Corporate Governance & Financial Management 3 — Questions and Answers
Question 1: Which of the following best describes the concept of 'earnings quality' in financial governance?
- The absolute dollar amount of net income reported
- The degree to which reported earnings reflect sustainable, cash-backed operating performance (Correct answer)
- The consistency of earnings per share across quarters
- The ratio of earnings to total assets
Correct answer: The degree to which reported earnings reflect sustainable, cash-backed operating performance
High earnings quality means reported profits are derived from core operations, backed by cash flows, and are repeatable rather than driven by one-time items or accounting choices.
Question 2: A board compensation committee ties executive bonuses exclusively to annual EPS growth. What financial governance risk does this create?
- Executives will focus too much on long-term value creation
- Executives may be incentivized to cut R&D or buy back shares to boost EPS short-term (Correct answer)
- The company will overpay taxes
- Auditors will refuse to certify financial statements
Correct answer: Executives may be incentivized to cut R&D or buy back shares to boost EPS short-term
EPS-only incentives can motivate executives to prioritize short-term EPS manipulation over sustainable value creation through real investment.
Question 3: What does the weighted average cost of capital (WACC) represent in corporate financial decision-making?
- The average interest rate paid on all outstanding debt
- The minimum return a company must earn on investments to satisfy all capital providers (Correct answer)
- The ratio of equity to total capital
- The cost of issuing new shares in the market
Correct answer: The minimum return a company must earn on investments to satisfy all capital providers
WACC is the blended required return across debt and equity capital, representing the hurdle rate that investments must exceed to create shareholder value.
Question 4: Under US corporate law, what is the board's duty when a company faces potential insolvency?
- Fiduciary duties shift to include creditors, not just shareholders (Correct answer)
- Duties remain exclusively to shareholders regardless of financial condition
- The board must immediately file for bankruptcy
- All asset sales must be approved by shareholders first
Correct answer: Fiduciary duties shift to include creditors, not just shareholders
In the 'zone of insolvency,' courts have held that directors' fiduciary obligations expand to include the interests of creditors as stakeholders.
Question 5: A company reports strong net income but consistently negative operating cash flow. What should the audit committee investigate?
- Whether dividends are being paid too generously
- Whether aggressive revenue recognition or accrual accounting is inflating reported profits (Correct answer)
- Whether the company needs to issue more equity
- Whether the external auditor should be replaced
Correct answer: Whether aggressive revenue recognition or accrual accounting is inflating reported profits
A persistent divergence between net income and operating cash flow is a red flag for aggressive accounting, such as premature revenue recognition.
Question 6: Which governance mechanism is specifically designed to prevent earnings manipulation through aggressive use of accounting estimates?
- Share buyback programs
- External auditor review of critical accounting estimates and judgments (Correct answer)
- Mandatory quarterly dividend payments
- Annual say-on-pay votes
Correct answer: External auditor review of critical accounting estimates and judgments
External auditors scrutinize management's key accounting estimates and judgments as part of their audit to detect and deter aggressive accounting choices.
Question 7: What is 'goodwill impairment' and why is it a significant corporate governance event?
- A tax credit for charitable donations
- A write-down acknowledging that an acquired business is worth less than the price paid, signaling potential overpayment (Correct answer)
- A required annual dividend payment to preferred shareholders
- An increase in reported asset values after an acquisition
Correct answer: A write-down acknowledging that an acquired business is worth less than the price paid, signaling potential overpayment
Goodwill impairment forces a company to recognize that a prior acquisition destroyed value, often raising questions about the board's due diligence on the original deal.
Corporate Governance & Financial Management 3
Which of the following best describes the concept of 'earnings quality' in financial governance?