SOLUTIONS

1. B is correct. Stellar's financial statements are GAAP compliant (Conclusion 1) but cannot be relied upon to assess earnings quality. There is evidence of earnings management: understating and overstating earnings depending upon the results of the period (Conclusion 1), understated amortizable intangibles (Conclusion 2), and a high accruals component in the company's earnings (Conclusion 3).
2. C is correct. Martinez believes that Stellar most likely understated the value of amortizable intangibles when recording the acquisition of a rival company last year. Impairment charges have not been taken since the acquisition (Conclusion 2). Consequently, the company's earnings are likely to be overstated because amortization expense is understated. This understatement has not been offset by an impairment charge.
3. B is correct. Martinez concluded that the accruals component of Stellar's earnings was large relative to the cash component (Conclusion 3). Earnings with a larger component of accruals are typically less persistent and of lower quality. An important distinction is between accruals that arise from normal transactions in the period (called non-discretionary) and accruals that result from transactions or accounting choices outside the normal (called discretionary accruals). The discretionary accruals are possibly made with the intent to distort reported earnings. Outlier discretionary accruals are an indicator of possibly manipulated—and thus low quality earnings. Thus, Martinez is primarily focused on discretionary accruals, particularly outlier discretionary accruals (referred to as abnormal accruals).
4. B is correct. Because accounts receivable will be lower than reported in the past, Stellar's DSO [Accounts receivable/(Revenues/365)] will decrease. Stellar's accounts receivable turnover (365/days' sales outstanding) will increase with the lower DSO, giving the false impression of a faster turnover. The company's current ratio will decrease (current assets will decrease with no change in current liabilities).