CFA Level I · CFA Level I Exam · Financial Reporting Quality
An analyst compares two companies with identical net income. Company X has operating cash flow well above net income, while Company Y has operating cash flow well below net income and rising receivables. Which conclusion about earnings quality is most likely?
Company Y's earnings are most likely of lower quality. Its operating cash flow lags net income and receivables are rising, signalling a high accrual component and possibly aggressive revenue recognition, whereas Company X's earnings are well supported by cash.
- ACompany Y's earnings are likely of lower quality because of high accrualsCorrect
- BBoth companies have equal earnings quality because net income is identical
- CCompany X's earnings are likely of lower quality because cash flow exceeds income
Explanation
Operating cash flow far below net income, together with growing receivables, indicates that a large part of earnings is accrual-based and may reflect aggressive revenue recognition. Company X's cash-backed earnings are generally viewed as higher quality, so the third option is reversed.
Did you get it right without looking?
One question tells you little. A timed set on Financial Reporting Quality shows your real accuracy, how long you take and where you lose marks.
More Financial Reporting Quality questions
- A manufacturer lengthens the estimated useful life of its equipment from 8 years to 12 years in a year when earnings are below analyst targe…
- Analyst: Company X lengthened the useful life of its equipment, reducing depreciation, and the change is within IFRS but not supported by ac…
- Management of a company repeatedly reports adjusted earnings that exclude 'one-time' restructuring charges that have occurred in each of the…
- A company reports a non-IFRS measure in its earnings release. Which of the following disclosures would most likely improve the quality of th…
- An analyst observes that a company's accrual ratio has risen sharply for three consecutive years while its operating cash flow has stagnated…
- At the start of the year, a company's net operating assets were 600 and at year-end 760. Net income for the year was 150. Using the balance …