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CFA Level I · CFA Level I Exam · Financial Reporting Quality

An analyst observes that a company's accrual ratio has risen sharply for three consecutive years while its operating cash flow has stagnated. Which action is most appropriate for the analyst?

The analyst should investigate the revenue and expense recognition policies behind the accruals. Rising accruals with stagnant cash flow typically signal lower earnings persistence and possible aggressive accounting, so relying on reported net income or assuming improving persistence would be inappropriate.

  1. ATreat the rising ratio as evidence of improving earnings persistence
  2. BIgnore accruals and value the company using reported net income only
  3. CInvestigate the revenue and expense recognition policies behind the accrualsCorrect

Explanation

High and rising accruals relative to cash flow tend to be associated with lower earnings persistence and possible earnings management. The appropriate response is to examine the accounting policies and estimates driving them, not to accept net income at face value.

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