Reference no: EM132795618

City Limited Company (CITY) is a manufacturing firm listed in the Hong Kong Stock Exchange. Mr. Lee is the major shareholder and Chairman of CITY, holding 60% of the company's total outstanding shares. The company enjoyed good performance in earlier years. However, in recent years, CITY finds it difficult to keep up earnings/profits due to keen product and market competition. Its profit margin has been squeezed and debt-to-equity ratio has increased. The major shareholder is concerned with CITY's stock price performance. A substantial portion of the CEO's total compensation and payments is based on executive bonuses and stock options.

• Prior to finalizing the financial statements of CITY, the external auditors discover in the auditing process that four year-end adjustments require further investigations. The contentious year-end adjustments are: (a) a decrease in the allowance for uncollectable accounts, (b) a reversal in the previous write-down of inventory, (c) an increase in the estimated useful life in the calculation of depreciation expense, and (d) a decrease in the liability reported for litigation compared to the expected contingent liability.

Problem 1. Classify each year-end adjustment as conservative or aggressive.

Problem 2. What effect do these adjustments have on expenses and the company's cash balance in the current year?

Problem 3. Do these adjustments, taken together, raise concerns about earnings management? Briefly justify your answer.

Problem 4. What are the reasons for CITY to commit earnings management?