SS 09

SS 09 Financial Reporting and Analysis: Financial Reporting Quality
and Financial Statement Analysis
Question #1 of 51 Question ID: 500867
An analyst has decided to identify value stocks for investment by screening for companies with high book-to-market ratios and
high dividend yields. A potential drawback of using these screens to find value stocks is that the firms selected may:
A) be concentrated in specific industries.

B) be those that have significantly underperformed the market.
C) have unsustainable dividend payments.
A significant increase in days payables above historical levels is most likely associated with:
A) an increase in net working capital.

B) an unsustainable increase in reported earnings.
C) low quality of the cash flow statement.
An analyst screening potential equity investments to identify value stocks is most likely to exclude companies with:
A) high dividend payout ratios.

B) low earnings growth rates.
C) high price-to-earnings ratios.
Which of the following actions is least likely to increase earnings for the current period?
A) Decreasing the salvage value of depreciable assets.
B) Selling more inventory than is purchased or produced.

C) Recognizing revenue before fulfilling the terms of a sale.
Under which inventory cost flow assumption is a firm most likely to show an unusual increase in gross profit margin by sales in
excess of current period production?
A) LIFO.
B) Average cost.
C) FIFO.
Comet Corporation is a capital intensive, growing firm. Comet operates in an inflationary environment and its inventory quantities
are stable. Which of the following accounting methods will cause Comet to report a lower price-to-book ratio, all else equal?
Inventory method Depreciation method
A) Last-in, First-out Accelerated
B) First-in, First-out Straight-line
C) First-in, First-out Accelerated
Joe Carter, CFA, believes Triangle Equipment, a maker of large, specialized industrial equipment, has overstated the salvage
value of its equipment. This would:
A) overstate liabilities.
B) overstate earnings.
C) understate earnings.
The price to tangible book value ratio subtracts what components from equity?
A) Goodwill and intangible assets.

B) Intangible assets and property, plant and equipment.
C) Goodwill and property, plant and equipment.

Which of the following is least likely one of the combinations of the quality of financial reporting and quality of reported earnings
along the spectrum of financial report quality?
A) Reporting is not compliant with GAAP, although reported earnings are sustainable and adequate.
B) Reporting is compliant with GAAP, but the amount of earnings is actively managed to smooth
earnings.
C) Reporting is not compliant and includes numbers that are fictitious or fraudulent.
Selected financial information gathered from Alpha Company and Omega Corporation follows:
Alpha Omega
Revenue $1,650,000 $1,452,000
Earnings before interest, taxes, 69,400 79,300

depreciation, and amortization
Quick assets 216,700 211,300
Average fixed assets 300,000 323,000
Current liabilities 361,000 404,400
Interest expense 44,000 58,100
Which of the following statements is most accurate?
A) Alpha has a higher operating profit margin than Omega.
B) Omega has lower interest coverage than Alpha.

C) Omega uses its fixed assets more efficiently than Alpha.
An IFRS-reporting firm includes in its financial statements a measure that is not defined under IFRS. The firm is least likely
required to:
A) define and explain the relevance of this measure.
B) show this measure for all periods presented.
C) reconcile this measure with the most comparable IFRS measure.

A spectrum for assessing financial reporting quality should consider:
A) quality of financial reports only.

B) quality of earnings only.
C) both quality of financial reports and quality of earnings.
A mechanism to discipline financial reporting quality for securities that trade in the United States that is not typically imposed on
security issuers elsewhere is that:
A) the firm must provide a signed statement by the person responsible for preparing the financial
statements.
B) management must attest to the effectiveness of the firm's internal controls.
C) financial statements must be audited by an independent party.
Jane Epworth, CFA, is preparing pro forma financial statements for Gavin Industries, a mature U.S. manufacturing firm with three
distinct geographic divisions in the Midwest, South and West. Epworth prepares estimates of sales for each of Gavin's divisions
using economists' estimates of next-period GDP growth and sums the three estimates to forecast Gavin's sales. Epworth's
approach to estimating Gavin's sales is:
A) inappropriate, because sales should be forecast on a firm-wide basis.
B) appropriate.
C) inappropriate, because sales should be forecast on a firm-wide basis and are unlikely to be related
to GDP growth.
Baetica Company reported the following selected financial statement data for the year ended December 31, 20X7:
in millions % of Sales
For the year ended December 31, 20X7: $500 100%
Sales
Cost of goods sold (300) 60%
Selling and administration expenses (125) 25%
Depreciation (50) 10%
Net income $25 5%
As of December 31, 20X7:
Non-cash operating working capital a $100 20%
Cash balance $35 N/A
a Non-cash operating working capital = Receivables + Inventory - Payables
Baetica expects that sales will increase 20% in 20X8. In addition, Baetica expects to make fixed capital expenditures of $75
million in 20X8. Ignoring taxes, calculate Baetica's expected cash balance, as of December 31, 2008, assuming all of the
common-size percentages remain constant.
A) $30 million.
B) $80 million.
C) $40 million.
Which of the following requirements are most likely to create incentives for management to manipulate earnings?
A) Audit requirements.
B) Disclosure regulations.
C) Debt covenants.
Patch Grove Nursery uses the LIFO inventory accounting method. Maria Huff, president, wants to determine the financial
statement impact of changing to the FIFO accounting method. Selected company information follows:
Year-end inventory: $22,000

LIFO reserve: $4,000
Change in LIFO reserve: $1,000
LIFO cost of goods sold: $18,000
After-tax income: $2,000
Tax rate: 40%
Under FIFO, the nursery's ending inventory and after-tax profit for the year would have been:
FIFO ending inventory FIFO after-tax profit
A) $26,000 $2,600
B) $18,000 $2,600
C) $26,000 $1,400
A firm has a debt-to-equity ratio of 0.50 and debt equal to $35 million. The firm acquires new equipment with a 3-year operating
lease that has a present value of lease payments of $12 million. The most appropriate analyst treatment of this operating lease
will:
A) increase the debt-to-equity ratio to 0.67.

B) leave the debt-to-equity ratio unchanged at 0.5.
C) increase the debt-to-equity ratio to 0.57.
If management is manipulating financial reporting to avoid breaching an interest coverage ratio covenant on the firm's debt, they
are most likely to:
A) overstate earnings.
B) understate assets.
C) capitalize leases.
On a spectrum for assessing financial reporting quality, which of the following represents the highest quality?
A) Reporting is compliant with GAAP and decision useful but earnings are not sustainable.
B) Reporting is not compliant with GAAP but the numbers presented reflect the company's actual
activities.
C) Reporting is compliant with GAAP but reporting choices and estimates are biased.

The quality of a company's reported earnings is low when they:
A) are not sustainable.
B) do not conform to GAAP.
C) are lower than for the prior-year period.
In which of the following situations is management most likely to make conservative choices and estimates that reduce the
quality of financial reports?
A) The firm must meet accounting benchmarks to comply with debt covenants.
B) Earnings for a period will be higher than analysts' expectations.
C) Management's compensation is closely tied to near-term performance of the firm's stock.
At the end of 2007, Decatur Corporation reported last-in, first-out (LIFO) inventory of $20 million, cost of goods sold (COGS) of
$64 million, and inventory purchases of $58 million. If the LIFO reserve was $6 million at the end of 2006 and $16 million at the
end of 2007, compute first-in, first-out (FIFO) inventory at the end of 2007 and FIFO COGS for the year ended 2007.
FIFO Inventory FIFO COGS
A) $36 million $74 million
B) $26 million $54 million
C) $36 million $54 million
Portsmouth Industries has stated that in the market for their medical imaging product, their strategy is to grow their market share
in the premium segment by leveraging their research and development capabilities to produce machines with greater resolution
for the most challenging cases of spinal degeneration. An analyst examining their financials for evidence that Portsmouth is
indeed successfully pursuing this strategy would least appropriately look for:
A) an increase in net revenue.

B) decreasing cost of goods sold as a percentage of net sales.
C) an increase in average unit prices.

With regard to a firm's financial reporting quality, an analyst should most likely interpret as a warning sign a focus by
management on an increase in the firm's:
A) asset turnover ratios.

B) pro forma earnings.
C) cash from operations.
To adjust for operating leases before calculating financial statement ratios, what value should an analyst add to a firm's liabilities?
A) Difference between present values of lease payments and the asset's future earnings.
B) Sum of future operating lease obligations.
C) Present value of future operating lease payments.
A firm that uses higher estimates of assets' useful lives or salvage values relative to its peers will report:
A) lower depreciation expense and higher net income.

B) lower depreciation expense and lower net income.
C) higher depreciation expense and higher net income.
A firm recognizes a goodwill impairment in its most recent financial statement, reducing goodwill from $50 million to $40 million.
How should an analyst most appropriately adjust this financial statement for goodwill when calculating financial ratios?
A) Decrease earnings but make no adjustment to assets.

B) Make no adjustments to assets or earnings because both reflect the impairment.
C) Decrease assets and increase earnings.
Mechanisms that enforce discipline over financial reporting quality least likely include:
A) accounting standard-setting bodies.

B) government securities regulators.
C) counterparties to private contracts.
Which of the following accounting warning signs is most likely to indicate manipulation of reported operating cash flows?
A) Higher estimated salvage values than are typical in a firm's industry.

B) Capitalizing purchases that comparable firms typically expense.
C) More aggressive revenue recognition methods than comparable firms.
Would projecting future financial performance based on past trends provide a reliable basis for valuation of the following firms?
Firm #1 - A rapidly growing company that has made numerous acquisitions and divestitures.
Firm #2 - A large, well-diversified, company operating in a number of mature industries.
Firm #1 Firm #2
A) No Yes
B) Yes No
C) No No
Falcon Financial Group is considering the purchase of Company A or Company B based on a low price-to-book investment
strategy that also considers differences in solvency. Selected financial data for both firms, as of December 31, 20X7, follows:
in millions, except per-share data Company A Company B
Current assets $3,000 $5,500
Fixed assets $5,700 $5,500

Total debt $2,700 $3,500
Common equity $6,000 $7,500
Outstanding shares 500 750
Market price per share $26.00 $22.50
The firms' financial statement footnotes contain the following:
Company A values its inventory using the first in, first out (FIFO) method.
Company B's inventory is based on the last in, first out (LIFO) method. Had Company B used FIFO, its inventory would have
been $700 million higher.
Company A leases its manufacturing plant. The remaining operating lease payments total $1,600 million. Discounted at 10%,
the present value of the remaining payments is $1,000 million.
Company B owns its manufacturing plant.
To make the firms financials ratios comparable, calculate the adjusted price-to-book ratios for Company A and Company B.
Company A Company B
A) $2.17 $2.06
B) $1.63 $2.06
C) $2.17 $2.81
Cody Scott would like to screen potential equity investments to identify value stocks and selects firms that have low price-to-sales
ratios. Unfortunately, screening stocks based only on this criterion may result in stocks that have poor profitability or high financial
leverage, which are undesirable to Scott. Which of the following filters could be added to the stock screen to best control for poor
profitability and high financial leverage?
Filter #1 - Include only stocks with a debt-to-equity ratio that is above a certain benchmark value.
Filter #2 - Include only dividend paying stocks.

Filter #3 - Include only stocks with an assets-to-equity ratio that is below a certain benchmark value.
Filter #4 - Include only stocks with a positive return-on-equity.
Poor profitability High financial leverage
A) Filter #2 Filter #3
B) Filter #4 Filter #3
C) Filter #4 Filter #1
For 2007, Morris Company had 73 days of inventory on hand. Morris would like to decrease its days of inventory on hand to 50.
Morris' cost of goods sold for 2007 was $100 million. Morris expects cost of goods sold to be $124.1 million in 2008. Assuming a
365 day year, compute the impact on Morris' operating cash flow of the change in average inventory for 2008.
A) $3.0 million source of cash.

B) $3.0 million use of cash.
C) $6.3 million source of cash.
Sterling Company is a start-up technology firm that has been experiencing super-normal growth over the past two years.
Selected common-size financial information follows:
2007 Actual 2008 Forecast

% of Sales % of Sales
Sales 100% 100%
Cost of goods sold 60% 55%
Selling and administration expenses 25% 20%
Depreciation expense 10% 10%
Net income 5% 15%
Non-cash operating working capital a 20% 25%
a
Non-cash operating working capital = Receivables + Inventory - Payables
For the year ended 2007, Sterling reported sales of $20 million. Sterling expects that sales will increase 50% in 2008. Ignoring
income taxes, what is Sterling's forecast operating cash flow for the year ended 2008, and is this forecast likely to be as reliable
as a forecast for a large, well diversified, firm operating in mature industries?
Operating cash flow Reliable forecast
A) $4.0 million No
B) $4.5 million No
C) $4.0 million Yes

An analyst makes the following two statements:
Statement #1 - From a lender's perspective, higher volatility of a borrower's profit margins is undesirable for floating-rate debt but
not for fixed-rate debt.
Statement #2 - Product and geographic diversification should lower a borrower's credit risk.
With respect to these statements:
A) both are correct.

B) both are incorrect.
C) only one is correct.
In estimating pro forma cash flows for a company, analysts typically hold which of the following factors constant?
A) Sales.
B) Noncash working capital as a percentage of sales.
C) Repayments of debt.
National Scooter Company and Continental Chopper Company are motorcycle manufacturing companies. National's target
market includes consumers that are switching to motorcycles because of the high cost of operating automobiles and they
compete on price with other manufacturers. The average age of National's customers is 24 years.
Continental manufactures premium motorcycles and aftermarket accessories and competes on the basis of quality and
innovative design. Continental is in the third year of a five-year project to develop a customized hybrid motorcycle. Which of the
two firms would most likely report higher gross profit margin, and which firm would most likely report higher operating expense
stated as a percentage of total cost?
Higher gross profit margin Higher percentage operating

expense
A) Continental
National
B) National Continental
C) Continental Continental
When assessing credit risk, which of the following ratios would best measure a firm's tolerance for additional debt and a firm's
operational efficiency?
Ratio #1 - Retained cash flow (CFO - dividends) divided by total debt.

Ratio #2 - Current assets divided by current liabilities.
Ratio #3 - Earnings before interest, taxes, depreciation, and amortization divided by revenues.
Tolerance for leverage Operational efficiency
A) Ratio #3 Ratio #1
B) Ratio #1 Ratio #3
C) Ratio #2 Ratio #3
If a firm's financial reports are of low quality, can users of the reports assess the quality of the firm's earnings?
A) No, because low-quality financial reports are not useful for assessing the quality of earnings.
B) Yes, because users can assess earnings quality independently of financial reporting quality.
C) Yes, because if financial reports are of low quality, earnings are also of low quality.
With regard to the goal of neutrality in financial reporting, accounting standards related to research costs and litigation losses
should be viewed as:
A) biased toward aggressive financial reporting.
B) biased toward conservative financial reporting.

C) promoting neutral financial reporting.
Which of the following is one of circumstances that is conducive to issuing low-quality financial reports?
A) Balance sheet values are likely to violate debt covenants.
B) Earnings per share are highly variable from year to year.

C) There is a large range of acceptable accounting treatments.
Which of the following is least likely to be a motivation for managers to issue financial reports of low quality?
A) Keeping earnings above the same period in the prior year.
B) Enhancement of the manager's career.

C) Accounting controls are weak within the company.
Conditions that may cause firms to issue low-quality financial reports are best described as:
A) unstable organizational structure and deficient internal controls.
B) inappropriate ethical standards and failing to correct known reportable conditions.

C) opportunity, motivation, and rationalization.
Management is most likely to be motivated to produce low-quality financial reports when:
A) the firm is not required to abide by loan covenants.

B) managers' compensation is unrelated to the firm's share price.
C) earnings are less than analysts expect.
Other things equal, which of the following firm characteristics are most likely to be viewed favorably by credit rating agencies?
A) Large size, diverse product lines, concentrated geographic regions.

B) Large size, diverse product lines, many geographic regions.
C) Small size, focused product lines, concentrated geographic regions.

Aggressive accounting choices include:
A) decreasing the estimated useful life of an asset.

B) classifying interest paid as an investing cash flow.
C) increasing the valuation allowance of a deferred tax asset.
Which of the following is most accurately described as a characteristic of a firm's quality of earnings?
A) Relevance.
B) Sustainability.
C) Completeness.
Samantha Cameron, CFA, is analyzing the financial reporting quality of Redd Networks. Cameron examines how the company is
responding to strict debt covenants and investigates executives' holdings of stock and options in the firm, which are believed to
be quite high. Which condition that may lead to low-quality financial reporting is Cameron investigating?
A) Motivation.
B) Opportunity.
C) Rationalization.
LIFO ending inventory can be adjusted to a FIFO basis by:
A) adding the change in the LIFO reserve.

B) adding the LIFO reserve.
C) subtracting the change in the LIFO reserve.

Aggressive accounting choices by management are most likely to:
A) report sustainable earnings.
B) comply with generally accepted accounting principles.
C) produce decision-useful financial reporting.

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SS 09 Financial Reporting and Analysis: Financial Reporting Quality

and Financial Statement Analysis

Question #1 of 51 Question ID: 500867

A) be concentrated in specific industries.

Question #2 of 51 Question ID: 456304

A) an increase in net working capital.

Question #3 of 51 Question ID: 414688

A) high dividend payout ratios.

C) high price-to-earnings ratios.

Question #4 of 51 Question ID: 460655

A) Decreasing the salvage value of depreciable assets.

B) Selling more inventory than is purchased or produced.

Question #6 of 51 Question ID: 414689

Inventory method Depreciation method

A) Last-in, First-out Accelerated

B) First-in, First-out Straight-line

C) First-in, First-out Accelerated

Question #7 of 51 Question ID: 414656

Question #8 of 51 Question ID: 434321

A) Goodwill and intangible assets.

C) Goodwill and property, plant and equipment.

Question #10 of 51 Question ID: 434319

Revenue $1,650,000 $1,452,000

Earnings before interest, taxes, 69,400 79,300

Quick assets 216,700 211,300

Average fixed assets 300,000 323,000

Current liabilities 361,000 404,400

Interest expense 44,000 58,100

Which of the following statements is most accurate?

A) Alpha has a higher operating profit margin than Omega.

B) Omega has lower interest coverage than Alpha.

Question #11 of 51 Question ID: 498765

A) define and explain the relevance of this measure.

B) show this measure for all periods presented.

C) reconcile this measure with the most comparable IFRS measure.

A spectrum for assessing financial reporting quality should consider:

A) quality of financial reports only.

Question #13 of 51 Question ID: 500865

C) financial statements must be audited by an independent party.

Question #14 of 51 Question ID: 414683

A) inappropriate, because sales should be forecast on a firm-wide basis.

Question #15 of 51 Question ID: 414681

For the year ended December 31, 20X7: $500 100%

Selling and administration expenses (125) 25%

Depreciation (50) 10%

Net income $25 5%

As of December 31, 20X7:

Non-cash operating working capital a $100 20%

Cash balance $35 N/A

a Non-cash operating working capital = Receivables + Inventory - Payables

Question #16 of 51 Question ID: 460654

Question #17 of 51 Question ID: 414692

Year-end inventory: $22,000

Question #18 of 51 Question ID: 500868

A) increase the debt-to-equity ratio to 0.67.

Question #19 of 51 Question ID: 414653

Question #20 of 51 Question ID: 492018

Question #21 of 51 Question ID: 500861

A) are not sustainable.