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Los 29f mechanisms that help to discipline financial

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LOS 29.f
Mechanisms that help to discipline financial reporting quality include regulation, auditing,and private contracts. Regulators typically require public companies to provide periodicfinancial statements and notes, including management commentary, and obtain independentaudits.A clean audit opinion offers reasonable assurance that financial statements are free frommaterial errors but does not guarantee the absence of error or fraud. The fact that firms selectand pay their auditors may limit the effectiveness of auditing to discipline financial reportingquality.LOS 29.gFirms may attempt to influence analysts’ valuations by presenting non-GAAP measures, suchas earnings that exclude certain nonrecurring items. IFRS requires firms to define and explainthe relevance of any non-GAAP measures and reconcile them to the most comparable IFRSmeasure. Similar requirements apply to U.S. public firms.LOS 29.hAccounting choices and estimates that can be used to manage earnings include:Revenue recognition choices such as shipping terms (FOB shipping point versus FOBdestination), accelerating shipments (channel stuffing), and bill-and-hold transactions.Estimates of reserves for uncollectible accounts or warranty expenses.Valuation allowances on deferred tax assets.Depreciation methods, estimates of useful lives and salvage values, and recognition ofimpairments.Inventory cost flow methods.Capitalization of expenses.Related-party transactions.LOS 29.iAccounting warning signs that indicate a need for closer analysis may include:Revenue growth out of line with comparable firms, changes in revenue recognitionmethods, or lack of transparency about revenue recognition.Decreases over time in turnover ratios (receivables, inventory, total asset).Bill-and-hold, barter, or related-party transactions.Net income not supported by operating cash flows.Capitalization decisions, depreciation methods, useful lives, salvage values out of linewith comparable firms.Fourth-quarter earnings patterns not caused by seasonality.Frequent appearance of nonrecurring items.Emphasis on non-GAAP measures, minimal information and disclosure in financialreports.
ANSWER KEY FOR MODULE QUIZZESModule Quiz 29.11.ABecause a large proportion of net income is due to a one-time gain, this period’searnings are likely not sustainable and the firm may be said to have low quality ofearnings for the period. Clear disclosure of this fact in the financial statements suggestshigh quality of financial reporting. (LOS 29.a)2.CIn the spectrum of financial reporting quality, financial reports that depart fromgenerally accepted accounting principles are considered to be of lower quality thanthose that reflect biased accounting choices. Financial reports that reflect unsustainableearnings, such as one-time gains, can still be of high quality if they state the situationclearly. (LOS 29.b)3.AFinancial reporting is most likely to be decision useful when accounting choices areneutral. Either aggressive or conservative accounting choices by management may beviewed as biases. (LOS 29.c)4.

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