For each of the following two scenarios, identify

(1) factors that might motivate the company’s managers to manipulate reported financial amounts

(2) applicable mechanisms that could discipline financial reporting quality.

1. ABC Co. is a private company. Bank NTBig has made a loan to ABC Co. ABC is required to maintain a minimum 2.0 interest coverage ratio. In its most recent financial reports, ABC reported earnings before interest and taxes of $1,200 and interest expense of $600. In the report’s notes, the company discloses that it changed the estimated useful life of its property, plant, and equipment during the year. Depreciation was approximately $150 lower as a result of this change in estimate.

2. DEF Co. is a publicly traded company. For the most recent quarter, the average of analysts’ forecasts for earnings per share was $2.50. In its quarterly earnings announcement, DEF reported net income of $3,458,780. The number of common shares outstanding was 1,378,000. DEF’s main product is a hardware device that includes a free two-year service contract in the selling price. Based on management estimates, the company allocates a portion of revenues to the hardware device, which it recognizes immediately, and a portion to the service contract, which it defers and recognizes over the two years of the contract. Based on the disclosures, a higher percentage of revenue was allocated to hardware than in the past, with an estimated after-tax impact on net income of $27,000.