Answer the following three questions as fully and completely as possible. 1. Com

Question

Answer the following three questions as fully and completely as possible.

1. Companies listed in the stock market are required to use the accrual basis of accounting to recognize assets, liabilities, expenses, and revenues. Explain the key elements of the accrual basis of accounting and how it allows managers to manipulate reported earnings.

2. Derivative instruments have been used increasingly inside and outside the United States in recent years. Explain the meaning of the following derivative instruments:

a) European-style Options

b) American-Style Option

c) In-the-money (ITM)

d) out-of-the-money (OTM)

e) at-the money (ATM)

f) call option

g) put option

h) future contracts

i) options on futures contracts

3) Management tends to manipulate and manage reported income by applying different management earning techniques. Explain these techniques and management’s motives for manipulating and smoothing earnings.

Explanation / Answer

1)Key Elements are as follows

a)Revenue Recognition Principle-Revenue is the money a business generates by selling products and services to customers. The revenue recognition principle states that a business must recognize revenue in its records in the period in which a sale occurs, even though the business may collect payment from the customer in a different period. The result is that a company’s reported revenue for a particular period typically differs from the cash it collects from customers during that period. This gives managers an oppurtunity to show revenue on the time period which suits them. for eg they will show more revenue in periods of higher tax rates and vice versa

b)Matching Principle Expenses are costs that a business incurs to generate revenue. The matching principle states that a business must record the expenses it incurs in the same accounting period as the revenue to which those expenses contribute, even though a business may pay for those expenses in a different accounting period. The result is that a company’s reported expenses typically differ from the amount of cash it paid for expenses in a particular period. Eg - Management would use this to show sham expenses i.e they havent actually been incurred. To reduce profits in order to pay less taxes on income.

2) a) European Style Options- A European option can only be exercised at the end of its life, at its maturity.European options tend to trade at a discount when compared to similar Americanoptions

b) American style options- An option contract that may be exercised at any time on or before the expiration date. For example, if one buys anAmerican call giving him/her the right to buy shares in X expiring on the final Friday in March, the call may beexercised at any time on or before the final Friday in March.

c)In the money- In the money (ITM) means that a call option's strike price is below the market price of the underlying asset, or that the strike price of a put option is above the market price of the underlying asset. An option that is in the money has intrinsic value, where as an option that is out of the money (OTM) does not.

d) Out of money- Out of the money (OTM) is term used to describe a call option with a strike price that is higher than the market price of the underlying asset, or a put option with a strike price that is lower than the market price of the underlying asset.

e) At the money- At the money (ATM) is a situation where an option's strike price is identical to the price of the underlying security. Both call and put options can be simultaneously ATM. For example, if XYZ stock is trading at $75, then the XYZ 75 call option is at the money and so is the XYZ 75 put option.

f)Call Option- Call options are an agreement that give the option buyer the right, but not the obligation, to buy a stock, bond, commodity or other instrument at a specified price within a specific time period. The stock, bond, or commodity is called the underlying asset.

g)Put Option - A put option is an option contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying security at a specified price within a specified time frame. This is the opposite of a call option, which gives the holder the right to buy an underlying security at a specified price, before the option expires.

h)Futures Contract- A futures contract is a contract between two parties where both parties agree to buy and sell a particular asset of specific quantity and at a predetermined price, at a specified date in future.

i) Options on futures contract -An option on a futures contract is very similar to a stock option in that it gives the buyer the right, but not obligation, to buy or sell the underlying asset, while creating a potential obligation for the seller of the option to buy or sell the underlying asset if the buyer so desires by exercising that option.

3)

There are three primary reasons why management manipulates financial statements. First, in many cases the compensation of corporate executives is directly tied to the financial performance of the company. As a result, management has a direct incentive to paint a rosy picture of the company's financial condition in order to meet established performance expectations and bolster their personal compensation.

Second, it is relatively easy to manipulate corporate financial statements because the Financial Accounting Standards Board (FASB), which sets the GAAP standards, provides a significant amount of latitude in the accounting provisions that are available to be used by corporate management. For better or worse, these GAAP standards afford a significant amount of flexibility, making it very easy for corporate management to paint a favorable picture of the financial condition of the company.

Third, it is unlikely that financial manipulation will be detected by investors due to the relationship between the independent auditor and the corporate client. In the U.S., the Big Four accounting firms and a host of smaller regional accounting firms dominate the corporate auditing environment. While these entities are touted as independent auditors, the firms have a direct conflict of interest because they are compensated by the very companies that they audit. As a result, the auditors could be tempted to bend the accounting rules to portray the financial condition of the company in a manner that will keep their client happy.

methods include - False Sales reporting, Teaming and lading, etc

Related Questions

Navigate

• Browse (All)
• Browse A
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.