CHAPTER 16
EVALUATING FINANCIAL REPORTING QUALITY
SOLUTIONS
1. A is correct. Because debt covenants typically mandate a certain level of financial performance, they can serve to encourage rather than discourage earnings manipulation.
2. B is correct. Earnings quality is typically defined in terms of persistence and sustainability. By contrast, earnings may be manipulated to deliver steady growth. Conservatism in accounting choices may reduce the persistence of earnings as the accounting often reverts to the mean over time.
3. B is correct. Accrual accounting is based on the “matching principle” under which revenues and the associated expenses are recognized concurrently even when the cash flow timing may differ.
4. B is correct. Cash accounting does not rely on discretionary estimates but rather on actual cash flows. This may be either more or less conservative than accrual-based accounting.
5. B is correct. A is the balance sheet aggregate accrual measure, while C is the cash flow aggregate accrual measure.
6. A is correct. Net operating assets=(Assets−Cash and short-term investments)−(Liabilities−Total debt), or in Profile’s case, (97,250−14,000)−(87,000−50,000)=46,250 in 2007 and 40,800 in 2006. The accrual ratio in 2007 is the change in NOA divided by average NOA, or (46,250−40,800)/[(46,250+40,800)/2]=5,450/43,525=12.5%.
7. C is correct. The accrual ratio is [NI−(CFO+CFI)]/NOA or [14,000−(17,300−12,400)]/39,000=9,100/39,000=23.3%.
8. A is correct. Sales=Cash collected from ...
