FSA MODULE 36

Question 1

36.1 What is meant by financial reporting quality?

Answer 1

Accounts are of high accounting quality if they are decision useful.
- for them to be decision useful, they need to have 1) faithful representation, and 2) relevance

faithful representation: monitored for 1) completeness (that all transactions are recorded) 2) neutrality 3) an absence of errors or at least material errors.

Question 2

36.1 What is meant by earnings quality?

Answer 2

Economic profit,
- ROE > r
- sustainability of earnings
- net income: cash based earnings, and accruals based earnings (idea here is the idea that cash based earnings are of higher quality than accruals based earnings)
- ABE are often unsustainable - because accruals will automatically reverse at some point in the future

Question 3

36.1 What is the difference between conservative and aggressive accounting choices?

Answer 3

Conservative =
- essentially leads to lower earnings and lower net assets in the current period

capitalisation - is the aggressive accounting procedure

expensing - is the conservative way, hits the balance sheet immediately

depreciation - straight line is aggressive, charges less in the early years. Accelerated (double declining balance) is the more conservative choice, more depreciation passes through the BS in earlier years

Aggressive does not really mean bad - but it just needs to properly reflect the ‘economic structure of transactions’

Question 4

36.1 what are the various motivations for earnings management?

Answer 4

Question 5

36.1 Who are the regulators of financial reporting quality?

Answer 5

SEC/FCA

Auditors

Question 6

36.1 What are important choices important to financial reporting quality?

Answer 6

ALSO:

impairments (due to subjectivity of undercounted cash flows)

Inventory - FIFO/LIFO, NRV is also really subjective
- write downs - can be reversed or not under IFRS and GAAP

Capitalising vs Expensing

Question 7

36.1 What are ‘pro forma earnings’?

Answer 7

One potential warning sign of low-quality financial reporting is management’s focus on “pro forma” or non-GAAP measures of earnings. Increases in operating cash flows or asset turnover ratios are not typically viewed as warning signs of poor financial reporting quality.

Question 8

36.1 What are debt covenants?

Answer 8

Debt covenants are rules written into a loan agreement that the borrower must follow while the loan is outstanding.

Debt covenants that require a firm to meet minimum financial measures may give management an incentive to manipulate earnings.

Question 9

36.1 An IFRS-reporting firm includes in its financial statements a measure that is not defined under IFRS. The firm is least likely required to:

Answer 9

A: show this measure for all periods presented

IFRS require firms that present a non-GAAP (i.e., non-IFRS) measure in their financial reports to define the measure and explain its relevance, and to reconcile the differences between this measure and the most comparable IFRS measure.

Question 10

36.2 Financial reporting is most likely to be decision useful when management’s accounting choices are:

Answer 10

NEUTRAL - Financial reporting is most likely to be decision useful when accounting choices are neutral. Either aggressive or conservative accounting choices by management may be viewed as biases.

Question 11

36.1 While motivation and opportunity both can lead to low quality of financial reporting, a third important contributing factor is:

Answer 11

Rationalisation of the actions

A mindset that allows rationalization is the third important condition underlying low-quality financial reporting. Poor financial controls are an example of opportunity and pressure to meet earnings expectations is a possible motivation.

Question 12

36.2 What is Channel stuffing?

Answer 12

it happens when a company tries to boost its reported sales by sending more products to its distributors or retailers than they can actually sell.

How it works: The company ships products to retailers/distributors.
It records this as revenue immediately under accounting rules.
However, those distributors haven’t sold the products to end customers yet.

Question 13

36.3 A potential warning sign that a firm is engaging in channel stuffing is an unusual increase in the firm’s:

Answer 13

Days of sales outstanding:

Question 14

36.3 What is days of sales outstanding:

Answer 14

The average number of days it takes a company to collect cash from its customers after a sale.