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Fundamentals of Financial Accounting with Annual Report

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Chapter 05 - Financial Reporting and Analysis Chapter 5 Financial Reporting and Analysis ANSWERS TO QUESTIONS 1. Managers at all levels within a company use accounting information to run the business by making decisions, such as obtaining debt versus issuing more stock. Directors use accounting information to oversee the business. One decision the directors make is the CEO’s pay. Creditors use accounting information to administer business contracts by evaluating loan covenant compliance. Investors value the business by using accounting information to estimate future earnings and stock price. Government agencies regulate businesses, relying on accounting information to determine income taxes for example. 2. The three points of the fraud triangle are incentive (which answers the question, “Why would someone commit fraud?”), opportunity (which answers the question “How would someone commit a fraud?”) and personality (which answers the question, “Who would commit a fraud?”). If any one of the elements is missing, (the person lacks the incentive, lacks the opportunity, or does not possess a questionable personality), the chances are less likely that a fraud will be committed. 3. Managers can be motivated to misreport financial results to create business opportunities (by satisfying loan covenants, increasing equity financing, and attracting business partners) and to satisfy personal greed (enhancing job security, increasing personal wealth, and obtaining a bigger paycheck). 4. The Sarbanes-Oxley Act counteracts the incentive to commit fraud by stipulating steeper fines and longer jail terms for those who willfully misrepresent financial data. 5-1
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Chapter 05 - Financial Reporting and Analysis 5. The Sarbanes-Oxley Act reduces the opportunity to commit fraud by requiring that management monitor their internal controls and submit a report that indicates whether the controls over financial reporting operated effectively. The board of directors must appoint an audit committee to oversee the financial matters of the company. External auditors must test the effectiveness of the company’s internal controls and submit a report stating whether they agree with the internal control report issued by management. 6. The Sarbanes-Oxley Act attempts to encourage good personality in employees by mandating the creation of confidential tip lines whereby employees can report potentially fraudulent conduct. It also offers protection to whistle-blowers. 7. Auditors provide quality assurance by reporting on the effectiveness of a company’s internal controls over financial reporting and by providing an independent opinion about whether the company’s financial statements are prepared in accordance with GAAP. 8. Like fraudulent financial reporting, academic dishonesty will occur only if an
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SM_Chap005 - Chapter 05 Financial Reporting and Analysis...

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