Chapter 6—Accounting Quality

23. One definition of earnings management is that it occurs when managers use: a. judgment in financial reporting to alter financial reports to mislead stakeholder. b. an accounting method that is inconsistent with other industry members. c. more conservative accounting estimates than other companies. d. pro forma accounting results as opposed to GAAP results.

A

4. The best measure of a firm's sustainable income is: a. net income. b. income from continuing operations. c. income before extraordinary items. d. income before extraordinary item and change in accounting principle.

B

6. Users of financial statements should consider which of the following when evaluating the quality of accounting information? a. Economic faithfulness of accounting measurements and classifications. b. Reliability of the measurements. c. Reasonableness of the estimates made in applying GAAP or IFRS. d. All of these should be considered.

D

8. Which one of the following is an example of sustainable earnings? a. A gain from corporate restructuring. b. A loss from debt retirement. c. A settlement paid by the company for a class action suit. d. Earnings from repeat customers.

D

12. For each of the following factors, determine if the given change or level of that factor would lead an analyst to believe that managers of a firm are more or less likely to engage in earnings manipulation: Earnings Manipulation More likely/less likely 1. Days Sales in Receivable Index increases 2. Gross Margin Index decreases below 1 3. Asset Quality Index increases 4. Depreciation Index decreases to below 1 5. Leverage Index increases

Earnings Manipulation More likely/less likely 1. Days Sales in Receivable Index increases more likely 2. Gross Margin Index decreases below 1 less likely 3. Asset Quality Index increases more likely 4. Depreciation Index decreases to below 1 less likely 5. Leverage Index increases more likely

5. Mattel, Inc. designs, manufactures and markets various toy products worldwide through sales to retailers and directly to consumers. Among the company's many products are Barbie, GI Joe, and American Girls. Below is an income statement for Mattel for years 2002, 2001 and 2000. Notes to the financial statements reveal the following information. 1. Discontinued Operations - In 1999 Mattel merged with Learning Company, with Mattel being the surviving company. The Learning Company, which produced consumer software, represented a separate line of business for Mattel. In 2000 Mattel's Board of Directors committed to dispose of the Learning Company and its consumer software operations. In 2000 the Learning Company was reported as a discontinued operation and the company was sold to Gores Technology on October 18, 2000. In 2002 Mattel received a contractual payment from Gores Technology based on the sale of assets of Learning Company and other liquidation events. 2. Accounting Change - In 2001 Mattel changed the manner in which it accounted for derivative instruments consistent with the issuance of SFAS No. 133 Accounting for Derivative Instruments and hedging Activities. The change resulted in Mattel recording a one-time adjustment of $12 million. 3. Accounting Change - In 2002 the FASB issued SFAS No. 142 Goodwill and Other Intangible Assets. The standard requires that management estimate the value of its goodwill and, if necessary, record an impairment charge. Consistent with SFAS No. 142 Mattel recorded a one-time adjustment of $252.2 million, net of tax, as the cumulative effect of the change in accounting principle. Mattel, Inc. Selected Income Statement data Fiscal year end 12/31/2002 12/31/2001 12/31/2000 (amounts in thousands of dollars) Net sales $4,885,340 $4,687,924 $4,565,489 Cost of Goods Sold (2,524,353) (2,538,990) (2,572,247) Gross profit 2,360,987 2,148,934 1,993,242 Selling and Administrative Expenses (1,602,846) (1,507,793) (1,560,157) Amortization of Goodwill 0 (46,121) (46,561) Non-operating income/expense (22,747) (9,878) (8,121) Interest expense (113,897) (155,132) (152,979) Income from Continuing Operations before Income Taxes 621,497 430,010 225,424 Provision for income taxes (166,455) (119,090) (55,247) Income from Continuing Operations 455,042 310,920 170,177 Gain (Loss) from Discontinued Oper., net of tax 27,253 (601,146) Income (Loss) before Cumulative Effect of Change in Accounting Principles 482,295 310,920 (430,969) Cumulative Effect of Change in Accounting Principles, net of tax (252,194) (12,001) 0 Net Income (Loss) $230,101 $298,919 ($430,969) Required: a. Discuss whether or not you would adjust for each of the following items when using earnings to forecast the future profitability of Mattel: (1) Discontinuance of the Consumer Software operations. (2) The change in accounting for derivative instruments. (3) The change in accounting for goodwill and other intangible assets. b. Indicate the adjustment you would make to Mattel's net income for each of the items in part a. c. Prepare a common size income statement for 2002, 2001, and 2000 for Mattel. d. Repeat part c after making the income statement adjustments in part b. e. Assess the changes in profitability of Mattel during the three-year period.

SUGGESTED ANSWER a. The case for eliminating the discontinued operations amounts is that the gain and loss relate to a business Mattel is no longer engaged in and for this reason Mattel should not be recognizing additional discontinued operations gains or losses from consumer software. A more major issue might be examining the strategy with respect to Mattel's decision to purchase the Learning Company and so quickly dispose of the operations. The case for eliminating the two amounts related to changes in accounting principles seems clearer as they both relate to one-time charges. The analyst needs to consider the effect of omitting this information on past income statements when making interpretations of profitability and risk ratios. b. In all three of the items a case can be made to eliminate the amounts altogether. In this case adjusted net income becomes what is originally reported as "income from continuing operations". c. Common size financial statements Mattel, Inc. Selected Income Statement data Fiscal year end 12/31/2002 12/31/2001 12/31/2000 (amounts in thousands of dollars) Net sales $4,885,340 100.0% $4,687,924 100.0% $4,565,489 100.0% Cost of Goods Sold (2,524,353) -51.7% (2,538,990) -54.2% (2,572,247) -56.3% Gross profit 2,360,987 48.3% 2,148,934 45.8% 1,993,242 43.7% Selling and Administrative Expenses (1,602,846) -32.8% (1,507,793) -32.2% (1,560,157) -34.2% Amortization of Goodwill 0 0.0% (46,121) -1.0% (46,561) -1.0% Non-operating income/expense (22,747) -0.5% (9,878) -0.2% (8,121) -0.2% Interest expense (113,897) -2.3% (155,132) -3.3% (152,979) -3.4% Income from Continuing Operations before Income Taxes 621,497 12.7% 430,010 9.2% 225,424 4.9% Provision for income taxes (166,455) -3.4% (119,090) -2.5% (55,247) -1.2% Income from Continuing Operations 455,042 9.3% 310,920 6.6% 170,177 3.7% Gain (Loss) from Discontinued Oper., net of tax 27,253 0.6% 0.0% (601,146) -13.2% Income (Loss) before Cumulative Effect of Change 482,295 9.9% 310,920 6.6% (430,969) -9.4% in Accounting Principles Cumulative Effect of Change in Accounting Principles, net of tax (252,194) -5.2% (12,001) -0.3% 0 0.0% Net Income (Loss) 230,101 4.7% $298,919 6.4% ($430,969) -9.4% d. Common size financial statements adjusted for removal of discontinued operations and changes in accounting principles: Mattel, Inc. Selected Income Statement data Fiscal year end 12/31/2002 12/31/2001 12/31/2000 (amounts in thousands of dollars) Net sales $4,885,340 100.0% $4,687,924 100.0% $4,565,489 100.0% Cost of Goods Sold (2,524,353) -51.7% (2,538,990) -54.2% (2,572,247) -56.3% Gross profit 2,360,987 48.3% 2,148,934 45.8% 1,993,242 43.7% Selling and Administrative Expenses (1,602,846) -32.8% (1,507,793) -32.2% (1,560,157) -34.2% Amortization of Goodwill 0 0.0% (46,121) -1.0% (46,561) -1.0% Non-operating income/expense (22,747) -0.5% (9,878) -0.2% (8,121) -0.2% Interest expense (113,897) -2.3% (155,132) -3.3% (152,979) -3.4% Income from Continuing Operations before Income Taxes 621,497 12.7% 430,010 9.2% 225,424 4.9% Provision for income taxes (166,455) -3.4% (119,090) -2.5% (55,247) -1.2% Income from Continuing Operations 455,042 9.3% 310,920 6.6% 170,177 3.7% Gain (Loss) from Discontinued Oper., net of tax 27,253 0.6% 0.0% (601,146) -13.2% Income (Loss) before Cumulative Effect of Change 482,295 9.9% 310,920 6.6% (430,969) -9.4% in Accounting Principles Cumulative Effect of Change in Accounting Principles, net of tax 0 0.0% 0 0.0% 0 0.0% Net Income (Loss) 482,295 9.9% $310,920 6.6% ($430,969) -9.4% e. When examining the common size financial statements without the discontinued operations or accounting change data it appears that Mattel's business is doing better. The net income to sales ratio is increasing each year and its gross margin ratio has improved each year. Mattel has also lowered its selling and administrative expense ratio each year.

4. On July 15, 2009 Time Services decided to sell its agricultural business and focus on its landscape equipment business. The sale of the agricultural business qualifies for discontinued operations accounting treatment. On November 11, 2009 Time Services signs a firm contract to sell the agricultural business to Acme Inc. on March 10, 2010. For each of the situations listed discuss how Time Services would report the discontinued operations in its December 31, 2009 income statement. (You may disregard tax issues with respect to the sale.) Situation 1: For the period January 1, 2009 to July 15, 2009 Time Services reports that the agricultural business lost $3.2M. From July 16, 2009 to November 11, 2009 Time Services reports that the agricultural business loses an addition $1.4 million dollars. At the end of the 2009 Time estimates that it will lose an additional $800,000 on the sale of the agricultural business when it is finally completed in 2010. Situation 2: For the period January 1, 2009 to July 15, 2009 Time Services reports that the agricultural business had a profit of $1.5M. From July 16, 2009 to November 11th, 2009 Time Services reports that the net income from the agricultural business was $600,000 dollars. At the end of the 2009 Time estimates that the sale of the agricultural business will result in a gain of $1.7 million dollars when it is finally completed in 2010. Situation 3: For the period January 1, 2009 to July 15, 2009 Time Services reports that the agricultural business lost $3.2M. From July 16, 2009 to November 11th, 2009 Time Services reports that the agricultural business loses an addition $1 million dollars. However, at the end of the 2009 Time estimates that the sale of the agricultural business will result in a gain of $1.3 million dollars when it is finally completed in 2010.

Situation 1: Time Services Selected Information Related to Discontinued Operations Year Ended 2009 Income from Discontinued Operations Net Loss of Discontinued Business ($3,200,000) Loss on Disposal of Discontinued Business ($2,200,000) Loss from Discontinued Business ($5,400,000) Situation 2: Time Services Selected Information Related to Discontinued Operations Year Ended 2009 Income from Discontinued Operations Net Earnings of Discontinued Business $1,500,000 Gain on Disposal of Discontinued Business $ 600,000 Income from Discontinued Business $2,100,000 Situation 3: Time Services Selected Information Related to Discontinued Operations Year Ended 2009 Income from Discontinued Operations Net Loss of Discontinued Business ($3,200,000) Estimated Gain on Disposal of Discontinued Business $ 0 Loss from Discontinued Business ($3,200,000)

3. First Bank recognized an extraordinary loss from the settlement of a lawsuit with Fifth Street Bank that it had impeded on a processing patent. The extraordinary loss was in the amount of $4,250,000 and First Bank Corporation has an effective tax rate of 35%. First Bank paid the settlement immediately and recognized the tax benefit as a receivable to offset the current period's taxes. Instructions: a. Prepare the extraordinary item portion of First Bank Corporation's financial statement. b. Using the analytical framework discussed in the text and reprinted below show the effect of following event on First Bank Corporation's financial statements. Analytical Framework: Shareholders' Equity Entry Assets = Liabilities + CC + AOCI + RE

a. Extraordinary loss on the settlement of lawsuit (net of $1,487,500 tax benefit) -2,762,500 b. Analytical Framework: Shareholders' Equity Entry Assets = Liabilities + CC + AOCI + RE -4,250,000 -4,250,000 +$1,487,500 +$1,487,500

11. In the empirical research on earnings manipulation discussed in the chapter, a number of firm characteristics are found to be associated with the likelihood of engaging in earnings manipulation. For each of the characteristics listed below, discuss the rationale for their inclusion in the model: a. Gross Margin Index b. Asset Quality Index c. Sales Growth Index d. Depreciation Index e. Leverage Index

a. Gross Margin Index - Firms with weaker profitability in a given year are more likely to engage in earnings manipulation in the future. b. Asset Quality Index - Represents the proportion of total assets comprising assets other than current assets and PP&E and investments in securities. The index represents the proportion of lower quality assets relative to the prior year. An increase in this factor suggests the company may be trying to capitalize and defer costs that should have been expensed. c. Sales Growth Index - Sales growth this period relative to the prior period. The need for low cost external financing might motivate managers to manipulate earnings and sales. d. Depreciation Index - Depreciation expense as a proportion of PP&E before depreciation, this period relative to the prior period. A higher ratio implies that the company has slowed its rate of depreciation, resulting in increased earnings. e. Leverage Index - The proportion of total financing comprised of current liabilities and long-term debt for the current year relative to the prior period. An increase in the proportion of debt puts the company at greater risk of violating debt covenants and needing to manipulate earnings and sales.

2. Accounting information should provide relevant information to forecast the firm's expected future earnings and _________________________.

cash flows

7. A change in the useful life of an asset is treated as a(n) _____________

change in accounting estimate

5. The _________________________ is the date on which a firm commits itself to a formal plan to dispose of a business segment.

measurement date

14. On the income statement the disposal of a segment of a business should be shown _________ .

net of applicable income taxes

18. U.S. GAAP requires that changes in estimates be accounted for by recognizing the effect ________________________________________ period(s).

over current and future

COMPLETION 1. Accounting information should be a fair and complete representation of the firm's economic ____________________, ____________________, and ____________________.

performance, position, risk

8. Gains and losses differ from revenues and expenses in that they are produced by ____________________ activities.

peripheral

13. Earnings are informative if they signal the portion of current period's due to a new product and the additional earnings in the future as a result of the ____________________ of this new earnings stream.

persistence

22. One of the conditions that must be met to recognize an estimated loss from a contingency is that the amount of loss can be estimated with ________________________________________.

reasonable precision SHORT ANSWER 1. Banks Corp. reported net income of $595,000 in 2012. During 2012 Banks reported a loss of $87,435 from a peripheral activity. The loss was included as part of income from continuing operations. Assuming that the loss is a one-time event and that Banks has an effective tax rate of 35%, calculate Banks' adjusted net income. Show all of your calculations for credit. In addition, discuss why analysts might make an adjustment of this type. ANS: Banks' income statement: Adjusted As Reported Totals Income before tax (X - .35X=$595,000) $915,385 $1,002,820 Income tax expense (35%) (320,385) (350,987) Net Income $595,000 $651,833 The analyst may decide to adjust income totals because the gains or losses do not relate to the sale of the company's principal products and services. Normally, only gains and losses from the sale of principal products and services should enter the forecasts of future earnings and profitability.

10. When evaluating the quality of accounting information the user should consider the ____________________ of the measurements made.

reliability

3. Quality accounting information seeks to maximize relevance and economic faithfulness, subject to the constraints of the ____________________ of the measurements.

reliability

6. A(n) ____________________ of operations differs from a discontinuation of operations because the firm continues to operate in the business segment.

restructuring

8. A company may try to paint a favorable picture of itself by accelerating the timing of revenues or estimating the collectible amounts too aggressively. In these cases the quality of accounting information declines because it does not represent the company's true economic condition and may not be sustainable. List four conditions which might suggest that a company is recognizing revenues too early?

1. Large and volatile amounts of uncollectible accounts receivable. 2. Unusually large amounts of returned goods. 3. Excessive warranty expenditures. 4. A significant increase in days accounts receivable are outstanding.

9. Many users of financial statements believe that the quality of accounting information for intangible assets is low because firms seldom report intangible asset resources on the balance sheet. However, from the perspective of accounting quality what are arguments in favor of expensing most intangibles and not recording them on the balance sheet?

1. The expense occurs in the same period as the cash outflow when the economic resource is sacrificed. 2. Firms must replace intangibles that are consumed if they expect to continue operating profitably. 3. Immediate expensing reduces the opportunities for earnings management that arise when firms must decide on an amortization period and pattern for capitalized intangibles. 4. For a stable or moderate-growth firm, the expense each year from immediate expensing is approximately the same as the expense from capitalizing expenditures and subsequently amortizing them.

11. Under new accounting standards passed in 2006 firms must report changes in accounting principle in the current and prior years as if the new accounting principle had been applied all along. The rationale for this change was: a. using the same accounting principle in current and prior periods enhances the information content of reported earnings in forecasting future earnings. b. conservatism. c. comparability. d. materiality.

A

12. During July 2013, Ralston Company decides to dispose of one of its subsidiaries, which qualifies for accounting as a discontinued operation. At the July 2013 measurement date, Ralston Company estimates that it will report net income of $300,0000 dollars from the measurement date until the disposal date, which is expected to be in April 2014. In addition, Ralston estimates that it will lose 100,000 on the sale of the segment. How much gain or loss on discontinued operations will Ralston report in its 2012 income statement (net of income taxes)? a. $200,000 gain b. $0 c. $100,000 loss d. $300,000 loss

A

18. Which of the following items is consistent with earnings being informative about current performance and informing the analyst that level of current earnings are not sustainable? a. The firm recognizes an unexpected gain b. The firm recognizes a fair value gain on a financial asset as a result of a favorable move in interest rates. c. The firm recognizes additional expenses this period due to pre-opening costs associated with new stores. d. The firm experiences a large jump in sales and earnings as a result of successful research and development of new products.

A

21. Many times a financial analyst may decide to make adjustments to the financial statements in order to make the statements more useful. Which of the following would not require an adjustment to the financial statement? a. A company signs a new contract with a customer. b. A delivery company incurs a loss from disposition of used delivery trucks. c. A company changes the useful life of its equipment from 5 years to 8 years. d. A company incurs a charge related restructuring its operations.

A

26. Earnings that are high quality would: a. be informative about current performance and provide information about the long-run sustainability of profits. b. be informative about past performance and provide information about the long-run sustainability of profits. c. be informative about current performance and provide information about the long-run sustainability of assets. d. be informative about past performance and provide information about the long-run sustainability of assets and liabilities.

A

29. How is a disposal of a segment of the business reported? a. separately stated item on the income statement b. balance sheet c. statement of cash flows d. statement of retained earnings

A

34. Warranties payable and Notes payable are considered which of the following? a. Accounting Liabilities b. Assets c. Stockholders' Equity d. Other Financial Assets

A

PROBLEM 1. On September 1, 2012, Ramos Inc. approved a plan to dispose of a segment of its business. Ramos expected that the sale would occur on March 31, 2013, at an estimated gain of $375,500. The segment had actual and estimated operating profits (losses as follows): Realized loss from 1/1/12 to 8/31/12 $200,000 Realized loss from 9/1/12 to 12/31/12 (135,000 Expected profit from 1/1/13 to 3/31/13 475,000 Assume a marginal tax rate of 35% Required: A) In its 2012 income statement, what should Ramos report as profit or loss from discontinued operations (net of tax effects)? B) Calculate the amount of income that should be shown on the 2013 income statement as a result of the operating profit and the gain on disposal (net of tax)

A Under U.S. GAAP, results of operations on an operating segment or component of an entity classified as held for sale are to be reported in discontinued operations in the periods in which they occur (net of tax effects). The loss from operations for the discontinued segment would be $350,000 determined as follows: Loss from 1/1/12 to 8/31/12 ($200,000) Loss from 9/1/12 to 12/31/12 ($135,000) Total pre-tax loss ($335,000) Tax benefit at 35% 117,250 Operating loss, net of ($217,750) None of the expected profit from operating the segment or component for Ramos in 2013 or the estimated gain on sale is recognized in 2012. These amounts will be recognized in 2013 as they occur. Ans: B Operating income less tax at 35% ($166,250) $308,750 Plus gain on disposal less tax at 35% ($131,425) 244,075 Total income after tax $552,825

14. Which of the following does not describe an extraordinary gain or loss? a. infrequent in occurrence b. peripheral to the company's core business c. unusual in nature d. material in amount

B

16. Which of the following items is consistent with earnings being informative about current performance but not informative about future earnings? a. The firm recognizes an unexpected gain b. The firm recognizes a fair value gain on a financial asset as a result of a favorable move in interest rates. c. The firm recognizes additional expenses this period due to pre-opening costs associated with new stores. d. The firm experiences a large jump in sales and earnings as a result of successful research and development of new products.

B

25. Firm's choices and estimates within U.S. GAAP should be determined by: a. how the industry operates. b. the firm's underlying economic circumstances. c. SEC interpretations regarding specific choices. d. the firm's auditor.

B

32. All of the following are the general principles underlying the valuation of liabilities except: a. Liabilities requiring future cash payments appear at the present value of the required future cash flows discounted at an interest rate that reflects the uncertainty that the firm will be able to make the cash payments. b. The fair value of a liability cannot differ from the amount appearing on the balance sheet, particularly for long-term debt. c. Liabilities representing cash advances from customers appear at the amount of the cash advance. d. Liabilities requiring the future delivery of goods or services appear at the estimated cost of those goods and services.

B

33. All of the following are typically recognized as accounting liabilities except: a. Obligations with Fixed Payment Dates and Amounts b. Obligations under Mutually Unexecuted Contracts c. Obligations Arising from Advances from Customers on Unexecuted Contracts and Agreements d. Obligations with Fixed Payment Amounts but Estimated Payment Dates

B

13. During July 2012, Ralston Company decides to dispose of one of its subsidiaries, which qualifies for accounting as a discontinued operation. At the July 2012 measurement date, Ralston Company estimates that it will report net losses of $1,500,000 dollars from the measurement date until the disposal date, which is expected to be in April 2013. In addition, Ralston estimates that it will lose $300,000 on the sale of the segment. How much gain or loss on discontinued operations will Ralston report in its 2012 income statement (net of income taxes)? a. $1,500,000 loss b. $0 c. $1,800,000 loss d. $300,000 loss

C

15. Which of the following items is consistent with earnings not being informative about current performance but are informative about future earnings? a. The firm recognizes an unexpected gain b. The firm recognizes a fair value gain on a financial asset as a result of a favorable move in interest rates. c. The firm recognizes additional expenses this period due to pre-opening costs associated with new stores. d. The firm experiences a large jump in sales and earnings as a result of successful research and development of new products.

C

20. When a company makes a change in an estimate that it has used in its financial statements, it should account for the change by: a. retroactively restating all prior financial statements b. treat the change as a cumulative effect change in accounting estimate c. spread the effect of the change over the current and future periods d. companies are not allowed to make changes to estimates

C

22. Which of the following is not considered a motive to manage earnings? a. To create optimal manager compensation payments b. To create optimal job security for senior management c. To create optimal measures of assets and liabilities for balance sheet purposes d. To manage reported earnings in order to reduce industry-specific actions

C

24. The Orbus Company has a 30,000 unrealized gain and a 10,000 unrealized loss. Where would Orbus Company report these transactions? a. Only in non-current assets and liabilities b. In stockholders' equity c. Other comprehensive income d. On the balance sheet as a current asset

C

27. When evaluating the quality of accounting information, an analyst should consider all of the following except: a. reliability of the measurements made b. adequacy of disclosures c. comparability of estimates d. economic faithfulness of the measurements made

C

31. All of the following are criteria that financial reporting requires before recognizing an obligation as a liability except: a. The transaction or event that gave rise to the obligation has already occurred. b. The firm has a present obligation and little or no discretion to avoid the transfer. c. The firm must know the precise amount of the obligation before recording it. d. The obligation involves a probable future sacrifice of economic benefits—a future transfer of cash, goods, or services; the forgoing of a future cash receipt; or the transfer of equity shares—at a specified or determinable date. The firm can measure with reasonable precision the cash-equivalent value of the resources needed to satisfy the obligation.

C

35. All of the following are typically recognized as accounting liabilities except: a. Bonds Payable b. Rental Fees Received in Advance c. Loan Guarantees d. Taxes Payable

C

7. Income or loss from discontinued operations would best be regarded by an analyst as: a. sustainable earnings. b. impairments. c. transitory earnings. d. permanent earnings.

C

9. As transitory components become a more important part of a firm's reported earnings, the reported earnings: a. are more quality enhanced. b. become a more reliable indicator of sustainable cash flows. c. are a less reliable indicator of sustainable cash flows. d. are a more reliable indicator of fundamental value.

C

19. ____________________ represents the concept of being able to compare financial statement data across years for any particular firm.

Consistency

3. Examples of poor earnings quality that hinder the forecasting of expected future earnings include all of the following except: a. Earnings dominated by a substantial one-time gain from the sale of real estate tangential to the firm's operations. b. Reporting a large expense from a warehouse fire that was not covered by insurance. c. A local government corrects a processing error and a firm receives an unexpected rebate on property taxes previously paid. d. The company adds equipment that reduces carbon emissions in response to EPA requirements and increases production efficiency.

D

30. Accounting information should provide a fair and complete representation about a number of a firm's characteristics. Which of the following is not one of those characteristics? a. risk b. position c. performance d. conservatism

D

2. Creighton Corp., a textile manufacturer, reported net income of $258,000 in 2012. During 2012 Creighton reported a gain of $29,800 from the sale of three used delivery trucks. The gain was included as part of income from continuing operations. Assuming that the gain is a one-time event and that Creighton has an effective tax rate of 35% calculate Creighton's adjusted net income. Show all of your calculations for credit. In addition, discuss why analysts might make an adjustment of this type.

Creighton's income statement: Adjusted As Reported Totals Income before tax (X - .35X = $396,923) $396,923 $367,123 Income tax expense (35%) (138,923) (128,493) Net Income $258,000 $238,630 The analyst may decide to adjust income totals because the gains or losses do not relate to the sale of the company's principal products and services. Normally, only gains and losses from the sale of principal products and services should enter the forecasts of future earnings and profitability.

10. The assessment of earnings quality is best accomplished through the use of which one of the following? a. Balance sheet and cash flow statement. b. Single-step financial statements. c. Single-step income statement, balance sheet, and cash flow statement. d. Multi-step income statement, balance sheet, and cash flow statement.

D

17. Which of the following items is consistent with earnings being informative about current performance and informing the analyst that level of current earnings is sustainable? a. The firm recognizes an unexpected gain b. The firm recognizes a fair value gain on a financial asset as a result of a favorable move in interest rates. c. The firm recognizes additional expenses this period due to pre-opening costs associated with new stores. d. The firm experiences a large jump in sales and earnings as a result of successful research and development of new products.

D

19. In a restructuring it is possible that managers may use the opportunity to write down assets that do not even relate directly to the restructuring action. Why might a manager decide to write down an asset that is not included in the restructuring action? a. The manager is practicing conservatism. b. The write down relieves future periods of depreciation expense, which increases cash flows. c. Normally the stock market reacts positively to restructuring and the greater the amount the better. d. The write down relieves future periods of depreciation expense, which increases earnings.

D

2. Firms' choices and estimates within U.S. GAAP or IFRS should be determined by all of the following except: a. firms' underlying economic circumstances. b. conditions in the company's industry. c. the company's competitive strategy. d. accelerated management efforts to meet earnings projections.

D

28. Which of the following are characteristics of an extraordinary item? a. Unusual in nature b. Infrequent in occurrence c. Material in amount d. All of the above

D

5. On the income statement, income from discontinued operations is shown: a. as an accounting principle change. b. without any income tax effect. c. as a separate section of income from continuing operations. d. net of taxes after income from continuing operations.

D

7. Achieving comparability in financial reporting is important to the analysis of multinational firms. However, the data from the reconciliation of foreign firm's financial statement to U.S. GAAP must be carefully interpreted. What types of things complicate the analysis of multinational firms?

Financial analysis of multinational firms is complicated by the fact that the environments in which the firms operate may vary extensively across countries. Operational strategies may exist in one firm's home country that are not common in another. Institutional arrangements, such as significant alliances with banks and extensive intercorporate holdings, may be common in one country and not in another. Cultural characteristics may exist in one country that affect how firms do business in that country—with those same characteristics foreign to other business settings.

20. In bankruptcy prediction analysis, a type ____________________ error is classifying a firm as nonbankrupt when it ultimately goes bankrupt.

I

21. In bankruptcy prediction analysis, a type ____________________ error is classifying a firm as bankrupt and it ultimately survives.

II

3. On November 15, 2012, Jacobs Co. sold a segment of its business for $2,750,000. The net book value of the segment at the time of its disposal was $3,000,000. Jacobs had pretax operating income of $1,750,000 for 2012 which included $380,000 earned by the discontinued segment prior to its disposal. Assume Jacobs' tax rate is 30%. Required: Prepare a partial income statement for Jacobs Co. beginning with pretax income from continuing operations.

Income from continuing operations ($1,750,000 - 380,000) $1,370,000 Income tax expense $1,370,000 x 30% 411,000 Income from continuing operations after tax 959,000 Discontinued operations: Operating income (net of taxes of $114,000) from 1/1/12 through 11/15/12 266,000 Loss on disposal of discontinued operation (net of tax benefit of $75,000) (175,000) Net income $1,050,000 Sale price of segment - book value of segment = gain (loss) on disposal = $2,750,000 - $3,000,000 = $(250,000) pretax loss.

5. Healy and Wahlen state that one type of earnings management occurs when managers use judgement in financial reporting to alter financial reports in order to mislead some stakeholder about the economic performance of the company. Earnings management is a consequence of a judgement by management which results in lower economic information content of the financial reports. Discuss five motives that encourage managers to practice earnings management.

Motives to manage earnings: 1. Managers want to maximize their compensation packages. 2. Managers want to protect their jobs and gain more job security. 3. Managers want to reduce risk in order to create a more optimal lending environment and to manage debt restrictions and covenants. 4. Managers want to influence short-term stock price movements for their advantage. 5. Managers want to manage earnings in order to thwart industry-specific and anti-trust actions against the firm.

: 2 Problem 1A Referring to the information in problem one how would a$255,750 loss on disposal instead of a gain affect the answer to part B in problem one? Ans: Operating income less tax at 35% (166,250) $308,750 Minus loss on disposal less tax at 35% ($89,513) (166,237) Total income $142,513 2. Motor Corporation's income statements for the years ended December 31, 2012 and 2011 included the following information before adjustments: 2012 2011 Operating income $900,000 $600,000 Gain on sale of division 450,000 ---0------ $1,350,000 $600,000 Provision for income taxes (405,000) (180,000) Net income $945,000 $420,000 On January 1, 2012, Motor Corporation agreed to sell the assets and product line of one of its operating divisions for $1,600,000. The sale was consummated on December 31, 2012, and it resulted in a gain on disposition of $450,000. This division's pre-tax net losses were $320,000 in 2012 and $250,000 in 2011. The income tax rate for both years was 30%. Required: Starting with operating income (before tax), prepare revised comparative income statements for 2012 and 2011 showing appropriate details for gain (loss) from discontinued operations.

Motor Corporation Partial Income Statement For the Years Ended December 31 2012 2011 **Income from continuing operations, before taxes $1,220,000 $ 850,000 Income tax expenses 366,000 255,000 Income from continuing operations after taxes 854,000 595,000 Discontinued operations: Loss from discontinued division, net of tax benefits of $96,000 in 2012 and $75,000 in 2011 (224,000) (175,000) Gain from sale of discontinued division, net of taxes expense of $135,000 315,000 - 0 - Net income $945,000 $420,000 **Income from continuing operations, before taxes excludes the losses from discontinued division and is calculated as follows: 2012 2011 Income from continuing operations, before taxes $900,000 $ 600,000 Loss from discontinued division, before taxes 320,000 250,000 Income from continuing operations, before taxes (excluding losses from discontinued division): $1,220,000 $ 850,000

6. Healy and Wahlen state that one type of earnings management occurs when managers use judgement in financial reporting to alter financial reports in order to mislead some stakeholder about the economic performance of the company. Earnings management is a consequence of a judgement by management which results in lower economic information content of the financial reports. Discuss four reasons that discourage managers from practicing earnings management.

Reasons to NOT manage earnings: 1. At some point earnings and cash flows come together and there is a settling up. If a manager manages earnings early on, later years will see lower earnings or losses to compensate. 2. Capital markets and regulators such as the SEC and state securities regulators can penalize firms that aggressively manage earnings. 3. Firms and managers that are perceived as practicing aggressive earnings management will lose reputation as being honest and trustworthy among capital market participants and stakeholders. 4. Legal consequences can result from aggressive earnings management, as well as from earnings management that reverts to earnings manipulation and fraud.

10. Penny Corp. manufactures telecommunication equipment and has been profitable each year for the past ten years. During 2014 the company saw its core market decline sharply when a competitor introduced a significant new product technology. In response to the decline in business Penny Corp. announced a major restructuring of its operations. The restructuring plan which would be implemented in 2010 would involve the following changes (all of the charges are material): a. Severance payments to reduce work force $ 9 million b. Write-down of inventory $13 million c. Penalty payment for termination of lease on manufacturing facility $ 6 million d. Write-down of equipment associated with manufacturing facility $12 million Total 2010 restructuring charge $40 million Penny Corp. has never previously restructured its operations and believes that it can return to profitability within two years based on its current research and development activity. Required: 1. Discuss whether or not you would eliminate the restructuring charge from the 2010 income statement of Penny Corp. when using earnings to forecast future profitability. 2. Penny Corp.'s restructuring charges cover a wide range of different cost categories; identify those that entail a cash payment and those that do not require a cash payment. For those charges not requiring a cash payment how would they be treated in the Statement of Cash Flows?

Suggested answer: 1. From the information provided it appears that this would be a case in which the restructuring charges should be adjusted. The company does not have a history of incurring restructuring charges and it has been profitable for a long period. The case against adjusting for the restructuring charges is that a return to profitability is not guaranteed, only forecasted by management based on current research and development. 2. The following two charges would require a cash payment: Severance payments to reduce work force $ 9 million Penalty payment for termination of lease on manufacturing facility $ 6 million The following two charges would not require a cash payment: Write-down of inventory $13 million Write-down of equipment associated with manufacturing facility $12 million These amounts would be included as an add back in 2010.

4. Many times an analyst will have to make judgments as to whether to include unrealized gains and losses when assessing earnings persistence and predicting future profitability. Discuss the case for and the case against including unrealized gains and losses as part of sustainable earnings when examining earnings persistence and future profitability.

The case for including unrealized gains and losses: 1. Unrealized gains and losses closely relate to ongoing operating activities and will likely recur. 2. Measuring the amount of unrealized gain or loss on certain assets is relatively objective in that active markets exist to indicate the amount of the value changes. The case against including unrealized gains and losses: 1. The amount of gain or loss that a firm will ultimately realize when it sells the asset or settles the liability will differ from the amount reported as an unrealized gain or loss in the current period. 2. The unrealized gains or losses could easily reverse in future periods. 3. The unrealized gains or losses have no immediate cash flow effect. 4. Measuring the amount of unrealized gain or loss on certain assets can be subjective if the asset or liability is not traded in an active market.

13. A. Listed below are 12 accounting liabilities: 1. Insurance paid in advance 2. Interest payable 3. Unsettled lawsuits where a reasonable estimate of loss can be determined and the loss is probable 4. Accounts payable 5. Warranties payable 6. Bonds payable 7. Accrued liabilities 8. Taxes payable 9. Employment commitments 10. Notes payable 11. Purchase commitments 12. Salaries payable Place each of these accounting liabilities into one of the following six categories: a. Obligations with fixed payment dates and amounts b. Obligations with fixed payment amounts but estimated payment dates c. Obligations for which the firm must estimate both timing and amount of payment d. Obligations arising from advances from customers on unexecuted contracts and agreements e. Obligations under mutually executed contracts f. Contingent obligations B. In addition, determine which of the liabilities would be recognized on the balance sheet as liabilities and which would not be recognized. Suggestion: format your answer as follows (this is not a correct sample answer): a. Obligations with fixed payment dates and amounts (not generally recognized): 1. Rent Payable

a. Obligations with fixed payment dates and amounts 1. Rent Payable 2. Interest payable 6. Bonds payable 10. Notes payable b. Obligations with fixed payment amounts but estimated payment dates 4. Accounts payable 8. Taxes payable 12. Salaries payable c. Obligations for which the firm must estimate both timing and amount of payment 5. Warranties payable d. Obligations arising from advances from customers on unexecuted contracts and agreements 7. Subscription fees received in advance e. Obligations under mutually unexecuted contracts - NOT GENERALLY RECOGNIZED 9. Employment commitments 11. Purchase commitments f. Contingent obligations 3. Unsettled lawsuits where a reasonable estimate of loss can be determined and the loss is probable.

16. Under current GAAP unrealized gains and losses from four balance sheet items are reported in ___________________________________________________________________________.

accumulated other comprehensive income or loss

11. When evaluating the quality of accounting information the user should consider the ____________________ of the firm's disclosures.

adequacy

17. Some firms attempt to maximize the amount of restructuring charge in a particular year; analysts refer to this as the _________________________ approach.

big bath

All of the following are true regarding a high quality balance sheet except: a. It should portray the economic resources that can be reasonably expected to generate future economic benefits. b. It should provide a complete and fair portrayal of all of the firm's obligations at a point in time, including the present value of long-term liabilities for future payments. c. It should minimize measurement error and bias. d. It should be optimistic in terms of accounting numbers.

d. It should be optimistic in terms of accounting numbers.

12. When evaluating the quality of accounting information the user should consider the _____________________________________________ of the measurements made.

economic faithfulness

4. Quality accounting information should be informative as to both the __________________________________________________ of the current period's earnings and the long-run sustainability of profits.

economic value implications

9. When evaluating the quality of accounting information the user should consider the reasonableness of the ____________________ made in applying GAAP.

estimates

15. An extraordinary gain or loss is unusual in nature, _____________________________________________, and material in amount.

infrequent in occurrence