LM9: Analysis of Income Tax

1. In the current year, Michaels Company has a carrying amount of USD3,500,000 and tax base
of USD5,000,000 for accounts receivable. Michaels will most likely recognize:
A. a deferred tax asset.
B. a deferred tax liability.
C. no deferred tax asset or liability.
Solution
A is correct. Because the carrying amount is less than the tax base for this asset, this difference
is a temporary difference that will result in a deferred tax asset. B is incorrect because a deferred
tax liability would apply if the carrying amount was greater than the asset base. C is incorrect
because this is not a permanent difference thus there will be either a deferred tax asset or
deferred tax liability.

2. James Company has received USD500,000 of tax credits from the recent installation of solar
panels that will directly reduce their taxes. Which of the following best describes these tax
credits?
A. Permanent difference
B. Taxable temporary difference
C. Deductible temporary difference.

Solution
A is correct. Permanent differences are differences between tax laws and accounting standards
that will not be reversed at some future date. Because they will not be reversed at a future date,
these differences do not give rise to deferred tax. These items include tax credits for expenditures
that directly reduce taxes, such as tax credits related to the purchase of solar power. B is
incorrect because taxable temporary differences result in the recognition of deferred tax
liabilities. C is incorrect because deductible temporary differences result in a deferred tax asset.

3. Please use the selected data in Exhibit 1 for the Samuels Corporation.
Solution
A is correct. USD450 is calculated as: (USD7,000 − USD5,714) × 0.35 = USD450. B is
incorrect because it incorrectly sums the deferred tax liabilities from Years 2 and 3: (USD7,000
− USD5,714) × 0.35 + (USD8,000 − USD7,143) × 0.35 = USD750. C is incorrect because it
incorrectly sums the deferred tax liabilities from Years 1, 2 and 3: (USD7,000 − USD5,714) ×
0.35 + (USD8,000 − USD7,143) × 0.35 + (USD9,000 − USD8,571) × 0.35 = USD900.

4. Which of the following is added to income tax payable to determine the company’s income tax
expense as reported on the income statement?
A. Deferred tax assets
B. Deferred tax liabilities
C. Changes in deferred tax assets and liabilities

Solution
C is correct. The changes in deferred tax assets and liabilities are added to income tax payable to
determine the company’s income tax expense (or credit) as it is reported on the income
statement. A and B are incorrect because it is the changes in deferred tax assets and liabilities that
are added to income tax payable.
5. Jamison Corp. is domiciled in the United States and has significant operations in the United
Kingdom and Australia. The statutory tax rates are 21 percent in the United States, 19 percent in
the United Kingdom, and 30 percent in Australia. The company generates Profit before tax of
USD2,000,000 in the United States, USD500,000 in the United Kingdom, and USD750,000 in
Australia. There are no other differences between Jamison’s effective and statutory tax rates.
Jamison’s combined effective tax rate is closest to:
A. 21.0 percent.
B. 22.8 percent.
C. 23.3 percent.

Solution
B is correct. The combined effective tax rate is calculated as:

Country Taxable Income Statutory Rate Taxes

U.S. USD2,000,000 21% USD420,000

U.K. 500,000 19 95,000

Australi 750,000 30 225,000

a

Total USD3,250,000 740,000

Effective tax rate: 740,000/3,250,00 22.8%

0

The effective tax rate is a blend of the different tax rates of the countries in which the activities
take place in relation to the profit generated in each country.
A is incorrect because 21.0 percent is the statutory tax rate in the US and does not incorporate
statutory tax rates in the United Kingdom and Australia. C is incorrect because 23.3 percent is
the simple average of all three statutory tax rates.
6. Which of the following statements about tax rates is correct?
A. The effective tax rate is typically used for forecasting cash flows.
B. The cash tax rate is relevant for projecting earnings on the income statement.
C. A company’s income tax expense equals the sum of current taxes plus the change in
deferred tax assets and liabilities.
Solution
C is correct. A company’s income tax expense equals the sum of current taxes (i.e., the amount
currently payable) plus the change in deferred tax assets and liabilities. A is incorrect because the
cash tax rate is typically used for forecasting cash flows. B is incorrect because the effective tax
rate is relevant for projecting earnings on the income statement.
7. Please use the selected disclosure data in Exhibit 1 and Exhibit 2 for the Marcy Corporation.
Marcy’s effective tax rate was lowest in:
A. Year 1.
B. Year 2.
C. Year 3.
Solution
C is correct. The effective tax rate of 24.5 percent (USD42,986/USD175,284) in Year 3 was
lower than the effective tax rates in Year 1 and Year 2. A is incorrect because its effective tax rate
of 30.1 percent is higher than that of Year 3. B is incorrect because its effective tax rate of 26.1
percent is higher than that of Year 3.
8. Using information in question 7, Relative to Marcy’s effective tax rate on foreign income, the
company’s effective tax rate on US income was:
A. lower in each year presented.
B. higher in each year presented.
C. higher in some periods and lower in others.
Solution
C is correct. In Year 1, the effective tax rate on foreign operations was 37.6 percent
[(USD17,591 + USD262)/USD47,542], and the effective US tax rate was [(USD31,143 −
USD5,325)/USD97,321] = 26.5 percent. In Year 2, the effective tax rate on foreign operations
was 25.6 percent, and the US rate was 26.4 percent. In Year 3, the foreign rate was 25.7 percent,
and the US rate was 24.0 percent.

9. In the current year, a company increased its deferred tax asset by $500,000. During the year,
the company most likely:
A. became entitled to a $500,000 tax refund.
B. reported a lower accounting profit than taxable income.
C. had permanent differences between accounting profit and taxable income.

Solution
A. Incorrect. Deferred tax assets are simply the results of differences between accounting
profit and taxable income. It is not an amount of a tax refund that would be an income tax
receivable.
B. Correct. Deferred tax assets represent taxes that have been paid (because of the higher
taxable income) but have not yet been recognized on the income statement (because of
the lower accounting profit).
C. Incorrect. Only temporary differences create deferred tax assets or liabilities
10. The following information is available for a company that prepares its financial statements
according to US GAAP:
The overall effect on 2015 net income from the above changes in the company’s deferred tax
accounts is closest to a:
A. $200,000 increase.
B. $300,000 increase.
C. $200,000 decrease.
Solution
A. Correct. A valuation allowance reduces the value of the deferred tax assets under US
GAAP, so the total change in net income as a result of the changes in the three accounts
can be calculated as follows:
Effect of Change on Net
Income
Change in Account from
Account 2014 Direction Dollar Effect
Deferred tax assets $ 200,000 increase Increase $200,000
Deferred tax $100,000 decrease Increase 100,000
liabilities
Valuation allowance $100,000 increase Decrease (100,000)
Overall effect: A net increase of: $200,000
B. Incorrect. It incorrectly ignores the change in the valuation allowance (doesn’t realize it is
related to deferred tax assets).
C. Incorrect. This is the inverse of the correct answer.
LM 10: Financial Reporting Quality
1. In contrast to earnings quality, financial reporting quality most likely pertains to:
A. sustainable earnings.
B. relevant information.
C. adequate return on investment.

Solution
B is correct. Financial reporting quality pertains to the quality of information in financial
reports. High-quality financial reporting provides decision-useful information, which is relevant
and faithfully represents the economic reality of the company’s activities. Earnings of high
quality are sustainable and provide an adequate level of return. Highest-quality financial reports
reflect both high financial reporting quality and high earnings quality.

2. 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.

Solution
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.

3. 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.
Solution
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 of little use in
assessing 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.

4. 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.
Solution
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. 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.
5. Earnings that result from non-recurring activities most likely indicate:
A. lower-quality earnings.
B. biased accounting choices.
C. lower-quality financial reporting.
Solution
A is correct. Earnings that result from non-recurring activities are unsustainable. Unsustainable
earnings are an example of lower-quality earnings. Recognizing earnings that result from non-
recurring activities is neither a biased accounting choice nor indicative of lower quality financial
reporting because it faithfully represents economic events.
6. Which attribute of financial reports would most likely be evaluated as optimal in the financial
reporting spectrum?
A. Conservative accounting choices
B. Sustainable and adequate returns
C. Emphasized pro forma earnings measures
Solution
B is correct. At the top of the quality spectrum of financial reports are reports that conform to
GAAP, are decision useful, and have earnings that are sustainable and offer adequate returns. In
other words, these reports have both high financial reporting quality and high earnings quality.
7. Financial reports of the lowest level of quality reflect:
A. fictitious events.
B. biased accounting choices.
C. accounting that is non-compliant with GAAP.

Solution:
A is correct. Financial reports span a quality continuum from high to low based on decision-
usefulness and earnings quality (see Exhibit 2). The lowest-quality reports portray fictitious
events, which may misrepresent the company’s performance or obscure fraudulent
misappropriation of the company’s assets.

8. When earnings are increased by deferring research and development (R&D) investments until
the next reporting period, this choice is considered:
A. non-compliant accounting.
B. earnings management as a result of a real action.
C. earnings management as a result of an accounting choice.
Solution
B is correct. Deferring R&D investments into the next reporting period is an example of earnings
management by taking a real action
9. A high-quality financial report may reflect:
A. earnings smoothing.
B. low earnings quality.
C. understatement of asset impairment.
Solution
B is correct. High-quality financial reports offer useful information, meaning information that is
relevant and faithfully represents actual performance. Although low earnings quality may not be
desirable, if the reported earnings are representative of actual performance, they are consistent
with high-quality financial reporting. Highest-quality financial reports reflect both high financial
reporting quality and high earnings quality.
10. If a particular accounting choice is considered aggressive in nature, then the financial
performance for the reporting period would most likely:
A. be neutral.
B. exhibit an upward bias.
C. exhibit a downward bias.
Solution
B is correct. Aggressive accounting choices aim to enhance the company’s reported performance
by inflating the amount of revenues, earnings, or operating cash flow reported in the period.
Consequently, the financial performance for that period would most likely exhibit an upward
bias.
11. Conservative accounting choices will most likely lead to:
A. decreased reported earnings in later periods.
B. increased reported earnings in the period under review.
C. increased debt reported on the balance sheet at the end of the current period.
Solution
C is correct. Accounting choices are considered conservative if they decrease the company’s
reported performance and financial position in the current period under review. Conservative
choices may increase the amount of debt reported on the balance sheet. They may decrease the
revenues, earnings, or operating cash flow reported for the period and increase those amounts in
later periods.
12. Which of the following is most likely to be considered a potential benefit of accounting
conservatism?
A. A reduction in litigation costs
B. Less biased financial reporting
C. An increase in current period reported performance
Solution
A is correct. Conservatism reduces the possibility of litigation and, by extension, litigation costs.
Rarely, if ever, is a company sued because it understated good news or overstated bad news.
Accounting conservatism is a type of bias in financial reporting that decreases a company’s
reported performance. Conservatism directly conflicts with the characteristic of neutrality.
13. Which of the following statements most likely describes a situation that would motivate a
manager to issue low-quality financial reports? The manager has:
A. increased the market share of products significantly.
B. earned compensation that is linked to stock price performance.
C. brought the company’s profitability to a level higher than competitors.
Solution
B is correct. Managers often have incentives to meet or beat market expectations, particularly if
management compensation is linked to increases in share prices or to reported earnings.
14. Which of the following concerns would most likely motivate a manager to make conservative
accounting choices?
A. Attention to future career opportunities
B. Debt covenant violation risk in the current period
C. Unexpected strength in the business environment
Solution
C is correct. Managers may be motivated to understate earnings in a period with unexpected
strong performance by delaying revenue recognition or accelerating expense recognition to
increase the probability of exceeding expectations in a subsequent period (referred to as
“banking” some earnings for the next period.)
15. Which of the following conditions best explains why a company’s manager would obtain
legal, accounting, and board level approval prior to issuing low-quality financial reports?
A. Motivation
B. Opportunity
C. Rationalization
Solution
C is correct. Typically, conditions of opportunity, motivation, and rationalization exist when
individuals issue low-quality financial reports. Rationalization occurs when an individual is
concerned about a choice and needs to be able to justify it to herself or himself. If the manager is
concerned about a choice in a financial report, the manager may ask for other opinions to
convince herself or himself that it is okay.

16. A company is experiencing a period of strong financial performance. To increase the

likelihood of exceeding analysts’ earnings forecasts in the next reporting period, the company
would most likely undertake accounting choices for the period under review that:
 A. inflate reported revenue.
B. delay expense recognition.
C. accelerate expense recognition.
Solution
C is correct. In a period of strong financial performance, managers may pursue accounting
choices that increase the probability of exceeding earnings forecasts for the next period. By
accelerating expense recognition or delaying revenue recognition, managers may reduce
financial performance in the current period in order to inflate earnings in the next period and
increase the likelihood of exceeding targets.
17. Which of the following situations represents a motivation, rather than an opportunity, to issue
low-quality financial reports?
A. Poor internal controls
B. Search for a personal bonus
C. Inattentive board of directors
Solution
B is correct. Motivation can result from pressure to meet some criteria for personal reasons, such
as a bonus, or corporate reasons, such as concern about future financing. Poor internal controls
and an inattentive board of directors offer opportunities to issue low-quality financial reports.
18. Which of the following situations will most likely motivate managers to inflate reported
earnings?
A. Possibility of bond covenant violation
B. Earnings that have exceeded analysts’ forecasts
C. Earnings that have grown from the prior-year period
Solution
A is correct. The possibility of bond covenant violations may motivate managers to inflate
earnings in the reporting period. In so doing, the company may be able to avoid the
consequences associated with violating bond covenants.
19. Which of the following best describes an opportunity for management to issue low-quality
financial reports?
A. Ineffective board of directors
B. Pressure to achieve some performance level
C. Corporate concerns about financing in the future
Solution
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 a certain level of performance and
corporate concerns about future financing 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.
20. An audit opinion of a company’s financial reports is most likely intended to:
A. detect fraud.
B. reveal misstatements.
C. ensure that financial information is presented fairly.
Solution
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 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.
21. 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.
Solution
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 requires 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.
22. A company wishing to increase earnings in the reporting 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.
Solution
B is correct. If a company wants to increase reported earnings, the company’s managers may
reduce the allowance for uncollected accounts and the related expense reported for the period.
Decreasing the useful life of depreciable assets would increase depreciation expense and
decrease earnings in the reporting period. Classifying a purchase as an expense, rather than
capital expenditure, would decrease earnings in the reporting period. The use of accrual
accounting may result in estimates 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
managed by the company to present a desired financial picture.
23. Which technique most likely increases the cash flow provided by operations?
A. Stretching the accounts payable credit period
B. Applying all non-cash discount amortization against interest capitalized
C. Shifting classification of interest paid from financing to operating cash flows
Solution
A is correct. Managers can temporarily show a higher cash flow from operations by stretching
the accounts payable credit period. In other words, the managers delay payments until the next
accounting period. Applying all non-cash discount amortization against interest capitalized
causes reported interest expenses and operating cash outflow to be higher, resulting in a lower
cash flow provided by operations. Shifting the classification of interest paid from financing to
operating cash flows lowers the cash flow provided by operations.
24. 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.
Solution
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 insufficient to determine if there is bias in revenue recognition. Additional
analytical procedures must be performed to identify 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 before goods are shipped
to customers, may be a warning sign of accounting malfeasance.
25. 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.
Solution
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.
Numerous analytical procedures 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.
26. 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.
Solution
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.
27. An analyst reviewing a firm with a large reported restructuring charge to earnings should:
A. view expenses reported in prior years as overstated.
B. disregard it because it is solely related to past events.
C. consider making pro forma adjustments to prior years’ earnings.
Solution
C is correct. To extrapolate historical earnings trends, an analyst should consider making pro
forma analytical adjustments of prior years’ earnings to reflect in those prior years a reasonable
share of the current period’s restructuring and impairment charges.
28. The effectiveness of a debt covenant in disciplining financial reporting quality is most often
limited due to:
A. ineffectiveness of financial triggers.
B. reporting requirements that may not be legally binding.
C. potential for managers to inflate earnings.
Solution
A. Incorrect because financial triggers can be effective deterrents of debt covenant violations
because the investors have the option to recover all or part of their investment.
B. Incorrect because loan agreements often contain loan covenants, which create specifically
tailored financial reporting requirements that are legally binding for the issuer.
C. Correct. Avoidance of debt covenant violation is a potential motivation for managers to
inflate earnings.

29. Which of the following conditions would most likely create opportunities for a company to
issue low-quality financial reports?
A. A company with an audit committee comprised only of independent board members
B. Government cutbacks in the enforcement branch of the financial regulator
C. Accounting standards that provide few choices
Solution
A. Incorrect. An independent audit committee reduces the opportunity to produce low-
quality financial reports.
B. Correct. Cutbacks in the enforcement branch of the financial regulator could lead to less
effective enforcement and oversight of financial issuers, thus creating an opportunity for
low-quality financial reporting.
C. Incorrect. Accounting standards that do not allow a range of choices reduce the
opportunity for low-quality financial reporting.

30. Overloading distribution channels (“channel stuffing”) would understate:

A. inventories.
B. accounts receivable.
C. revenues.
Solution
A. Correct. “Channel stuffing,” or inducing customers to buy more than usual, will produce
an overstatement of revenues, which may be corrected in future periods if product is
returned. Returned product in future periods would tend to understate inventories in the
current period.
B. Incorrect because “channel stuffing,” or inducing customers to buy more than usual, will
most likely produce a higher ratio of accounts receivable to revenues because of an
overstatement of accounts receivable.
C. Incorrect because “channel stuffing,” or inducing customers to buy more than usual, will
produce an overstatement of revenues.
31. Which of the following is the best example of conservative accounting?
A. Reducing the allowance for bad debt expense below the experienced loss rate.
B. Deferring R&D expenses to a subsequent year.
C. Choosing to depreciate new equipment over the shortest estimate of its useful life.
Solution
A. Incorrect. Reducing the bad debt allowance below the experienced loss rate is an
aggressive choice that causes earnings to appear higher in the current year.
B. Incorrect. Deferring R&D is an aggressive choice that causes earnings to appear higher in
the current year.
C. Correct. Depreciating equipment over the shortest estimated period of its useful life is a
conservative accounting choice that reduces earnings in the early years and increases
them in the future, creating a positive trajectory.

32. Which of the following items is a non-GAAP financial measure?

A. Net income after taxes
B. Income from operations
C. EBITDA
Solution
A. Incorrect because net income after taxes is a GAAP-compliant financial measure that
should be defined, calculated, and presented consistently with the same measure on
income statements of other US-based publicly traded companies.
B. Incorrect because income from operations is a GAAP-compliant financial measure that
should be defined, calculated, and presented consistently with the same measure on
income statements of other US-based publicly traded companies.
C. Correct. EBITDA is a non-GAAP financial measure. The SEC prohibits the exclusion of
charges or liabilities requiring cash settlement from any non-GAAP liquidity measures
other than EBIT and EBITDA.

33. Conservative, rather than aggressive, accounting is most likely associated with:
A. increased sustainability of earnings.
B. higher current reported performance.
C. recognition of losses once certain.
Solution
A. Correct. Conservative accounting choices decrease a company’s reported performance
and results in the current period and may increase its reported performance and financial
position in later periods. Therefore, it typically avoids a sustainability issue.
 B. Incorrect because higher current reported performance is a result associated with
aggressive accounting choices, not conservative ones.
C. Incorrect because in general, conservatism means that losses are recognized when
probable; waiting to recognize losses until they are certain would be an aggressive
approach rather than a conservative one.

34. Changing the estimates of the salvage value of capital assets is the least effective way to
manage earnings during the life of an asset for companies whose method of depreciation is:
A. straight-line.
B. units-of-production.
C. double-declining balance.
Solution
A. Incorrect. The straight-line method calculates depreciation on the net cost of the assets.
Changing the salvage value will change the depreciation deduction and thereby affect
earnings.
B. Incorrect. The units-of-production method calculates depreciation rate based on the net
cost of the assets. Changing the salvage value will change the depreciation rate and
thereby affect earnings.
C. Correct. The double-declining balance depreciation method applies the rate to the gross
cost of the equipment, so a change in the salvage assumption will have no effect on
earnings until the net book value reaches the estimated salvage value, at which point the
company ceases to take depreciation on the asset.

35. Which of the following conditions is most likely associated with decreased earnings quality?
Compared with the prior year, the reporting entity’s earnings:
A. decreased slightly in response to the introduction of conservative accounting policies.
B. were similar in magnitude but included a large gain on the sale of a manufacturing
plant.
C. increased slightly because of a reduction in bad debt expense based on more-current
experiences.
Solution
A. Incorrect. This is an example of decreased financial reporting quality because
conservatism, a choice made by management, is making it more difficult to establish
expectations for the future. Since the earnings only decreased because of the
conservatism, there is no decrease in the underlying earnings quality.
B. Correct. The sale of a manufacturing plant is likely a one-time transaction that will not
be sustained in future years. The quality of reported earnings has therefore decreased
from the prior year.
 C. Incorrect. If the estimates are based on more recent experiences, it does not imply the
intent to manipulate earnings and will provide a more faithful representation of the
company’s performance.

36. Under the indirect method of presenting operating cash flows, which action to alter the cash
flow from operations will be most difficult to detect?
A. Defer payment of a current liability
B. Transact with an unconsolidated special purpose entity
C. Change inventory costing from FIFO to weighted average
Solution
A. Incorrect because an examination of cash provided by operating activities will reveal that
the increase in cash due to the deferred payment is offset by a comparable increase in
accounts payable.
B. Correct. Unconsolidated special purpose entities are outside of the view of investors.
Transacting with such an entity may initially produce the appearance of a positive or
negative cash flow for the controlling company. Ultimately, this transaction will most
likely be reversed along with the appearance of the initial cash flow.
C. Incorrect because changes in inventory accounting may affect gross profit and therefore
net income, but with an opposite effect on the ending inventory value. Together these
effects would likely have an offsetting impact on the appearance of cash generated by
operating activities. One possible exception might be the effect on derived expenses such
as the provision for income tax.

37. Which of the following descriptions of financial reporting is considered to be of the highest
quality?
A. Within GAAP but with earnings management
B. Within GAAP but with biased choices
C. Outside GAAP but with conservative choices
Solution
A. Incorrect. Along the financial reporting quality spectrum, financial reporting that is
within GAAP but subject to earnings management is considered to be inferior to within-
GAAP financial reporting that has biased choices.
B. Correct. Along the financial reporting quality spectrum, financial reporting that is within
GAAP but has biased choices is considered to be better quality than within-GAAP
financial reporting that is subject to earnings management. Financial reporting that is
non-compliant with GAAP is considered to be even lower quality.
C. Incorrect. Along the financial reporting quality spectrum, financial reporting that is non-
compliant with GAAP is considered to be inferior to GAAP-compliant financial
reporting.
38. Which of the following approaches will most likely reveal manipulation of financial
reporting?
A. Using EBITDA to adjust for non-recurring items
B. Evaluating potential warning signals in isolation
C. Comparing a company’s methods and policies to those of its peers
Solution
A. Incorrect because companies may construct or report their own version of EBITDA.
Thus, adjusting EBITDA for a non-recurring item, in and of itself, does not reflect or
reveal manipulation or financial reporting.
B. Incorrect because investors need to evaluate warning signals cohesively, not on an
isolated basis.
C. Correct. An investor should compare a company’s policies with those of its peers to
determine whether its approaches match or differ from industry norms; if a company is
the only one in its industry following a particular approach, a red flag is raised.