CFA LEVEL - 1 FINANCIAL REPORTING QUALITY

A. Distinguish between financial reporting quality and quality of reported

results (including quality of earnings, cash flow, and balance sheet items)

QUESTION 1
For a company reporting under IFRS, which of the following events most
likely represents low financial reporting quality? The company:
A. included gains from foreign exchange rate changes in its cost of goods sold.
B. entered a long-term lease for a customized piece of equipment and classified
it as a financing lease.
C. reported an increase in EPS as a result of the sale of a subsidiary.

Page 1
CFA LEVEL - 1 FINANCIAL REPORTING QUALITY
Solution
A is correct.
High financial reporting quality provides useful information to decision makers.
Since foreign exchange gains and losses may not recur, they should be disclosed
separately and not included in cost of goods sold.
B is incorrect because long-term leases for customized pieces of equipment
should be reported as finance leases and conforms to IFRS, therefore this is not
low quality reporting.
C is incorrect because if properly disclosed, an increase in EPS from the sale of a
subsidiary does not represent low quality financial reporting, but it may be low
quality earnings.

Page 2
CFA LEVEL - 1 FINANCIAL REPORTING QUALITY
B.Describe a spectrum for assessing financial reporting quality

QUESTION 2
Which of the following is lowest in quality on the spectrum of GAAP conforming
financial reports?
A. Aggressive accounting choices
B. Earnings management
C. Conservative accounting choices

Page 3
CFA LEVEL - 1 FINANCIAL REPORTING QUALITY
Solution
B is correct.
Earnings management represents deliberate actions to influence reported
earnings and their interpretation. The distinction between earnings management
and biased choices is subtle and, primarily, a matter of intent.
A is incorrect because aggressive accounting is a biased choice. Biased accounting
choices are higher in quality than earnings management on the spectrum of GAAP
conforming financial reports.
C is incorrect because conservative accounting is a biased choice. Biased
accounting choices are higher in quality than earnings management on the
spectrum of GAAP conforming financial reports.

Page 4
CFA LEVEL - 1 FINANCIAL REPORTING QUALITY
B.Describe a spectrum for assessing financial reporting quality

QUESTION 3
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

Page 5
CFA LEVEL - 1 FINANCIAL REPORTING QUALITY
Solution
B is 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.
A is incorrect because 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.
C is incorrect because along the financial reporting quality spectrum, financial
reporting that is non-compliant with GAAP is considered to be inferior to GAAP-
compliant financial reporting.

Page 6
CFA LEVEL - 1 FINANCIAL REPORTING QUALITY
C. Distinguish between conservative and aggressive accounting

QUESTION 4
Which of the following statements about financial reporting is correct?
A. Conservative accounting choices help a company with good performance
issue higher quality financial reports.
B. High-quality financial reports contain information that is relevant, complete,
conservative, and free from error.
C. Aggressive accounting choices in the current period may decrease the
company’s future reported earnings.

Page 7
CFA LEVEL - 1 FINANCIAL REPORTING QUALITY
Solution
C is correct.
Aggressive accounting choices in the current period may decrease the company’s
reported performance and financial position in later periods, which creates a
sustainability issue.
A is incorrect because high-quality financial reports embody the characteristics of
decision-useful information, and one of the fundamental characteristics of useful
information is faithful representation. Conservative (biased) choices result in
financial reports that do not faithfully represent economic phenomena and thus
are of lower quality, not higher.
B is incorrect because high-quality reports contain information that is relevant,
complete, neutral, and free from error.

Page 8
CFA LEVEL - 1 FINANCIAL REPORTING QUALITY
C. Distinguish between conservative and aggressive accounting

QUESTION 5
Accounting choices within GAAP that decrease reported performance in the
current period and may increase performance in later periods are most likely
examples of:
A. aggressive accounting.
B. conservative accounting.
C. earnings that are not sustainable.

Page 9
CFA LEVEL - 1 FINANCIAL REPORTING QUALITY
Solution
B is correct.
Conservative accounting choices decrease the company’s reported performance
and financial position in the current period and may increase its reported
performance and financial position in later periods.
A is incorrect because aggressive accounting choices have the opposite effect of
increasing the company’s reported performance and financial position in the
current period and may decrease its reported performance and financial position
in later periods.
C is incorrect because conservative accounting such as decreasing current
reported performance and increasing later reported performance does not
typically create a sustainability issue.

Page 10
CFA LEVEL - 1 FINANCIAL REPORTING QUALITY
E. Describe conditions that are conducive to issuing low-quality, or even
fraudulent, financial reports

QUESTION 6
Which of the following conditions conducive to issuing low-quality financial
reports is most likely a result of poor internal controls?
A. Rationalization
B. Opportunity
C. Motivation

Page 11
CFA LEVEL - 1 FINANCIAL REPORTING QUALITY
Solution
B is correct.
Poor internal controls provide opportunities for errors or fraud to be
incorporated in financial reporting without being detected.
A is incorrect because rationalization takes place after the low-quality reporting
act has taken place and is a psychological process used by individuals to justify
their actions. Poor internal controls are not a psychological process.
C is incorrect because motivation results from personal pressures or corporate
pressures to report on a low-quality basis. Poor internal controls provide the
vehicle through which low-quality reporting can be concealed, not the motivation
for it.

Page 12
CFA LEVEL - 1 FINANCIAL REPORTING QUALITY
E. Describe conditions that are conducive to issuing low-quality, or even
fraudulent, financial reports

QUESTION 7
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

Page 13
CFA LEVEL - 1 FINANCIAL REPORTING QUALITY
Solution
B is 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.
A is incorrect because an independent audit committee reduces the opportunity
to produce low-quality financial reports.
C is incorrect because accounting standards that do not allow a range of choices
reduce the opportunity for low-quality financial reporting.

Page 14
CFA LEVEL - 1 FINANCIAL REPORTING QUALITY
F. Describe mechanisms that discipline financial reporting quality and the
potential limitations of those mechanisms

QUESTION 8
Private contracts, such as bank loan agreements, are most likely to provide an
effective disciplinary mechanism to insure high financial reporting quality
because:
A. loan covenants require the firm to meet specific financial ratios in order to
renew the loan.
B. lenders monitor managers and pay close attention to the firm’s financial
reports.
C. loan covenants may allow the lender to recover all or part of their investment
if certain financial conditions are triggered.

Page 15
CFA LEVEL - 1 FINANCIAL REPORTING QUALITY
Solution
B is correct.
The monitoring role of lenders is most likely to insure high-quality financial
reports because the lenders inspect financial reports carefully to be sure they are
not manipulated.
A is incorrect because the need to meet specific financial ratios may motivate
managers to manipulate financial reports to achieve the target ratios.
C is incorrect because the desire to avoid financial triggers may motivate
managers to manipulate financial reports so that loan covenants are not violated.

Page 16
CFA LEVEL - 1 FINANCIAL REPORTING QUALITY
G. Describe presentation choices, including non-GAAP measures, that could be
used to influence an analyst’s opinion

QUESTION 9
Which of the following items is a non-GAAP financial measure?
A. Net income after taxes
B. Income from operations
C. EBITDA

Page 17
CFA LEVEL - 1 FINANCIAL REPORTING QUALITY
Solution
C is 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.
A is 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 is 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.

Page 18
CFA LEVEL - 1 FINANCIAL REPORTING QUALITY
G. Describe presentation choices, including non-GAAP measures, that could
be used to influence an analyst’s opinion

QUESTION 10
An analyst would most likely conduct additional analysis when faced with which
of the following financial presentations?
A. A non-GAAP financial measure that excludes an expense that is likely to recur
B. Reporting a non-GAAP financial measure in an SEC filing
C. A change from LIFO inventory accounting to FIFO

Page 19
CFA LEVEL - 1 FINANCIAL REPORTING QUALITY
Solution
A is correct.
The exclusion of recurring items from non-GAAP financial measures is strictly
prohibited by the SEC and should raise concerns that additional analysis is
needed.
B is incorrect because if a company uses non-GAAP measures in its SEC filings, it
must display the comparable GAAP measure with equal prominence and provide
a reconciliation between the two.
C is incorrect because LIFO reporting provides sufficient information in the Notes
to convert from LIFO to FIFO so a formal change should not alter an analyst’s
opinion about the company.

Page 20
CFA LEVEL - 1 FINANCIAL REPORTING QUALITY
H. Describe accounting methods (choices and estimates) that could be used
to manage earnings, cash flow, and balance sheet items

QUESTION 11
Under International Financial Reporting Standards (IFRS), reported operating
cash flows are most likely to be increased by the classification choice made for:
A. impairment losses on fixed assets.
B. dividends paid.
C. interest expense.

Page 21
CFA LEVEL - 1 FINANCIAL REPORTING QUALITY
Solution
C is correct.
IFRS allows the classification of interest expense as either an operating or a
financing cash flow. When interest expense is shown as a financing cash flow,
reported operating cash flows are higher.
A is incorrect because IFRS does not allow classification of impairment losses as
anything other than an operating cash flow.
B is incorrect because IFRS allows classification of dividends paid as either an
operating or a financing cash flow. However, when dividends paid is shown as an
operating cash flow, reported operating cash flows are lower.

Page 22
CFA LEVEL - 1 FINANCIAL REPORTING QUALITY
H. Describe accounting methods (choices and estimates) that could be used to
manage earnings, cash flow, and balance sheet items

QUESTION 12
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.

Page 23
CFA LEVEL - 1 FINANCIAL REPORTING QUALITY
Solution
C is 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.
A is incorrect because 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 is incorrect because 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.

Page 24
CFA LEVEL - 1 FINANCIAL REPORTING QUALITY
I. Describe accounting warning signs and methods for detecting
manipulation of information in financial reports

QUESTION 13
Which of the following is most likely a sign of inventory manipulation to improve
reported financial results?
A. Inventory markdowns for obsolescence.
B. Declining inventory turnover ratio.
C. Selective sales of older layers of inventory.

Page 25
CFA LEVEL - 1 FINANCIAL REPORTING QUALITY
Solution
C is correct.
A company can intentionally sell older, lower-cost layers of inventory to generate
earnings without supporting cash flow in order to produce specific earnings
benefits.
A is incorrect because a company simply may have obsolete inventory on hand
that should be marked down to its net realizable value; such markdowns alone do
not represent attempts to manipulate inventory in order to improve reported
financial results.
B is incorrect because declining inventory turnover may be a result of
obsolescence problems that should be recognized, not because of deliberate
attempts to manipulate inventory in order to improve reported financial results.

Page 26
CFA LEVEL - 1 FINANCIAL REPORTING QUALITY
I. Describe accounting warning signs and methods for detecting
manipulation of information in financial reports

QUESTION 14
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

Page 27
CFA LEVEL - 1 FINANCIAL REPORTING QUALITY
Solution
C is 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.
A is 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 is incorrect because investors need to evaluate warning signals cohesively, not
on an isolated basis.

Page 28
CFA LEVEL - 1 FINANCIAL REPORTING QUALITY
I. Describe accounting warning signs and methods for detecting
manipulation of information in financial reports

QUESTION 15
Overloading distribution channels (“channel stuffing”) would understate:
A. inventories.
B. accounts receivable.
C. revenues.

Page 29
CFA LEVEL - 1 FINANCIAL REPORTING QUALITY
Solution
A is 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 is 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 is incorrect because “channel stuffing,” or inducing customers to buy more than
usual, will produce an overstatement of revenues.

Page 30
CFA LEVEL - 1 FINANCIAL REPORTING QUALITY
I. Describe accounting warning signs and methods for detecting
manipulation of information in financial reports

QUESTION 16
A company that reports under IFRS shows internally generated development
costs in its balance sheet. Which of the following policies should raise concern
when analyzing that company?
A. Intangibles capitalization
B. Revenue recognition
C. Long-lived asset depreciation

Page 31
CFA LEVEL - 1 FINANCIAL REPORTING QUALITY
Solution
A is correct.
Analysts’ concerns may be raised with respect to the capitalization of
expenditures for intangible assets such as internally generated development
costs.
B is incorrect because internally generated development costs are unrelated to
revenue recognition.
C is incorrect because internally generated development costs are intangible and
not likely to be capitalized as long-lived assets.

Page 32