Quiz 2

Amount of Bonus

Part 1: Multiple Choice

Bogey (L)
Cap (U)
Questions 1 and 2 refer to the above diagram
Reported Net Income
1) If the firms reported net income is at the Bogey, the manager in charge may do which of the
following to increase future bonuses:
a)
b)
c)
d)

Use the highest possible Inventory value for some assets

Write off some questionable accounts receivable
Re-evaluate warranties payable to a lower level
None of the above

2) If the firms reported net income were at the Cap, what would be the main reason a manager
would want to decrease reported net income?
a) To appear more profitable to shareholders
b) To pay less tax
c) To allow for extra income to be reported in future years to hopefully increase future
bonuses
d) All of the above

3) Healys study of companies with both a bogey and a cap on their bonus schemes showed that:
a) Most executives do not let bonuses affect how income is reported
b) Companies in the MID range (net income between the cap and bogey limits) tend to up
their reported net income to increase bonuses
c) Companies in the UPP range (net income above the cap level) almost always lower
reported net income
d) Both B and C
4) A company managing earnings by using LIFO inventory method in periods of rising prices
and FIFO inventory method in periods of falling prices is doing so for:
a)
b)
c)
d)

Taxation Motivations
Contractual Motivations
Political Motivations
Better communication of fiscal information to investors

5) Murphy and Zimmermans 1993 study of changes in discretionary variables (research and
development, advertising, capital expenditures, and accruals) as companies change CEOs
showed that:
a) Most of the unusual behaviour in these variables was due to poor operational
performance
b) CEOs do not maximize income as they approach retirement age
c) Some incoming CEOs of poor performing firms take baths during the first years
d) All of the above
6) What is NOT a reason an executive would partake in income smoothing:
a)
b)
c)
d)

To maintain reported net income between the bogey and cap levels
The manager in charge is risk-averse
To communicate the firms expected persistent earnings power to the external world
To reduce corporate income tax

Part two: Essay Questions

Question 1
An amount is said to be material if the magnitude of the item is such that it is probable that the
judgement of a reasonable person relying on the financial statements would have changed their
decision by the inclusion or correction of the amount.
a) Briefly explain the relationship between this concept of materiality and earnings
management.
b) Propose TWO (2) ways that the auditors can do to protect themselves in situation where
individual misstatements are material whereas overall misstatements are not material due
to some creative earnings (mis)management.
c) Identify the implications that such misstatements have for the efficient markets theory.
Question 2
When it comes to accounting firms providing audit services and non-audit services to clients,
especially when the revenues to the firm from non-audit services are greater than revenues from
audit services, at least two viewpoints exist. One viewpoint is that the provision of non-audit
services results in lower audit quality and an increased likelihood that the auditor will waive
earnings management attempts. A competing viewpoint is that provision of non-audit services
strengthens audit quality and can thus reduce earnings management. From your knowledge of
earnings management, present a discussion and analysis of these opposing viewpoints.
Question 3
William R. Scott states that, there is a fine line between earnings management and earnings
mismanagement. Ultimately, the location of this line must be determined by standard setters,
security commissions, and the courts. Discuss whether you agree or disagree with his statement
and providing reasons for your answer.