock in an initial
public offering.
a. Only 3
b. Only 4
c. 3 and 4
d. 1, 2, 3, and 4
23. Which of the following is true?

a. Companies can raise common equity only by issuing new shares of common stock.
b. There is no opportunity cost associated with use of retained earnings as a source of
common equity.
c. Most large mature firms issue new shares of common stock on a regular basis.
d. Companies can raise common equity by issuing new shares of common stock and through
retained earnings.
24. Which of the following is NOT correct?

a. The after-tax cost of debt for a firm with losses is equal to the interest rate on the debt.
b. Firms always pay dividends on their common stock issues because of the ease with which
common shareholders can assume control of the firm.
c. Flotation costs for preferred stock are higher than for debt.
d. Most debt is placed privately and thus there is no flotation cost.
ANS: B PTS: 1 DIF: Challenging OBJ: LO 5
TOP: AICPA FN-Decision Modeling MSC: AACSB Analytic
25. Which of the following is NOT a function of a financial analyst?

a. Providing buy recommendations on a company’s stock
b. Providing sell recommendations on a company’s stock
c. Generating forecasts of company earnings
d. Serving as an investment banker for a company for which the analyst is providing research
coverage
26. The practice of carefully timing the recognition of revenues and expenses to even out the amount of
reported earnings from one year to the next is called
a. revenue recognition.
b. income smoothing.
c. restructuring.
d. accrual-basis accounting.
ANS: B PTS: 1 DIF: Easy OBJ: LO 1
27. Recognizing more bad debt expense in a year than is necessary in order to have flexibility in
recognizing bad debt expense in a future year is an example of
a. a big bath charge.
b. creative acquisition accounting.
c. a cookie jar reserve.
d. premature recognition of revenue.
ANS: C PTS: 1 DIF: Easy OBJ: LO 2
28. Which of the following is true about a pro forma earnings number?
a. A pro forma earnings number is in total conformity with GAAP.
b. A pro forma earnings number is a forecast of earnings in future periods.
c. Reporting pro forma earnings by companies subject to SEC regulation is illegal.
d. A pro forma earnings number is regular GAAP earnings with certain exclusions.
PROBLEM
1. One of the five techniques of earnings management identified by the Securities and Exchange
Commission relates to materiality. Independent auditors have traditionally used arbitrary quantitative
benchmarks to define how large an amount must be to be considered material.
During the course of auditing the financial statements of a company, an auditor finds some
misstatements in the client's financial statements. When combined, the misstatements, result in a 4%
overstatement of net income and a $.02 (4%) overstatement of earnings per share. The auditor's
materiality threshold is 5%, that is, an item in the financial statements must be misstated by more than
5% to be considered a material deviation from generally accepted accounting principles. On the basis
of the established materiality threshold, the auditor concludes that the deviation from GAAP is
immaterial and the accounting is permissible.
Define the term "materiality" and explain whether the auditor is justified in the conclusion that the
accounting proposed by the client is permissible.
ANS:
Materiality is defined by the FASB in its Statement of Financial Accounting Concepts No. 2 as
follows:
The omission or misstatement of an item in a financial report is material if, in light of surrounding
circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable
person relying upon the report would have been changed or been influenced by the inclusion or
correction of the item.
This definition requires that the auditor consider the facts in the context of the surrounding
circumstances. The FASB has never endorsed a quantitative threshold as the sole basis for determining
the materiality of an item. The FASB has said that the magnitude of an item by itself, without regard to
the nature of the item and the circumstances in which the judgment must be made, is not a sufficient
basis for a materiality judgement. Auditors must therefore consider qualitative and quantitative factors
in assessing an item's materiality. Among the qualitative factors that might be considered are:
-Intentional misstatements are more important than unintentional misstatements (such as clerical error)
since an intentional error reflects on the integrity and reliability of management and employees of the
client company.
-Immaterial misstatements may be material if they allow the client to avoid violation of a contractual
agreement such as a debt covenant.
-Does an immaterial misstatement affect the trend in earnings?
-Does the immaterial misstatement allow the company to meet financial analysts' expectations for the
company?
-Does the immaterial misstatement result in meeting the threshold for management bonuses where the
bonus compensation is based on earnings?
If the auditor discovers that any of the situations from the list above apply to the misstatements in
question, then the auditor should investigate each misstatement thoroughly. Reliance on a quantitative
threshold alone may not be adequate.
PTS: 1 DIF: Challenging OBJ: LO 2 TOP: AICPA FN-Measurement

MSC: AACSB Analytic
2. You are auditing a company whose management has intentionally made adjustments to various
financial statement items that are not in accordance with generally accepted accounting principles.
This behavior has occurred over a number of accounting periods. None of the individual adjustments
by itself is material and the aggregate effect on the financial statements taken as a whole is immaterial.
Top management of the client are aware of these misstatements and consider them part of their
strategic management of earnings.
Explain how you as the independent auditor should respond to this situation.
ANS:
The fact that the client's records contain intentional errors may be indicative that the client (if a public
company) has violated securities laws by failing to maintain accounting records that accurately and
fairly reflect in reasonable detail the transactions of the company. This would be considered an illegal
act and would require, among other things, that the auditor communicate with the audit committee of
the client board of directors.
The following represent important considerations in formulating a response to this situation:
-An inconsequential misstatement should be viewed differently than those that are more significant.
-The clarity of authoritative accounting guidance with respect to the misstatement (i.e., if clear and
authoritative guidance exists, the misstatement should be corrected).
-The manner in which the misstatement arose; in this case, a misstatement, even though immaterial,
that is part of an ongoing earnings management initiative sanctioned by management likely is not
acceptable
-Intentional misstatements are more important than unintentional misstatements (such as clerical error)
since an intentional error reflects on the integrity and reliability of management and employees of the
client company.
-Immaterial misstatements may be material if they allow the client to avoid violation of a contractual
agreement such as a debt covenant.
-Does an immaterial misstatement affect the trend in earnings?
-Does the immaterial misstatement allow the company to meet financial analysts' expectations for the
company?
-Does the immaterial misstatement result in meeting the threshold for management bonuses where the
bonus compensation is based on earnings?
The fact that the departure from GAAP in this case is intentional should alert the auditor to look for
motivations for the client to make such a departure. The honesty and integrity of the client must be
considered. Although immaterial, the misstatements should be closely reviewed to see if they are
motivated by any of the above mentioned factors or other factors that the auditor might identify.
PTS: 1 DIF: Challenging OBJ: LO 2 TOP: AICPA FN-Risk Analysis

MSC: AACSB Analytic
3. Several catastrophic accounting failures have occurred over the last few years. Although the details of
each failure is different, each case stems from attempts to manage earnings and thus all of these
failures have common elements.
One of the elements identified in these earnings management meltdowns is the auditor's calculated
risk.
Explain what is meant by the term "the auditor's calculated risk".
ANS:
The financial statements of an enterprise may be viewed as a negotiated settlement between the client
management and the independent auditor. Management has many incentives to portray the company in
the best light possible through the financial statements. The independent auditing firm wishes to
preserve its reputation and to avoid investor lawsuits. Accordingly, the auditor has a strong incentive
to reject any accounting treatment that appears overly optimistic. Much discussion may ensue
regarding a questionable accounting practice before management and the auditor reach an agreement
and the auditor signs the audit opinion and releases the audited statements to the public.
The auditor is faced in these situations with the choice of continuing to serve the audit client or
withdrawing from the engagement. Withdrawing from the engagement results in the loss of significant
amounts of revenue. Alternatively, continuing to serve the client when the client's actions result in an
accounting scandal can result in lawsuits, loss of reputation, loss of clients, and even the demise of the
accounting firm. The auditor's decision to sign the audit opinion thus is always a calculated risk for the
auditor. Independent auditors should not underestimate the magnitude of this risk and the devastating
effects that can result from signing an audit report in error.
PTS: 1 DIF: Medium OBJ: LO 4 TOP: AICPA FN-Risk Analysis

MSC: AACSB Analytic
4. Recent accounting scandals have raised concerns over the quality and transparency of financial
accounting and reporting in the United States. Critics of what is termed the "rules-based" system
currently used in the U.S. cite the increasingly detailed and complex nature of rule-driven accounting
pronouncements. These critics suggest that the United States should adopt a principles-based system
similar to that of the International Accounting Standards Board.
Explain what is meant by a principles-based system and the advantages and disadvantages of such a
system.
ANS:
Under a principles-based approach, the principles developed would apply more broadly than current
accounting standards under the rules-based approach. These broad principles would be applicable to a
wide variety of situations and would require more professional judgment on the part of both auditors
and preparers of financial statements in order to comply with the intent and spirit of the principles. The
wider applicability of the principles would result in less need for interpretation and detailed
implementation guidance and would be more responsive to emerging issues in the changing financial
and economic environment.
A complete, consistent, and clear conceptual framework is absolutely necessary for the development of
principles-based system. An overall reporting framework providing guidance on issues such as
materiality assessments, going-concern assessments, professional judgments, accounting policies,
consistency and presentation of comparative information also is required. A principles-based system
also may require a true and fair view override of principles in order to deal with extremely rare
circumstances in which management concludes that compliance with a requirement in a
principles-based accounting standard would be so misleading that it would conflict with the objectives
of financial accounting and reporting.
Accounting standards based on principles would result in an increase in the number of similar
transactions and events being accounted for similarly. Principles-based accounting standards should
allow participants in the financial reporting process to focus on the substance rather than the form of
transactions and events. A rules-based system often results in an emphasis of the form over the
substance of transactions and events. Comparability would be enhanced while the detail and
complexity of accounting standards would be reduced. Principles that are more broadly applicable
would reduce the need for interpretive and implementation guidance for applying accounting
standards. There would be no need for interpretations of exceptions to detailed accounting rules nor a
need for exceptions to detailed rules to achieve desired accounting results.
A principles-based approach would require a commitment by all involved in the financial reporting
process. The FASB would be required to develop a complete, consistent, and clear conceptual
framework while resisting pressure from constituents for exceptions to be included both in the
conceptual framework and in the principles developed based on the conceptual framework. The
absence of exceptions that reduce the volatility of accounting earnings, for example, must be
recognized and accepted by preparers, investors, creditors, analysts, and other users of financial
information. Historically, the demands for exceptions on the part of the FASB's constituents have been
frequent and strong. The FASB's constituency has shown a definite propensity to pressure not only the
Board but also the SEC and even Congress for exceptions under the current rules-based system.
The principles-based approach could lead to situations where professional judgments made in good
faith could result in different interpretations for similar transactions and events, thus diminishing
comparability. This may lead to a demand for interpretative guidance from the FASB regarding the
principles. If FASB adheres to a strict interpretation of the concept of principles-based accounting
standards and does not provide such guidance, other standard-setting bodies (either existing or to be
created) may emerge as providers of implementation guidance. Such guidance may be provided
without the due process procedures that have been characteristic of FASB pronouncements.
A principles-based system may be abused by those who do not apply the standards produced under
such a system in good faith consistent with the intent and spirit of the standards. Critics of the
principles-based approach suggest substituting so-called professional judgment for detailed rules and
restrictions will serve to increase rather than diminish accounting abuses as the dishonest take
advantage of the absence of specific guidance on what is and is not acceptable.
Critics also suggest that the honest manager or auditor may be hurt more than helped by
principles-based system. The detailed guidance provided by the current rules-based system not only
provides the SEC with an effective enforcement mechanism but also limits the ability of the SEC to
second-guess professional judgments. Critics of the principles-based system suggest that mounting a
viable defense when accused of faulty financial reporting will be much more difficult without detailed
rules on which to base a judgment. This could result in more frequent and costly litigation against
managers and auditors than currently exists under the existing rules-based system.
PTS: 1 DIF: Medium OBJ: LO 5 TOP: AICPA FN-Measurement

MSC: AACSB Analytic
5. Recent accounting scandals suggest the need for care on the part of an independent auditor in
accepting new clients. The independent auditor needs to know both the business of and the personnel
employed by a prospective client. All other control procedures are fruitless if a CPA chooses to serve
an undesirable client. The damage suffered as a result of associating with an undesirable client can be
irreparable.
Discuss some key issues an independent auditor should consider in the client acceptance decision.
ANS:
The following issues are relevant to the client acceptance decision:
a. Management Integrity. Can the CPA rely on the management of the prospective client
to provide meaningful disclosures and representations during the engagement?
-Has any member of management or the board ever been convicted of a criminal
offense?
-Has management ever been suspended or sanctioned by an administrative body?
-Does management take an overly aggressive position in making decisions concerning

key determinants of financial position?
-Does management take overly aggressive tax positions?
-What is management's attitude toward the company's system of internal control?
-Does management have established policies relating to budgeting, cash flow, and
costing systems?
-Is the president of the company autocratic and the board of directors passive?
-What is the professional experience and background of management and the board of
directors?
-Is executive compensation based on some measure of accounting earnings?
b. Relationships with Other Professionals. What is the relationship of the prospective

client with current and former lawyers and bankers and with the predecessor
independent auditor?
-Did the prospective client have disagreements with the predecessor independent
auditor regarding accounting principles or auditing procedures?
-Do other reputable professionals such as bankers and lawyers possess relevant
knowledge regarding the prospective client's financial stability and litigation history
and have these other professionals been contacted?
c. Risk of Association. What is the risk to the CPA of becoming associated with the
prospective client, particularly with regard to the CPA's professional reputation and
profitability?
-Is the prospective client a public company that must report to the SEC?
-Is the prospective client involved in or about to be involved in litigation?
-Has the prospective client been involved in a dispute with a regulatory agency that
might lead to litigation?
-Has the prospective client been involved in a dispute with a predecessor auditor?
-Is the prospective client engaged in legitimate business activities that do not violate
the law?
-Is the prospective client firm financially stable and does it possess sufficient liquidity?
What financial models might be applied to the prospective client firm's financial
statements to determine financial strength and liquidity?
-Is the prospective client dependent on a single customer or a small group of

customers?
d. Technical competence. Does the CPA possess the technical competence to perform the
necessary services for the prospective client, particularly when functional or industry
specialization is a factor?
-Does the CPA possess specific knowledge of the industry in which the prospective
client operates such as knowledge of industry production processes, industry
economics, industry accounting principles, industry laws and regulations, and industry
tax laws?
e. Can the prospective client pay a fee commensurate with the level of accounting and
auditing services required?
f. How should the information needed to make an informed client acceptance decision be
obtained?
-Should the CPA use a detailed checklist listing all matters relevant to the client
acceptance decision? Can a single checklist adequately cover all the issues that may
arise for any given client?
-Should the CPA use a more generalized form in which information regarding the
prospective client's circumstances as regards the issues listed above is documented in a
memorandum? Will all the necessary issues concerning the prospective client be
covered without a checklist?
-What financial models (e.g., Altman's z-score to predict bankruptcy) are available to
evaluate the prospective client financially?
PTS: 1 DIF: Challenging OBJ: LO 4 TOP: AICPA FN-Risk Analysis

MSC: AACSB Analytic
6. The Securities and Exchange Commission (SEC) has the right granted to it by Congress to issue
accounting standards. The Commission has exercised this right on a relatively infrequent basis. The
SEC is not a passive observer to the financial accounting standard setting process, however.
Explain the general mission of the SEC and how the SEC fulfills its mission as regards financial
reporting specifically.
ANS:
The primary mission of the SEC is to protect investors and maintain the integrity of the securities
markets. In terms of financial reporting specifically, this means that the SEC monitors the accounting
standard-setting process of the FASB. One former Chief Accountant of the SEC described the
atmosphere in which the SEC and the FASB work as one of "mutual surprise". The SEC and FASB are
in nearly daily communication. A representative of the SEC attends the meetings of both the Financial
Accounting Standards Board and the Emerging Issues Task Force. The SEC has officially endorsed the
FASB as the official financial accounting standard setting body. The SEC has great influence on the
FASB's agenda in terms not only of which projects are admitted to the agenda but also what position
on the agenda the projects occupy.
The SEC has the right to establish accounting standards but has rarely exercised that right. The SEC
typically acts to encourage the FASB to resolve issues the Commission views as important to the
integrity of financial accounting and reporting.
The SEC also requires companies issuing securities that will be issued to the public to make quarterly
as well as annual financial statements available to investors on a timely basis. This is part of the
Commission's efforts to protect investors who would otherwise have great difficulty obtaining
financial information from companies whose stock these investors hold. The 10-Q is the quarterly
report while the 10-K is the annual report.
PTS: 1 DIF: Medium OBJ: LO 5 TOP: AICPA FN-Reporting

MSC: AACSB Reflective Thinking
7. The following summarized information is available for Saunders Company at December 31 of the
current year:
Recorded Value Market Value

Dollars Percent Dollars Percent
Long-term Debt $ 750 32% $ 620 18%
Preferred Stock 100 4% 90 2%
Common Stock 1,500 64% 1,700 80%
Total $2,350 100% $2,410 100%
The debt of Saunders has a before-tax cost rate of 12%, preferred stock has a cost of 12.3%, and
common equity has a cost of 14.6%. The tax rate for Saunders is 34%.
Calculate the weighted average cost of capital for Saunders at December 31 of the current year.
ANS:
Weight-average Cost of Capital = 0.18 (12.0%)(1 - 0.34) + 0.02(12.3%) + 0.80(14.6%)
= 1.43% + 0.25% + 11.7%
= .133516 = 13.35%

MSC: AACSB Analytic
8. The following summarized information is available for Eastern Valley Company at December 31 of
the current year:
Recorded Value Market Value

Dollars Percent Dollars Percent
Long-term Debt $ 800 31% $ 825 31%
Preferred Stock 150 6% 95 4%
Common Stock 1,600 63% 1,700 65%
Total $2,550 100% $2,620 100%
The debt of Eastern Valley has a before-tax cost rate of 11.5%, preferred stock has a cost of 12.1%,
and common equity has a cost of 14.2%. The tax rate for Eastern Valley is 34%.
Calculate the weighted average cost of capital for Eastern Valley at December 31 of the current year.
ANS:
Weight-average Cost of Capital = 0.31 (11.5%)(1 - 0.34) + 0.04(12.1%) + 0.65(14.2%)
= 2.35% + 0.48% + 9.23%
= 12.06%

MSC: AACSB Analytic
9. Research has shown that numerous companies manage their earnings. A variety of earnings
management techniques are available ranging from income smoothing to outright fraud.
Define income smoothing and explain how it is implemented.
ANS:
Income smoothing is the careful timing of the recognition of revenues and expenses in order to reduce
the volatility of income. Managers of many companies seek to report gradual and continual increases
in income in the belief that investors view an erratic earnings trend as being more risky than a smooth
trend. These managers fear the economic consequences of lower earnings in the form of reduced stock
prices, higher borrowing costs, or possible technical default as a result of noncompliance with debt
covenants.
Income smoothing can be implemented in a number of ways. Large corporations with diverse
operating units can match a large one-time loss for one operating unit with a large one-time gain of
another operating unit to achieve the desired earnings result. Careful timing of the recognition of such
gains and losses can eliminate much of the volatility in earnings. Other means of smoothing include
deferring revenues from sales to a later period or accelerating the recognition of sales revenue to the
current period. Prices of products also can be lowered to facilitate additional sales that otherwise might
not have occurred.
Expenses can be used to smooth income as well. A purchaser can persuade a supplier to split a single
purchase order into several orders with invoice dates in more than one accounting period. Bad debt
expense, warranty expense, and other estimated expenses can be manipulated to reach a desired
earnings goal. Oil and gas companies have particular flexibility in their choice of when to declare a dry
well as unsuccessful thus timing needed reductions in income to suit their needs.

10. Internal earnings targets represent an important tool in motivating managers to increase sales efforts,
control costs, and use resources more efficiently. Such internal targets also can cause managers to
resort to extreme measures in order to meet goals established by upper management. Earnings
management often appears in a variety of forms as a means of reaching these internal goals.
Earnings management also is associated with earnings-based internal bonus plans which are also a
form of internal target.
Explain how earnings management is related to earnings-based internal bonus plans and how managers
behave in response to such plans.
ANS:
Academic research has shown that managers subject to an earnings-based bonus plan are indeed
motivated to manage earnings. Managers are likely to manage earnings upward if they are close to the
bonus threshold. Conversely, research has shown that managers are more likely to manage earnings
downward if reported earnings are substantially in excess of the maximum bonus level, causing
managers to defer these excess earnings for use in future periods when operating results may be less
favorable.
Bonus plans typically provide a maximum amount that can be transferred to the bonus pool from
which bonuses are paid. The maximum transfer usually is some percentage of earnings over a target
earnings number, the target frequently being a percentage of shareholder equity or total assets. When
earnings are below the target, no bonuses are awarded.
If actual earnings are above the upper bound, managers have an incentive to reduce reported earnings
by deferring earnings. Failure to defer the earnings in excess of the upper bound would resort in the
loss of the bonus on the excess earnings. Alternatively, deferring the excess earnings increases
expected future bonuses.
If actual earnings are between the target and the upper bound, managers will take steps to ensure that
the current period's earnings are equal to the upper bound in an effort to maximize the amount received
currently. If earnings are below the target, then manager may engage in "big bath" accounting and
recognize as much expense as possible in the current period in order to avoid recognizing such
expenses in the future.

MSC: AACSB Analytic
11. Trashbin is a waste disposal company. Explain the effect the following actions of the management of
Trashbin Company might have in managing earnings:
1. Management assigned unsupported and inflated salvage values and extended the useful
lives of company garbage trucks.
2. Management assigned arbitrary salvage values to other assets that previously had not
salvage value.
3. Management did not record expenses required to write off the costs of unsuccessful and
abandoned landfill development projects.
4. Management recorded inflated environmental liabilities in connection with acquisitions
of other companies.
5. Management improperly capitalized a variety of expenses.
6. Management did not establish sufficient liabilities for income taxes and other expenses.
ANS:
1. Unsupported and inflated salvage values for the garbage trucks (a major category of
asset for a company in this line of business) would reduce the depreciable base and thus
reduce periodic depreciation expense. The effect would be to increase net income or
reduce net losses. Extending the useful lives of the trucks would result in a smaller
depreciation charge against income each period.
2. Newly-assigned, arbitrary salvage values would result in a smaller depreciable base and
thus lower amounts of depreciation expense and would increase net income or decrease
net losses.
3. Failure to write-off unsuccessful landfill development projects would overstate both net
income and assets.
4. The acquisition of another company often entails assuming environmental liabilities
associated with the operations of the acquired company. Overstating these liabilities
allows management to subsequently record expenditures (perhaps even those having
nothing to do with environmental liabilities) by reducing these liabilities rather than
properly recording the expenditures as expenses.
5. Improper capitalization of expenses defers these amounts on the balance sheet and
allows them to be amortized against revenues over an extended period of time (or to not
be expensed at all).
6. Failure to record expenses incurred increases net income or decreases net losses and
understates liabilities on the balance sheet.

MSC: AACSB Analytic
12. The term “earnings quality” refers to the ability of reported earnings to predict an entity’s future
earnings. To enhance predictability, financial analysts attempt to distinguish between a company’s
transitory earnings (transactions or events not likely to occur in the future) and its permanent earnings.
It is tempting to assume that transitory earnings are represented primarily by discontinued operations
and extraordinary items. All items of revenue and expense included in operating income may not be
permanent, however. Restructuring costs often are included in determining operating income, yet may
or may not continue in the future.
Required:
Do you think restructuring costs represent transitory earnings or permanent earnings? Explain.
ANS:
Restructuring costs might represent either transitory earnings or permanent earnings. The
determination is very much dependent on the history of a company in recording such charges. Some
would argue that for a company recording frequent restructuring charges such charges represent more
of a permanent element of earnings. Much of the determination depends on the nature of the
restructuring charges. Information provided in the notes to the financial statements describing the
nature of the restructuring and management’s future plans is vital in determining if the restructuring
charge is permanent or transitory.
PTS: 1 DIF: Challenging OBJ: LO 2 TOP: AICPA FN-Reporting

MSC: AACSB Analytic
13. Managers of many companies frequently provide a pro forma earnings amount in conjunction with
their annual or quarterly earnings calculated in accordance with GAAP. Managers claim that pro forma
earnings numbers more fairly reflect a company’s performance.
Required:
1. Explain the meaning of the term “pro forma earnings”.

2. Discuss the advantages and disadvantages of reporting pro forma earnings numbers.
ANS:
1. Pro forma earnings are the regular GAAP earnings number with certain revenue,
expense, gains, or losses excluded. The exclusions are made on the premise that
earnings measured in conformity with GAAP do not fairly reflect the company’s
performance. Pro forma earnings may be viewed as representing management’s view
conception of permanent earnings.
2. The key issue regarding pro forma earnings is whether the number helps financial
statement users better understand a company or whether it represents an attempt to
disguise poor financial results. Research on pro forma earnings has demonstrated that
both answers may be correct.
For some companies, the pro forma earnings number may be a more accurate reflection
of the entity’s economic performance than GAAP net income. In this case, the pro forma
earnings number allows managers to provide additional useful information to the
financial statement user.
Pro forma earnings numbers can also be controversial as they may represent
management’s biased view of permanent earnings. Managers may use pro forma
earnings to hide poor operating performance.
Pro forma earnings may represent an extension of the choices available to managers in
reporting GAAP earnings. A trustworthy manager that provides reliable GAAP earnings
can be expected to reveal even more useful information through the means of pro forma
earnings. Similarly, a deceitful manager will provide unreliable GAAP earnings and
deceptive pro forma earnings. The dilemma is distinguishing between the reliable
manager and the deceitful manager.

MSC: AACSB Analytic
14. The existence of earnings management techniques does not justify their use. Some would say that any
form of earnings management is unethical. Others would say that some amount of earnings
management within certain bounds is necessary to survival in the modern world.
Required:
Is earnings management ethical?
ANS:
Universal agreement exists that creating fictitious transactions is unethical. Universal agreement also
exists that short of reporting fictitious transactions, managers have a broad range of options available
to them as regards the application of generally accepted accounting principles in the reporting of
earnings. Managers are faced with the choice of reporting the most conservative, worst-case number,
the most optimistic, highest earnings number, or something between these two extremes.
One method of achieving a particular earnings amount is a change in accounting estimate or principle.
Managers may choose to make a change in accounting estimate or principle within the bounds of
GAAP. Questions then arise as to whether the change really results in an earnings figure that more
accurately reflects the financial position, operations, or cash flows of an entity, or whether the change
is made in order to achieve a specific earnings amount and perhaps even deceive the users of financial
information. Managers also face the task of determining the level of disclosure required to sufficiently
inform the user of financial information regarding an accounting change and to avoid deception.
Should managers make such a change?
Managers also have an ethical and fiduciary responsibility to carefully manage resources of a publicly
traded company in order to maximize the value to the shareholder. Investors and creditors are unlikely
to be willing to risk providing funds to a company that does not appear to be capable of succeeding.
Accounting income is viewed as a key measure (though not the only measure) of an enterprise’s
success. This line of reasoning suggests that managers have a responsibility to manage reported
earnings within the constraints of generally accepted accounting principles.
The cost of capital is another consideration in the debate of managing earnings. The cost of capital is
the cost a company bears to obtain external financing. The more reliable the information provided by a
company, the more confidence potential investors and creditors can place in that information. Better
decisions can made if high-quality information is available. The ability to make better decisions
reduces the risk to potential investors and creditors and thus reduces a company’s cost of capital.
Many managers would suggest that some level of earnings management is necessary for an entity to
survive in the current business environment. This earnings management must always remain within the
bounds of GAAP. Managers face a trade-off between say strategically matching gains and losses
versus not being able to obtain financing for their companies in order to ensure the survival of these
companies. These managers hold that strategically matching gains and losses, for example, is far less
costly and damaging to investors and creditors than to endanger the enterprise’s continued existence as
a result of not being able to obtain financing.
Earnings management is a function of a manager’s personal ethics. Each individual must be constantly
aware of the earnings management continuum and where his/her behavior falls on that continuum.
Each individual also must be aware of how close he/she is to the boundaries of what is acceptable
under GAAP. Proper corporate governance policies can be helpful in creating a process for boards of
directors to review the earnings management activities of a company’s management. The overly
optimistic attitude of corporate managers and the temptations to always hit the earnings target can be
controlled by the constant supervision of an active and qualified board of directors.

MSC: AACSB Ethics
15. Earnings management can range from methods that suggest astute management to outright fraud.
Required:
1. Identify and discuss the activities on the earnings management continuum.

2. Express your opinion as to where on the earnings management continuum most
companies likely fall.
ANS:
1. The activities on the earnings management continuum are as follows:
a. Strategic Matching. Many companies time transactions so that large one-time gains and
losses occur in the same quarter in an attempt to smooth income. These companies are
continuously aware of the benefits of meeting earnings targets and/or reporting a stable
stream of income. These benefits may be realized by accelerating or delaying the
completion of certain key transactions so that these transactions are recognized in the
most advantageous quarter.
b. Change in Methods or Estimates with Full Disclosure. Companies frequently change
accounting estimates such as the percentage receivables not expected to be collected, the
useful lives of depreciable assets, and the return on pension fund assets. These changes
often are simply a part of ordinary business activities, but, when applied aggressively,
these changes can be used to manage the amount of reported earnings. Full disclosure of
these changes allows reasonably sophisticated financial statement users to determine if a
change is motivated by the need to manage earnings or by legitimate business reasons.
c. Change in Methods or Estimates with Little or No Disclosure. Changes in accounting
principles or estimates are sometimes made without full disclosure. The lack of full
disclosure may make it difficult, if not impossible, for the financial statement user to
determine either the nature of the change effected or the motivation for the change.
Changes in methods or estimates with little or no disclosure constitute deceptive
accounting.
d. Non-GAAP Accounting. Although non-GAAP accounting can result from inadvertent
errors, this earnings management tool also can result in fraudulent financial reporting.
As an example, business entities are required to capitalize and amortize expenditures for
assets that benefit more than one accounting period. Capitalizing and amortizing over a
number of accounting periods an expenditure that benefits only one accounting period
results in fraudulent financial reporting.
e. Fictitious Transactions or the Concealment of Actual Transactions That Affect the
Financial Position or Results of Operations of a Business Entity Adversely. These
approaches represent outright fraud. Recording sales as a result of channel stuffing is an
example of a fictitious transaction. Failing to record the return of goods sold as a result
of customer dissatisfaction is an example of concealing transactions that have an adverse
effect on the finances of a business.
2. Many reputable companies engage in the legitimate practice of the strategic timing of
transactions. Techniques utilized beyond strategic timing of transactions usually are
employed as a result of operating results falling short of targets. Changing methods or
estimates can easily lead to even more egregious methods if operating results continue to
deteriorate.

MSC: AACSB Ethics
16. Net income is a key number for shareholders, creditors, and analysts alike. Indeed, analysts’
projections of net income for a company are viewed as a standard a company must achieve for a period
of time. Failure to achieve this standard can have devastating effects on a company’s stock price and
its management.
The importance of net income in the eyes of analysts and others can tempt managers to take steps to
ensure that the appropriate level of net income is achieved. The process of manipulated net income to
achieve a desired level of earnings is referred to as earnings management.
Required:
List and explain the economic motivations for earnings management.
ANS:
There are four economic motivations for earnings management. They are:
1. Meet internal targets.Internal earnings targets are important tools in motivating
managers to increase sales, control costs, and use resources efficiently. Unfortunately,
the economic factors underlying a metric may be overshadowed by the desire of
managers to achieve the measured number itself.
The pressure to achieve the target level of earnings may cause managers to engage in
activities that are fraudulent and unlawful. More than one manager has tried to recognize
additional revenue during a period through creating fictitious sales transactions or
recording valid sales in the wrong accounting period. Some managers have forced their
customers to accept goods that the customers had not ordered and did not want in return
for not having to pay the vendor of the goods until the goods ultimately sold. This is
referred to as “channel stuffing”. All of these activities have occurred as the result of the
desire of managers to achieve budgetary and other goals so that they might remain
employed.
The existence of a bonus plan in which amounts awarded to management are based on
net income has been shown by academic researchers to be a motivation for managers to
engage in earnings management. Researchers have found that managers subject to the
bonus will manage earnings upward if earnings are near the bonus threshold.
Researchers also have demonstrated that managers will manage earnings downward if
the reported earnings are substantially greater than the maximum bonus level, thus defer
earnings to the next period to compensate for unfavorable earnings results. The
existence of earnings-based bonus plans and the accompanying temptations such plans
create for managers is major factor in the independent auditor’s assessing levels of audit
risk and designing of audit plans and programs.
2. Meet external expectations. A wide variety of stakeholders have an interest in the

company’s financial performance. Employees and suppliers want to see the entity thrive
in order to maintain continued employment and associated benefits and sales,
respectively.
Financial analysts make buy and sell recommendations to investors regarding company
stocks. Analysts prepare forecasts of the financial performance of companies as part of
their buy and sell recommendations. Analyst forecasts must be met in order to avoid a
drop in the market price of a company’s shares-actual net income must equal or exceed
the net income forecasted by the analyst! Managers of companies for which the net
income is just slightly below the analysts’ forecasts have a strong incentive to use
accounting assumptions to manipulate the level of earnings to the forecasted level.
3. Provide income smoothing. Investors, creditors, and others are interested in companies
whose earnings are increasing steadily year after year at a reasonable, sustainable rate.
Investors, creditors, and other external stakeholders interested in the enterprise derive a
sense of stability, reliability, and reduced risk related to the company if company
earnings are rising at a sustainable rate. It is an axiom that managers want no earnings
surprises.
The desire to avoid earnings surprises and maintain sustainable growth in earnings
encourages managers to consider using aggressive accounting assumptions in order to
defer or accelerate the recognition of revenues and expenses and to avoid earnings
volatility. Less volatility in earnings through income smoothing is attractive both to
investors buying stock and creditors extending loans.
4. Provide window dressing for an Initial Public Offering (IPO) or a loan. Research has
demonstrated that managers will engage in earnings management activities just prior to
IPOs and to making a large loan application. An increase in reported earnings can help
to ensure a successful IPO or a loan.

MSC: AACSB Ethics
17. Statement of Financial Accounting Concepts No. 1, “Objectives of Financial Reporting by Business
Enterprises,” identifies investors and creditors as the primary users of financial reporting information.
Investors in public companies express their opinions about an entity’s equity securities through
organized exchanges such as the New York Stock Exchange. Given that investors represent one of the
two primary groups to which financial reporting is directed, accountants and auditors preparing and
opining on, respectively, the financial statements of public companies should be aware of the effects of
the quality of financial reporting on stock prices.
Required:
Identify four major periods of decline in worldwide stock prices for the years 1997 through 2002 and
discuss the role (if any ) of financial reporting in these declines.
ANS:
The four major periods of decline in worldwide stock prices for the period 1997 through 2002 and the
role of financial reporting in these stock price declines are as follows:
1. The first period of decline occurred in 1997. This decline was a result of concerns by
investors regarding the reliability of banking and financial information in a number of
Asian countries.
2. The second period of decline occurred in 2000. This resulted primarily from the highly
speculative period associated with purported business possibilities related to the Internet.
Many investors relied on nonfinancial measures of success as guides to their investment
decisions. These nonfinancial measures were not found to demonstrate high correlation
with the ability of a company to generate profits through the use of the Internet. Many
investors failed even to consider financial information and, in many instances, were
making investment decisions based on unsupported promises of managers promoting the
stocks of their companies.
3. The third period of decline occurred as a result of the political and economic uncertainty
created by the September 11, 2001 terrorist attacks. Financial reporting did not have a
major (if any) role in creating this decline.
4. The fourth period of decline began in 2002. This decline was directly related to the lack
of credibility of the financial reports of U.S. corporations. This period brought to light
several accounting frauds resulting from the misapplication or outright violation of
generally accepted accounting principles.

18. The cost of capital is the cost a company bears to obtain external financing. A company’s cost of
capital is critical because it determines which long-term projects are profitable for the entity to
undertake. The higher the cost to obtain funds, the fewer the long-term projects are profitable for a
company to pursue.
Required:
Explain the role of financial statements generally and the roles of the FASB, the AICPA, the SEC, and
the IASB in lowering the cost of capital.
ANS:
The more risk associated with a company, the higher its cost of capital. One risk factor is the
information associated with uncertainty about a company’s future prospects. A company produces
financial statements to better inform investors and creditors of the entity’s past performance. The
information contained in the financial statements is used as a basis for forecasting the company’s
future performance. Quality financial statements reduce the uncertainty of investors and creditors. This
reduction of uncertainty results in investors and creditors providing financing at a lower cost.
Deterioration of the quality and credibility of financial statements does nothing to reduce the
information risk associated with a company and results in raising a company’s cost of capital.
The FASB and the AICPA help lower the cost of capital in the United States by promulgating uniform
recognition and disclosure standards to be applied by U.S. companies. The extensive and high-quality
accounting standards of the United States result in the reduction of information risk and thus help to
lower the cost of capital for U.S. companies.
The SEC serves to protect investors and to maintain the integrity of securities markets. The SEC plays
a specific role in protecting investors as regards financial reporting through is monitoring of the
standard-setting process of the FASB and through its quarterly and annual reporting requirements. The
SEC also investigates and punishes cases of deceptive financial reporting. The SEC’s actions increase
the reliability of the financial statements of companies trading on the U.S. securities markets. The
SEC’s actions contribute toward reducing information risk and lowering the cost of capital.
Transparent and reliable financial information is extremely important to providers of capital

internationally. Companies requiring investment capital may be in a different business environment
and a different culture than those providing the capital. The efforts of the IASB in developing
international accounting standards also serves to lower the cost of capital by lowering information risk.

19. One of the four factors that motivate managers to manage reported earnings is meeting
external expectations. Which external stakeholders have an interest in a company’s financial
performance, and why?
ANS:
Employees are interested in the long-term success of a company so that they may depend on
long and stable employment and count on the company delivering on its pension
commitments.
Customers are interested in a company’s financial performance because they expect the
company to make good on its warranty commitments.
Suppliers are interested in the consistently good financial performance of a company because
they want assurance of payment and more importantly, that the company remains a reliable
purchaser of the supplier’s products.
Current and potential stockholders base their buy, sell, or hold decisions on a company’s
financial performance.
PTS: 1 DIF: Easy OBJ: LO 1 TOP: AICPA FN--Reporting

MSC: AACSB Ethics

Chapter 6-Earnings Management: Multiple Choice

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Chapter 6-Earnings Management: Multiple Choice

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Chapter 6—Earnings Management

2. The cost of capital is defined as the

3. Which of the following is true?

5. Which of the following is the SEC authorized by Congress to do?

I. Monitor the standard-setting process of the FASB

6. "Purchased in-process research and development" is typically associated with

7. Which of the following is typically associated with cookie jar reserves?

12. Earnings management through strategic matching is best exemplified by

18. Excessive earnings management typically begins as a result of

19. The GAAP Oval best represents the

1. Assisting a firm in an initial public offering in determining a preliminary offering price.

23. Which of the following is true?

24. Which of the following is NOT correct?

25. Which of the following is NOT a function of a financial analyst?

-Does an immaterial misstatement affect the trend in earnings?

PTS: 1 DIF: Challenging OBJ: LO 2 TOP: AICPA FN-Measurement

The following represent important considerations in formulating a response to this situation:

-Does an immaterial misstatement affect the trend in earnings?

PTS: 1 DIF: Challenging OBJ: LO 2 TOP: AICPA FN-Risk Analysis

Explain what is meant by the term "the auditor's calculated risk".

PTS: 1 DIF: Medium OBJ: LO 4 TOP: AICPA FN-Risk Analysis

PTS: 1 DIF: Medium OBJ: LO 5 TOP: AICPA FN-Measurement

-Has management ever been suspended or sanctioned by an administrative body?

-Does management take an overly aggressive position in making decisions concerning

-Does management take overly aggressive tax positions?

-What is management's attitude toward the company's system of internal control?

-Is executive compensation based on some measure of accounting earnings?

b. Relationships with Other Professionals. What is the relationship of the prospective

-Is the prospective client involved in or about to be involved in litigation?

-Is the prospective client dependent on a single customer or a small group of

PTS: 1 DIF: Challenging OBJ: LO 4 TOP: AICPA FN-Risk Analysis

PTS: 1 DIF: Medium OBJ: LO 5 TOP: AICPA FN-Reporting

Recorded Value Market Value

PTS: 1 DIF: Medium OBJ: LO 5 TOP: AICPA FN-Measurement

Recorded Value Market Value

PTS: 1 DIF: Medium OBJ: LO 5 TOP: AICPA FN-Measurement

Define income smoothing and explain how it is implemented.

PTS: 1 DIF: Medium OBJ: LO 1 TOP: AICPA FN-Reporting

PTS: 1 DIF: Medium OBJ: LO 1 TOP: AICPA FN-Reporting

PTS: 1 DIF: Medium OBJ: LO 2 TOP: AICPA FN-Measurement

PTS: 1 DIF: Challenging OBJ: LO 2 TOP: AICPA FN-Reporting

1. Explain the meaning of the term “pro forma earnings”.

PTS: 1 DIF: Medium OBJ: LO 2 TOP: AICPA FN-Measurement

Is earnings management ethical?

PTS: 1 DIF: Challenging OBJ: LO 3 TOP: AICPA FN-Reporting

1. Identify and discuss the activities on the earnings management continuum.

PTS: 1 DIF: Challenging OBJ: LO 2 TOP: AICPA FN-Reporting

List and explain the economic motivations for earnings management.

2. Meet external expectations. A wide variety of stakeholders have an interest in the

PTS: 1 DIF: Medium OBJ: LO 1 TOP: AICPA FN-Measurement

PTS: 1 DIF: Medium OBJ: LO 4 TOP: AICPA FN-Reporting

Transparent and reliable financial information is extremely important to providers of capital

PTS: 1 DIF: Medium OBJ: LO 5 TOP: AICPA FN-Reporting

PTS: 1 DIF: Easy OBJ: LO 1 TOP: AICPA FN--Reporting

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