MCQ Quiz

A manager is most likely to employ aggressive accounting choices that increase current period earnings when:

• The company is close to violating a debt covenant based on a minimum interest coverage ratio.
• The company has already exceeded all analyst targets and wishes to create a cookie jar reserve.
• Tax rates are expected to decrease significantly in the next fiscal year.

An analyst observes that a company's financial reports are fully compliant with GAAP and decision-useful, but the earnings are generated from one-off asset sales that are unlikely to recur. This situation best describes:

• High financial reporting quality and high earnings quality.
• High financial reporting quality and low earnings quality.
• Low financial reporting quality and low earnings quality.

Consider the following statements regarding provisions and reserves ('Cookie Jar' accounting):
(1) Overestimating a restructuring provision in a profitable year allows a firm to shift income from the current period to future periods.
(2) Reducing the valuation allowance on a deferred tax asset decreases reported net income.
(3) Underestimating warranty expenses in the current year increases current net income and is a form of aggressive accounting.
Which of the statements given above are correct?

• 1 and 2 only
• 1 and 3 only
• 2 and 3 only

An analyst notices that a company has extended the useful lives of its proprietary manufacturing equipment compared to industry peers. This change will most likely:

• Increase depreciation expense and decrease operating margins.
• Decrease depreciation expense and increase fixed asset turnover.
• Decrease depreciation expense and increase net income.

Consider the following statements regarding non-GAAP financial measures:
(1) Firms use non-GAAP measures such as 'Core Earnings' or 'Adjusted EBITDA' to exclude items they deem non-recurring or non-cash.
(2) Under SEC Regulation G, firms are prohibited from presenting non-GAAP measures in their official filings.
(3) Requiring a reconciliation between the non-GAAP measure and the most comparable GAAP measure is a key regulatory safeguard.
Which of the statements given above are correct?

• 1 and 2 only
• 1 and 3 only
• 2 and 3 only

Consider the following statements regarding classification shifting:
(1) Shifting operating expenses to 'non-recurring' or 'special' items does not change net income but inflates 'Core Earnings'.
(2) Classification shifting of operating cash outflows to investing cash outflows improves reported Free Cash Flow (if defined as CFO minus CAPEX) when CAPEX is already high.
(3) Reporting a gain on the sale of an asset as a reduction in operating expenses rather than as 'Other Income' effectively increases reported Operating Profit.
Which of the statements given above are correct?

• 1 and 2 only
• 1 and 3 only
• 2 and 3 only

Consider the following statements regarding warning signs in financial statements related to revenue:
(1) If Accounts Receivable grows at a significantly faster rate than Sales, it may indicate channel stuffing or credit quality deterioration.
(2) A sudden decrease in the Days Sales Outstanding (DSO) ratio is a typical warning sign of fictitious revenue recognition.
(3) A significant increase in unbilled receivables (contract assets) relative to revenue is a potential sign of aggressive revenue recognition.
Which of the statements given above are correct?

• 1 and 2 only
• 1 and 3 only
• 2 and 3 only

Consider the following statements regarding real earnings management versus accrual earnings management:
(1) Deferring necessary maintenance expenditure to the next fiscal year is an example of accrual earnings management.
(2) Offering deep discounts near year-end to accelerate sales is an example of real earnings management.
(3) Accrual earnings management involves making accounting choices or estimates without changing the underlying business transactions.
Which of the statements given above are correct?

• 1 and 2 only
• 2 and 3 only
• 1 and 3 only

A company extends its days payable outstanding (DPO) significantly at year-end without a change in credit terms from suppliers. This action will most likely:

• Increase cash flow from operations (CFO) and decrease operating cycle.
• Increase cash flow from operations (CFO) and leave net income unchanged.
• Decrease cash flow from investing (CFI) and increase net income.

Assertion (A): A 'Big Bath' strategy involves recognizing unusually large restructuring charges or write-downs in a period where the company is already reporting poor results.
Reason (R): By taking all possible losses in one bad year, management resets the balance sheet and lowers future depreciation and amortization expenses, facilitating higher reported earnings in future periods.

• Both A and R are true and R is the correct explanation of A
• Both A and R are true but R is not the correct explanation of A
• A is true but R is false
• A is false but R is true

Consider the following statements regarding expense recognition and capitalization:
(1) Capitalizing an expenditure that should be expensed increases Cash Flow from Operations (CFO) in the current period.
(2) Capitalizing an expenditure lowers the variability of net income compared to expensing it immediately.
(3) Expensing a cost that produces future benefits is considered an aggressive accounting treatment.
Which of the statements given above are correct?

• 1 and 2 only
• 2 and 3 only
• 1 and 3 only

Assertion (A): A decrease in the valuation allowance for deferred tax assets results in an immediate increase in reported Net Income.
Reason (R): A reduction in the valuation allowance implies a higher probability of realizing future tax benefits, which is recorded as a reduction in income tax expense on the income statement.

• Both A and R are true and R is the correct explanation of A
• Both A and R are true but R is not the correct explanation of A
• A is true but R is false
• A is false but R is true

Management avoids an impairment charge on Goodwill by using aggressive assumptions in their fair value testing. This action results in:

• Overstated assets and overstated current period earnings.
• Understated assets and overstated current period earnings.
• Overstated assets and understated future expenses.

Consider the following statements regarding depreciation and amortization choices:
(1) Increasing the estimated useful life of a depreciable asset is an aggressive accounting change that increases current period earnings.
(2) Reducing the estimated salvage value of an asset decreases depreciation expense and increases net income.
(3) A company whose ratio of depreciation to gross fixed assets is significantly lower than its peers may be understating expenses.
Which of the statements given above are correct?

• 1 and 2 only
• 1 and 3 only
• 2 and 3 only

Assertion (A): The sale of accounts receivable (securitization) is often used to artificially boost Operating Cash Flow (CFO).
Reason (R): The proceeds from the sale are typically classified as a financing inflow, reflecting the collateralized nature of the borrowing arrangement.

• Both A and R are true and R is the correct explanation of A
• Both A and R are true but R is not the correct explanation of A
• A is true but R is false
• A is false but R is true

Consider the following statements regarding revenue recognition manipulation:
(1) Channel stuffing involves shipping excess inventory to distributors to boost current period revenues, typically leading to higher sales returns in subsequent periods.
(2) 'Bill-and-hold' transactions are always prohibited under US GAAP and IFRS due to the high risk of fraud.
(3) Recognizing revenue on a 'layaway' sale before the customer takes possession is an aggressive revenue recognition practice.
Which of the statements given above are correct?

• 1 and 2 only
• 1 and 3 only
• 2 and 3 only

Assertion (A): A company that acts as an agent but reports revenue on a gross basis (as a principal) will show a lower Net Profit Margin than if it reported on a net basis.
Reason (R): Reporting on a gross basis inflates the Revenue figure (denominator) without changing the Net Income (numerator), mathematically reducing the profit margin percentage.

• Both A and R are true and R is the correct explanation of A
• Both A and R are true but R is not the correct explanation of A
• A is true but R is false
• A is false but R is true

A company emphasizes a Non-GAAP earnings measure that excludes 'restructuring costs'. An analyst should view this exclusion with skepticism if:

• The restructuring costs are non-cash in nature.
• The restructuring costs occur every year.
• The company provides a reconciliation to the nearest GAAP measure.

Consider the following statements regarding cash flow manipulation:
(1) Stretching accounts payable is a technique to temporarily increase Cash Flow from Operations (CFO).
(2) Under IFRS, classifying interest paid as a financing cash flow rather than an operating cash flow results in higher reported CFO.
(3) Misclassifying the sale of trading securities as an investing cash flow rather than an operating cash flow decreases CFO.
Which of the statements given above are correct?

• 1 and 2 only
• 2 and 3 only
• 1 and 3 only

A company classifies interest paid as a financing cash flow (CFF) rather than an operating cash flow (CFO), as permitted under IFRS. Compared to a US GAAP firm (which requires CFO classification), this choice:

• Increases CFO and decreases CFF.
• Decreases CFO and increases CFF.
• Has no effect on free cash flow to the firm (FCFF).

Assertion (A): Analysts should generally prefer 'Adjusted EBITDA' over GAAP Net Income because it provides a more standardized view of a company's liquidity.
Reason (R): Adjusted EBITDA excludes non-cash charges like depreciation and stock-based compensation, as well as interest and taxes, offering a proxy for operating cash flow.

• Both A and R are true and R is the correct explanation of A
• Both A and R are true but R is not the correct explanation of A
• A is false but R is true
• A is true but R is false

Assertion (A): It is possible for a company to have high financial reporting quality but low earnings quality.
Reason (R): Financial reporting quality refers to the accuracy and compliance of the disclosures with standards, whereas earnings quality refers to the sustainability and cash-backing of the actual performance.

• Both A and R are true and R is the correct explanation of A
• Both A and R are true but R is not the correct explanation of A
• A is true but R is false
• A is false but R is true

Consider the following statements regarding inventory accounting and reporting quality:
(1) A write-down of inventory to net realizable value reduces current period net income and the carrying value of inventory.
(2) Reversing a previous inventory write-down is prohibited under both IFRS and US GAAP to prevent income manipulation.
(3) During a period of rising prices, a firm using LIFO liquidation will report artificially inflated gross profit margins.
Which of the statements given above are correct?

• 1 and 2 only
• 1 and 3 only
• 2 and 3 only

Assertion (A): Deferring necessary equipment maintenance to a future period is an example of 'real' earnings management.
Reason (R): Unlike accounting earnings management which involves estimates and accruals, real earnings management involves altering actual operational business decisions to achieve a financial reporting target.

• Both A and R are true and R is the correct explanation of A
• Both A and R are true but R is not the correct explanation of A
• A is true but R is false
• A is false but R is true

Assertion (A): For a company using LIFO, a reduction in inventory quantities (LIFO liquidation) can result in an unsustainable increase in gross profit margin.
Reason (R): LIFO liquidation matches older, typically lower, historical costs against current, higher selling prices, creating a one-time boost to earnings that does not reflect current operating margins.

• Both A and R are true and R is the correct explanation of A
• Both A and R are true but R is not the correct explanation of A
• A is true but R is false
• A is false but R is true

A company reduces the valuation allowance against its deferred tax assets (DTAs). This adjustment results in:

• A decrease in income tax expense and an increase in net income.
• An increase in income tax expense and a decrease in net income.
• No change to net income, but an increase in total assets.

In a period of rising prices, a LIFO firm experiencing a decline in inventory quantities will most likely report:

• Lower gross margins due to the LIFO conformity rule.
• Higher gross margins due to LIFO liquidation.
• Sustainable earnings growth driven by efficiency.

Assertion (A): A significant increase in Days Sales Outstanding (DSO) relative to recent history is a positive signal indicating strong customer demand and trust.
Reason (R): A rising DSO means customers are taking longer to pay, which increases the Accounts Receivable balance on the balance sheet.

• Both A and R are true and R is the correct explanation of A
• Both A and R are true but R is not the correct explanation of A
• A is false but R is true
• A is true but R is false

Which of the following practices is most consistent with aggressive revenue recognition?

• Recognizing revenue only after the customer has accepted delivery.
• Utilizing bill-and-hold arrangements with minimal business justification.
• Establishing a high allowance for sales returns based on historical data.

Consider the following statements regarding aggressive versus conservative accounting policies:
(1) Conservative accounting recognizes losses as they occur but delays the recognition of gains until they are realized.
(2) Aggressive accounting generally results in higher reported earnings and higher book value of assets in the current period.
(3) Over the entire life of a firm, the total earnings reported are significantly higher under aggressive accounting than under conservative accounting.
Which of the statements given above are correct?

• 1 and 2 only
• 2 and 3 only
• 1 and 3 only

Consider the following statements regarding warning signs related to inventories and margins:
(1) An increase in the inventory turnover ratio coupled with decreasing sales is a strong indicator of inventory obsolescence.
(2) If a firm reports increasing gross margins while the industry experiences declining margins, it may indicate accounting manipulation.
(3) LIFO liquidation can result in a one-time boost to net income that is not sustainable.
Which of the statements given above are correct?

• 1 and 2 only
• 2 and 3 only
• 1 and 3 only

Which of the following is considered an 'Opportunity' risk factor in the fraud triangle that could lead to low-quality financial reporting?

• A board of directors dominated by insiders.
• A significant portion of management compensation tied to earnings per share.
• A need to secure external financing to avoid bankruptcy.

Assertion (A): Underestimating warranty provisions is an aggressive accounting technique that increases current period liabilities.
Reason (R): By underestimating the provision, the company records a lower warranty expense in the current period, which directly increases reported net income.

• Both A and R are true and R is the correct explanation of A
• Both A and R are true but R is not the correct explanation of A
• A is false but R is true
• A is true but R is false

Which of the following relationships between Net Income (NI) and Cash Flow from Operations (CFO) is the strongest red flag for potential earnings manipulation?

• NI is consistently greater than CFO over time.
• NI and CFO are both growing at the same rate.
• CFO is consistently greater than NI over time.

Consider the following statements regarding the spectrum of financial reporting and earnings quality:
(1) It is possible for a firm to have high financial reporting quality but low earnings quality.
(2) Sustainable earnings and adequate returns on capital are characteristics of high financial reporting quality, regardless of the accounting standards used.
(3) Earnings quality is considered low if the reported earnings are not useful for predicting the firm's future performance.
Which of the statements given above are correct?

• 1 and 2 only
• 1 and 3 only
• 2 and 3 only

Consider the following statements regarding the 'Big Bath' accounting technique:
(1) Big Bath accounting involves recognizing large write-downs or expenses in a period of already poor performance.
(2) The objective of Big Bath accounting is to depress current earnings to ensure higher reported earnings in future periods.
(3) Big Bath accounting is an example of an income smoothing technique designed to reduce earnings volatility.
Which of the statements given above are correct?

• 1 and 2 only
• 1 and 3 only
• 2 and 3 only

Assertion (A): Capitalizing interest costs on a self-constructed asset results in higher reported Cash Flow from Operations (CFO) in the current period compared to expensing the same interest costs.
Reason (R): When interest is capitalized, the cash outflow is classified as an investing activity (part of the asset's cost), whereas interest treated as an expense is typically classified as an operating cash outflow (under US GAAP).

• Both A and R are true and R is the correct explanation of A
• Both A and R are true but R is not the correct explanation of A
• A is true but R is false
• A is false but R is true

Assertion (A): Under US GAAP, a company can reverse a previous inventory write-down if the value of the inventory subsequently recovers, thereby boosting current earnings.
Reason (R): Inventory write-downs establish a new cost basis for the asset, and accounting standards prohibit the upward revaluation of inventory above its historical cost.

• Both A and R are true and R is the correct explanation of A
• Both A and R are true but R is not the correct explanation of A
• A is false but R is true
• A is true but R is false

Assertion (A): Stretching accounts payable (delaying payments to suppliers) temporarily increases a company's Operating Cash Flow (CFO).
Reason (R): An increase in Accounts Payable is an operating liability, and increases in operating liabilities are added back to Net Income (or treated as inflows) in the indirect method of calculating CFO.

• Both A and R are true and R is the correct explanation of A
• Both A and R are true but R is not the correct explanation of A
• A is true but R is false
• A is false but R is true

A management team chooses to expense a cost immediately rather than capitalizing it, even though accounting standards allow for capitalization. The immediate effect of this choice is to:

• Decrease current period earnings and increase future period potential earnings.
• Increase current period earnings and decrease future period potential earnings.
• Decrease current period cash flow from operations and increase investing cash flow.

Assertion (A): 'Bill and hold' transactions are often scrutinized as a potential indicator of aggressive revenue recognition.
Reason (R): In a bill and hold arrangement, the seller does not recognize revenue until the goods are physically delivered to the customer's location.

• Both A and R are true and R is the correct explanation of A
• Both A and R are true but R is not the correct explanation of A
• A is true but R is false
• A is false but R is true

A company reports a 20% increase in revenue, but its Days Sales Outstanding (DSO) has increased from 45 days to 75 days. This most likely suggests:

• Improved credit terms leading to higher quality sales.
• Channel stuffing or poor credit quality of customers.
• Greater efficiency in collections relative to sales growth.