FINANCIAL REPORTING AND

ANALYSIS : FINANCIAL REPORTING

QUALITY AND FINANCIAL
STATEMENT ANALYSIS

FINANCIAL REPORTING QUALITY

Overview —
 Los a distinguish between financial reporting quality and quality of reported results (including
quality of earnings, cash flow, and balance sheet items);
 Los b describe a spectrum for assessing financial reporting quality;
 Los c distinguish between conservative and aggressive accounting;
 Los d describe motivations that might cause management to issue financial reports that are not high
quality;
 Los e describe conditions that are conducive to issuing low- quality, or even fraudulent, financial
reports;
 Los f describe mechanisms that discipline financial reporting quality and the potential limitations of
those mechanisms;
 Los g describe presentation choices, including non- GAAP measures, that could be used to influence
an analyst’s opinion;
 Los h describe accounting methods (choices and estimates) that could be used to manage earnings,
cash flow, and balance sheet items;
 Los i describe accounting warning signs and methods for detecting manipulation of information in
financial reports.

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 CLASS WORK QUESTIONS

1. The information provided by a low-quality financial report will most likely:

A. decrease company value.
B. indicate earnings are not sustainable.
C. impede the assessment of earnings quality.
2. To properly assess a company’s past performance, an analyst requires:
A. high earnings quality.
B. high financial reporting quality.
C. both high earnings quality and high financial reporting quality.
3. Low quality earnings most likely reflect:
A. low-quality financial reporting.
B. company activities which are unsustainable.
C. information that does not faithfully represent company activities.
4. Financial reports of the lowest level of quality reflect:
A. fictitious events.
B. biased accounting choices.
C. accounting that is non-compliant with GAAP.
5. If a particular accounting choice is considered aggressive in nature, then the financial performance for the
current period would most likely:
A. be neutral.
B. exhibit an upward bias.
C. exhibit a downward bias.
6. Which of the following is most likely to reflect conservative accounting choices?
A. Decreased reported earnings in later periods
B. Increased reported earnings in the current period
C. Increased debt reported on the balance sheet at the end of the current period
7. Which of the following statements most likely describes a situation that would motivate a manager to issue
low-quality financial reports?
A. The manager’s compensation is tied to stock price performance.
B. The manager has increased the market share of products significantly.
C. The manager has brought the company’s profitability to a level higher than competitors.
8. A company is experiencing a period of strong financial performance. In order to increase the likelihood of
exceeding analysts’ earnings forecasts in the next reporting period, the company would most
likely undertake accounting choices that:
A. inflate reported revenue in the current period.
B. delay expense recognition in the current period.
C. accelerate expense recognition in the current period.
9. Which of the following situations will most likely motivate managers to inflate earnings in the current
period?
A. Possibility of bond covenant violation
B. Earnings in excess of analysts’ forecasts
C. Earnings that are greater than the previous year
10. Which of the following best describes an opportunity for management to issue low-quality financial
reports?
A. Ineffective board of directors

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 B. Pressure to achieve some performance level
C. Corporate concerns about financing in the future
11. An audit opinion of a company’s financial reports is most likely intended to:
A. detect fraud.
B. reveal misstatements.
C. assure that financial information is presented fairly.
12. If a company uses a non-GAAP financial measure in an SEC filing, then the company must:
A. give more prominence to the non-GAAP measure if it is used in earnings releases.
B. provide a reconciliation of the non-GAAP measure and equivalent GAAP measure.
C. exclude charges requiring cash settlement from any non-GAAP liquidity measures.
13. A company wishing to increase earnings in the current period may choose to:
A. decrease the useful life of depreciable assets.
B. lower estimates of uncollectible accounts receivables.
C. classify a purchase as an expense rather than a capital expenditure.
14. Bias in revenue recognition would least likely be suspected if:
A. the firm engages in barter transactions.
B. reported revenue is higher than the previous quarter.
C. revenue is recognized before goods are shipped to customers.
15. Which of the following is an indication that a company may be recognizing revenue prematurely?
Relative to its competitors, the company’s:
A. asset turnover is decreasing.
B. receivables turnover is increasing.
C. days sales outstanding is increasing.
16. Which of the following would most likely signal that a company may be using aggressive accrual
accounting policies to shift current expenses to later periods? Over the last five-year period, the ratio of
cash flow to net income has:
A. increased each year.
B. decreased each year.
C. fluctuated from year to year.
17. A firm reports net income of $40 million. The firm's financial statements disclose in management's
discussion and analysis that $30 million of net income is attributable to a gain on the sale of assets. Based
only on this information, for this period, the firm is best described as having high quality of:
A. financial reporting only.
B. both earnings and financial reporting.
C. neither earnings nor financial reporting.
18. Which of the following financial reports are considered to be of the lowest quality? Financial reports that
reflect:
A. unsustainable earnings.
B. biased accounting choices.
C. departures from accounting principles.
19. Financial reporting is most likely to be decision useful when management's accounting choices are:
A. neutral.
B. aggressive.
C. conservative.
20. Which of the following is least likely to be a motivation to over report earnings?
A. Reduce tax obligations.
B. Meet analyst expectations.
C. Remain in compliance with bond covenants.

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21. With respect to conditions that may lead to low-quality financial reporting, ineffective internal controls
are best described as a(n):
A. motivation.
B. opportunity.
C. rationalization.
22. A limitation on the effectiveness of auditing in ensuring financial reporting quality is that:
A. detecting fraud is not the objective of audits.
B. public firms are not required to obtain audit opinions.
C. auditors may only issue a qualified or unqualified opinion but do not explain why.
23. Under IFRS, a firm that presents a nonstandard financial measure is least likely required to:
A. provide the same measure for at least two prior periods.
B. explain the reasons for presenting the nonstandard measure.
C. reconcile the nonstandard measure to a comparable standard measure.
24. For the current period, inappropriate capitalization is most likely to:
A. overstate revenues.
B. understate liabilities.
C. understate expenses.
25. A potential warning sign that a firm is engaging in channel stuffing is an unusual increase in the firm's:
A. receivables turnover.
B. days of sales outstanding.
C. number of days of payables.

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 SOLUTIONS
1. C is correct. Financial reporting quality pertains to the quality of the information contained in financial
reports. High-quality financial reports provide decision-useful information that faithfully represents the
economic reality of the company. Low-quality financial reports impede assessment of earnings quality.
Financial reporting quality is distinguishable from earnings quality, which pertains to the earnings and
cash generated by the company’s actual economic activities and the resulting financial condition. Low
quality earnings are not sustainable and decrease company value.
2. B is correct. Financial reporting quality pertains to the quality of the information contained in financial
reports. If financial reporting quality is low, the information provided is not useful to assess the
company’s performance. Financial reporting quality is distinguishable from earnings quality, which
pertains to the earnings and cash generated by the company’s actual economic activities and the resulting
financial condition.
3. B is correct. Earnings quality pertains to the earnings and cash generated by the company’s actual
economic activities and the resulting financial condition. Low-quality earnings are likely not sustainable
over time because the company does not expect to generate the same level of earnings in the future or
because earnings will not generate sufficient return on investment to sustain the company in the future.
Earnings that are not sustainable decrease company value. Earnings quality is distinguishable from
financial reporting quality, which pertains to the quality of the information contained in financial reports.
4. A is correct. Financial reports span a quality continuum from high to low based on decision-usefulness
and earnings quality (see Exhibit 2 of the reading). The lowest-quality reports portray fictitious events,
which may misrepresent the company’s performance and/or obscure fraudulent misappropriation of the
company’s assets.
5. B is correct. Aggressive accounting choices aim to enhance the company’s reported performance by
inflating the amount of revenues, earnings, and/or operating cash flow reported in the period.
Consequently, the financial performance for the current period would most likely exhibit an upward bias.
6. C is correct. Accounting choices are considered conservative if they decrease the company’s reported
performance and financial position in the current period. Conservative choices may increase the amount
of debt reported on the balance sheet. Conservative accounting choices may decrease the amount of
revenues, earnings, and/or operating cash flow reported in the current period and increase those amounts
in later periods.
7. A is correct. Managers often have incentives to meet or beat market expectations, particularly if
management compensation is linked to increases in stock prices or to reported earnings.
8. C is correct. In a period of strong financial performance, managers may pursue accounting choices that
increase the probability of exceeding next period’s earnings forecasts. By accelerating expense
recognition or delaying revenue recognition, managers may increase earnings in the next period and
increase the likelihood of exceeding next period’s earnings targets.
9. A is correct. The possibility of bond covenant violations may motivate managers to inflate earnings in the
current period. By inflating earnings in the current period, the company may be able to avoid the
consequences associated with violating bond covenants.
10. A is correct. Opportunities to issue low quality financial reports include internal conditions such as an
ineffective board of directors and external conditions such as accounting standards that provide scope for
divergent choices. Pressure to achieve some performance level and corporate concerns about financing in
the future are examples of motivations to issue low-quality financial reports. Typically, three conditions
exist when low-quality financial reports are issued: opportunity, motivation, and rationalization.
11. C is correct. An audit is intended to provide assurance that the company’s financial reports are presented
fairly, thus providing discipline regarding financial reporting quality. Regulatory agencies usually require

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 that the financial statements of publicly traded companies be audited by an independent auditor to provide
assurance that the financial statements conform to accounting standards. Privately held companies may
also choose to obtain audit opinions either voluntarily or because an outside party requires it. An audit is
not typically intended to detect fraud. An audit is based on sampling and it is possible that the sample
might not reveal misstatements.
12. B is correct. If a company uses a non-GAAP financial measure in an SEC filing, it is required to provide
the most directly comparable GAAP measure with equivalent prominence in the filing. In addition, the
company is required to provide a reconciliation between the non-GAAP measure and the equivalent
GAAP measure. Similarly, IFRS require that any non-IFRS measures included in financial reports must
be defined and their potential relevance explained. The non-IFRS measures must be reconciled with IFRS
measures.
13. B is correct. If a company wants to increase reported earnings, the company’s managers may reduce the
allowance for uncollected accounts and uncollected accounts expense reported in the period. Decreasing
the useful life of depreciable assets would increase depreciation expense and decrease earnings in the
current period. Classifying a purchase as an expense rather than a capital expenditure would decrease
earnings in the current period. The use of accrual accounting may result in estimates included in financial
reports, because all facts associated with events may not be known at the time of recognition. These
estimates can be grounded in reality or can be managed by the company to present a desired financial
picture.
14. B is correct. Bias in revenue recognition can lead to manipulation of information presented in financial
reports. Addressing the question as to whether revenue is higher or lower than the previous period is not
sufficient to determine if there is bias in revenue recognition. Additional analytical procedures must be
performed to provide warning signals of accounting malfeasance. Barter transactions are difficult to value
properly and may result in bias in revenue recognition. Policies that make it easier to prematurely
recognize revenue, such as revenue being recognized before goods are shipped to customers, may be a
warning sign of accounting malfeasance.
15. C is correct. If a company’s days sales outstanding (DSO) is increasing relative to competitors, this may
be a signal that revenues are being recorded prematurely or are even fictitious. There are numerous
analytical procedures that can be performed to provide evidence of manipulation of information in
financial reporting. These warning signs are often linked to bias associated with revenue recognition and
expense recognition policies.
16. B is correct. If the ratio of cash flow to net income for a company is consistently below 1 or has declined
repeatedly over time, this may be a signal of manipulation of information in financial reports through
aggressive accrual accounting policies. When net income is consistently higher than cash provided by
operations, one possible explanation is that the company may be using aggressive accrual accounting
policies to shift current expenses to later periods.
17. A Because a large proportion of net income is due to a one-time gain, this period's earnings are likely not
sustainable and the firm may be said to have low quality of earnings for the period. Clear disclosure of
this fact in the financial statements suggests high quality of financial reporting.
18. C In the spectrum of financial reporting quality, financial reports that depart from generally accepted
accounting principles are considered to be of lower quality than those that reflect biased accounting
choices. Financial reports that reflect unsustainable earnings, such as one-time gains, can still be of high
quality if they state the situation clearly.
19. A Financial reporting is most likely to be decision useful when accounting choices are neutral. Either
aggressive or conservative accounting choices by management may be viewed as biases.
20. A Reducing tax obligations would be a reason to underreport earnings. The other choices are motivations
to over report earnings.

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21. B Ineffective internal controls are a condition that provides an opportunity for low-quality financial
reporting.
22. A The objective of audits is to provide reasonable assurance that financial statements are presented fairly.
A firm that is engaging in accounting fraud may deceive its auditor. Regulators in most countries require
publicly traded firms to obtain independent audits of their financial statements. Auditors may issue a
qualified opinion noting certain aspects of financial statements that are inconsistent with accounting
principles or an adverse opinion if they find that financial statements are materially misstated and do not
conform with GAAP.
23. A IFRS require a firm that presents a nonstandard financial measure to reconcile that measure to an IFRS
measure and explain why the firm believes the nonstandard measure is relevant to users of the financial
statements. Presenting the nonstandard measure for prior periods is not a requirement.
24. C Management may make inappropriate capitalization decisions to understate expenses by creating
balance sheet assets for items that should instead be recognized as expenses in the current period,
increasing net income in the current period. Revenues and liabilities are unlikely to be affected by
capitalization decisions.
25. B Channel stuffing, which includes activities such as accelerating deliveries to distributors or sending
customers unordered merchandise, would likely increase accounts receivable as a percentage of revenues.
This would decrease the receivables turnover ratio and increase days of sales outstanding. Payables would
not be affected.

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 HOME WORK QUESTIONS

1. A significant increase in days payables above historical levels is most likely associated with:
A) low quality of the cash flow statement.
B) an increase in net working capital.
C) an unsustainable increase in reported earnings.
2. If a firm's financial reports are of low quality, can users of the reports assess the quality of the firm's
earnings?
A) Yes, because if financial reports are of low quality, earnings are also of low quality.
B) No, because low-quality financial reports are not useful for assessing the quality of earnings.
C) Yes, because users can assess earnings quality independently of financial reporting quality.
3. 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.
4. 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) Make no adjustments to assets or earnings because both reflect the impairment.
B) Decrease earnings but make no adjustment to assets.
C) Decrease assets and increase earnings.
5. LIFO ending inventory can be adjusted to a FIFO basis by:
A) adding the change in the LIFO reserve.
B) subtracting the change in the LIFO reserve.
C) adding the LIFO reserve.
6. 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 incorrect.
B) both are correct.
C) only one is correct.
7. 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 $1,400

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 B) $26,000 $2,600
C) $18,000 $2,600
8. For a publicly traded U.S. firm, which of the following profit measures would require reconciliation to
U.S. GAAP if it appeared in the firm's financial statements? Income from continuing operations
excluding:
A) discontinued operations.
B) extraordinary items.
C) research and development.
9. An analyst screening potential equity investments to identify value stocks is most likely to exclude
companies with:
A) high price-to-earnings ratios.
B) high dividend payout ratios.
C) low earnings growth rates.
10. With regard to the goal of neutrality in financial reporting, accounting standards related to research costs
and litigation losses should be viewed as:
A) promoting neutral financial reporting.
B) biased toward conservative financial reporting.
C) biased toward aggressive financial reporting.
11. 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) $4.5 million No
B) $4.0 million Yes
C) $4.0 million No
12. Management is most likely to be motivated to produce low-quality financial reports when:
A) earnings are less than analysts expect.
B) managers' compensation is unrelated to the firm's share price.
C) the firm is not required to abide by loan covenants.
13. 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?

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 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 #4 Filter #3
B) Filter #4 Filter #1
C) Filter #2 Filter #3
14. Conditions that may cause firms to issue low-quality financial reports are best described as:
A) inappropriate ethical standards and failing to correct known reportable conditions.
B) opportunity, motivation, and rationalization.
C) unstable organizational structure and deficient internal controls.
15. According to the Management Discussion and Analysis section of Frankfurt Supply Company's annual
report, Frankfurt recently decreased the sales prices of its products in order to increase market share. In
addition, Frankfurt recently lowered its requirements for credit customers and increased the credit limits
of some customers. If Frankfurt keeps its inventories unchanged, what is the most likely impact on
Frankfurt's accounts receivable turnover and inventory turnover as a result of these changes?
A) Only one will decrease.
B) Both will increase.
C) Both will decrease.
16. Aggressive accounting choices by management are most likely to:
A) produce decision-useful financial reporting.
B) report sustainable earnings.
C) comply with generally accepted accounting principles.
17. Which of the following requirements are most likely to create incentives for management to manipulate
earnings?
A) Disclosure regulations.
B) Audit requirements.
C) Debt covenants.
18. 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) Rationalization.
B) Motivation.
C) Opportunity.
19. Which of the following actions is least likely to increase earnings for the current period?
A) Recognizing revenue before fulfilling the terms of a sale.
B) Selling more inventory than is purchased or produced.
C) Decreasing the salvage value of depreciable assets.
20. 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) capitalize leases.
B) understate assets.
C) overstate earnings.
21. 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) FIFO.

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 B) LIFO.
C) Average cost.
22. In estimating pro forma cash flows for a company, analysts typically hold which of the following factors
constant?
A) Noncash working capital as a percentage of sales.
B) Sales.
C) Repayments of debt.
23. 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, many geographic regions.
B) Large size, diverse product lines, concentrated geographic regions.
C) Small size, focused product lines, concentrated geographic regions.
24. 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) Omega uses its fixed assets more efficiently than Alpha.
B) Alpha has a higher operating profit margin than Omega.
C) Omega has lower interest coverage than Alpha.
25. 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 #2 Ratio #3
B) Ratio #3 Ratio #1
C) Ratio #1 Ratio #3
26. 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.
27. 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) pro forma earnings.
B) asset turnover ratios.
C) cash from operations.
28. 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

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 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) $1.63 $2.06
B) $2.17 $2.06
C) $2.17 $2.81
29. 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 Accelerated
C) First-in, First-out Straight-line
30. 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) $80 million.
B) $30 million.
C) $40 million.

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31. 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 and are unlikely to be related to
GDP growth.
B) appropriate.
C) inappropriate, because sales should be forecast on a firm-wide basis.
32. 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 No
B) No Yes
C) Yes No
33. 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) understate earnings.
C) overstate earnings.
34. 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
35. 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.

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 SOLUTION
1. Answer A
A significant increase in days payables may indicate that payables have been "stretched" (not paid or paid
more slowly), which increases operating cash flow in an unsustainable manner and calls the quality of the
reported cash flow values into question. Stretching payables does not affect earnings because the related
expenses were recognized in the period incurred. An increase in days payables will decrease net working
capital, other things equal.
2. Answer B
Financial reports that are of low quality make it difficult or impossible for users of the statements to assess
the quality of the firm's earnings, cash flows, and balance sheet values.
3. Answer B
Aggressive accounting choices are those that increase earnings, operating cash flows, or asset values in
the current period. Classifying interest paid as an investing cash flow, rather than as an operating cash
flow, results in higher CFO and lower CFI.
The other choices are examples of conservative accounting choices because they decrease earnings in the
current period.
4. Answer C
The recommended adjustment for goodwill before calculating financial ratios is to remove goodwill from
the balance sheet (decreasing assets) and reverse any losses recognized due to goodwill impairment
(increasing earnings).
5. Answer C
LIFO ending inventory can be adjusted to a FIFO basis by adding the LIFO reserve, which a firm using
LIFO must disclose in the notes to its financial statements.
6. Answer C
Margin stability is desirable from the lender's perspective for both floating-rate and fixed-rate debt.
Higher volatility will increase credit risk. Product and geographic diversification should lower credit risk
as the borrower is less sensitive to adverse events and conditions.
7. Answer B
FIFO ending inventory = LIFO ending inventory + LIFO reserve = 22,000 + 4,000 = $26,000
FIFO after-tax profit = LIFO after-tax profit + (change in LIFO reserve)(1 − t) = $2,000 + ($1,000)(1 −
0.4) = $2,000 + $600 = $2,600
8. Answer C
Income from continuing operations excluding research and development is a non-GAAP measure that
would require reconciliation to a U.S. GAAP measure. Under U.S. GAAP, income from continuing
operations is reported net of discontinued operations and extraordinary items.
9. Answer A
Value stocks are considered to be those that have low prices relative to earnings (or relative to sales, cash
flow, or book value). Screens that exclude firms with low earnings growth rates or high dividend payout
ratios are more likely to be used to identify growth stocks.
10. Answer B
Some accounting principles, such as IFRS and U.S. GAAP standards for expensing research costs and
recognizing probable litigation losses, reflect conservatism rather than neutrality, in that they require
earlier recognition of probable losses and later recognition of probable gains.
11. Answer C
2008 sales are expected to be $30 million ($20 million 2007 sales × 1.5) and 2008 net income is expected
to be $4.5 million ($30 million 2008 sales × 15%). 2007 non-cash operating working capital was $4

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 million ($20 million 2007 sales × 20%) and 2008 non-cash operating working capital is expected to be
$7.5 million ($30 million 2008 sales × 25%). 2008 operating cash flow is expected to be $4 million ($4.5
million 2008 net income + $3 million 2008 depreciation - $3.5 million increase in non-cash operating
working capital). Forecasts for small firms, start-ups, or firms operating in volatile industries may be less
reliable than a forecast for a large, well diversified, firm operating in mature industries.
12. Answer A
Meeting analysts' earnings expectations may motivate management to produce low-quality financial
reports. Earning compensation based on the share price and avoiding breaches of loan covenants are also
possible motivations.
13. Answer C
Firms that have poor profitability are more likely to be non-dividend paying. Selecting only dividend
paying stocks can serve as a check on poor profitability. Using positive ROE to control for poor
performance can result in bogus results without additional filters. For example, if both the numerator (net
income) and the denominator (average equity) are negative, ROE will be positive. The higher the assets-
to-equity ratio, the higher the leverage. Selecting only stocks with an assets-to-equity ratio below a
certain cut-off point will eliminate stocks with high leverage. Debt-to-equity above a certain point would
include firms with higher, not lower, financial leverage.
14. Answer B
The three conditions that often lead to low-quality financial reporting are opportunity, motivation, and
rationalization.
15. Answer A
Accounts receivable turnover will likely decrease as a result of offering credit to customers with weak
credit histories. Collections will likely slow down and bad debt expense will likely increase. Inventory
turnover is likely to increase as sales (and therefore COGS) increase from more liberal credit terms and
the decrease in price.
16. Answer C
Management may follow generally accepted accounting principles and still make biased (i.e., aggressive
or conservative) accounting choices. Biased accounting choices diminish the decision-usefulness of
financial reporting. Aggressive accounting choices are those that increase earnings, revenues, or operating
cash flows in the current period (and likely reduce them in later periods).
17. Answer C
Debt covenants that require a firm to meet minimum financial measures may give management an
incentive to manipulate earnings. Audit requirements and disclosure regulations are mechanisms that
discipline financial reporting quality.
18. Answer B
The issues Cameron is investigating represent incentives that may lead to low-quality financial reporting.
19. Answer C
Decreasing the salvage value will result in higher depreciation expense and lower earnings in the current
period. Recognizing revenue before fulfilling all terms of a sale is an aggressive revenue recognition
method that will increase earnings in the current period. For firms that use LIFO inventory accounting and
in an increasing price environment, selling more inventory than is purchased or produced will increase
earnings unsustainably in the current period.
20. Answer C
Debt covenants may require a firm to maintain a minimum interest coverage ratio (EBIT / interest
expense). Manipulating the financial statements to increase the interest coverage ratio would most likely
involve overstating earnings, or possibly understating liabilities (for example by using operating leases
instead of capital leases) to decrease interest expense.
Understating or overstating assets would not affect the interest coverage ratio.

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21. Answer B
Under LIFO and with increasing prices, a firm that sells more goods than it purchases or produces in a
period may show an unsustainable increase in gross profit margin because items recognized in cost of
sales are valued older, lower prices, while sales are recorded at current, higher prices.
22. Answer A
To estimate pro forma cash flows, the analyst must make assumptions about future sources and uses of
cash. The most important of these will be increases in working capital, capital expenditures on new fixed
assets, issuance or repayments of debt, and issuance or repurchase of stock. A typical assumption is that
noncash working capital will remain constant as a percentage of sales.
23. Answer A
Other things equal, credit rating agencies tend to rate larger companies and those with diversified product
lines and greater geographic diversification to be better credit risks.
24. Answer C
Using the EBITDA coverage ratio (EBITDA / Interest expense), Omega's EBITDA coverage is 1.4
($79,300 EBITDA / $58,100 interest expense) and Alpha's EBITDA coverage is 1.6 ($69,400 EBITDA /
$44,000 interest expense). Using EBITDA to measure operating profit, Alpha has a lower operating profit
margin than Omega. Alpha's EBITDA margin is 4.2% ($69,400 EBITDA / $1,650,000 revenue) and
Omega's EBITDA margin is 5.5% ($79,300 EBITDA / $1,452,000 revenue). Using fixed asset turnover to
measure the efficiency of fixed assets, Omega uses its fixed assets less efficiently than Alpha. Alpha's
fixed asset turnover is 5.5 ($1,650,000 revenue / $300,000 average fixed assets) and Omega's fixed asset
turnover is 4.5 ($1,452,000 revenue / $323,000 average fixed assets).
25. Answer C
A firm's tolerance for additional debt can be measured by its capacity to repay debt. Retained cash flow
divided by total debt is one of several measures that can be used. Operational efficiency refers to the
firm's cost structure and can be measured by the "margin" ratios. EBITDA divided by sales is one version
of an operating margin ratio. The current ratio is a measure of short-term liquidity.
26. Answer A
2007 inventory turnover was 5 (365 / 73 days in inventory). Given inventory turnover and COGS, 2007
average inventory was $20 million ($100 million COGS / 5 inventory turnover). 2008 inventory turnover
is expected to be 7.3 (365 / 50 days in inventory). Given expected inventory turnover, 2008 average
inventory is $17 million ($124.1 million COGS / 7.3 expected inventory turnover). To achieve 50 days of
inventory on hand, average inventory must decline $3 million ($20 million 2007 average inventory - $17
million 2008 expected inventory). A decrease in inventory is a source of cash.
27. Answer A
One potential warning sign of low-quality financial reporting is management's focus on "pro forma" or
non-GAAP measures of earnings. Increases in operating cash flows or asset turnover ratios are not
typically viewed as warning signs of poor financial reporting quality.
28. Answer B
Company A should be adjusted for the operating lease liability and the related assets; however, adding the
present value of the lease payments to both assets and liabilities does not change equity (book value).
Thus, Company A's adjusted P/B ratio is 2.17 = [$26 price / ($6,000 million equity / 500 million shares)].
Company B's inventory should be adjusted back to FIFO by adding the LIFO reserve to both assets and
equity. Thus, Company B's P/B ratio is 2.06 = $22.50 / [($7,500 million equity + $700 million LIFO
reserve) / 750 million shares].
29. Answer C
FIFO results in higher assets and higher equity in an inflationary environment as compared to LIFO.
Equity is higher because COGS is lower (and inventory higher) under FIFO. Straight-line depreciation
will result in greater assets and equity compared to accelerated depreciation for a stable or growing firm.

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 Equity is greater because depreciation expense is less with straight-line depreciation. Greater equity will
result in greater book value per common share, the denominator of the price-to-book ratio.
Greater book value per share will result in a lower price-to-book ratio.
30. Answer B
2008 sales are expected to be $600 million ($500 million 2007 sales × 1.2) and 20X8 net income is
expected to be $30 million ($600 million 20X8 sales × 5%). 2008 non-cash operating working capital is
expected to be $120 million ($600 million 20X8 sales × 20%). The change in cash is expected to be -$5
million ($30 million 20X8 net income + $60 million 20X8 depreciation - $20 million increase in non-cash
operating working capital - $75 million 20X8 capital expenditures). The 20X8 ending balance of cash is
expected to be $30 million ($35 million beginning cash balance - $5 million decrease in cash).
31. Answer B
Sales estimates can be more sophisticated than simply estimating a single growth rate. One common
approach is to estimate the linear relationship between sales growth and economic growth and use this
relationship to estimate sales growth based on economists' forecasts of GDP growth. Segment-by-segment
analysis can also be applied, summing segment or division sales forecasts to produce an overall sales
forecast for the firm.
32. Answer B
Using past trends to project future financial performance would be reliable for a well-diversified firm
operating in a number of mature industries. The diversified firm would likely have relatively predictable
earnings. Using past trends to project future financial performance would not likely be reliable for the
rapidly growing firm involved in numerous acquisitions and divestitures.
Such a firm would likely have high earnings volatility.
33. Answer C
Overstating the salvage value reduces depreciation expense, which in turn increases earnings.
34. Answer C
2007 FIFO inventory was $36 million ($20 million LIFO inventory + $16 million reserve). 2007 FIFO
COGS was $54 million ($64 million LIFO COGS - $10 million increase in LIFO reserve).
35. Answer C
Before calculating ratios involving liabilities, an analyst should estimate the present value of operating
lease obligations and add this value to the firm's liabilities.

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