FSA Question: Overstatement of Profit

Joan Zeller, CFA, suspects Cornwall Carpets is overstating its profits. Which of the following is least likely to motivate Cornwall to overreport? A) Cornwall is attempting to get lawmakers to institute a tariff. B) Cornwall’s debt covenants are strict. C) Wall Street’s growth expectations are high. D) Cornwall depends heavily on stock options to compensate its employees.

A when companies try to get trade relief

A because they would have incentive to under-report. Same thing if they are trying to negotiate with labor unions.

A is the only one that makes any real sense.

Yeah that one certainly stood out. One thing though - I thought strict debt covenants would often say ‘you can’t pay out too much in dividends’ which sort of implies that in order to avoid your stockholders expecting a high payout, you might understate your earnings. Why couldn’t B be a valid answer? And here’s another question: Frank Brill, CFA, is concerned that Moses Aviation is overstating its profits. The best indicator of such action would be Moses Aviation’s: A) rising inventory. B) rising ratio of operating cash flow to earnings. C) sales-growth rate of nearly twice the industry average. D) recognition of revenue from barter transactions.

A) Rising inventory would lower profits and CFO as purchases increased. B) This would tell me that they are understating profits due to something like accelerated depreciation or something of the like. C) Sales and profits are not the same thing. D) Again, the only one that makes any real sense.


D it is.

aren’t barter transactions supposed to be recorded as revenue and as an expense…so they are netted out?