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Complete the following sentence. When earnings are relatively free of accruals, mean reversion will occur __________.

A) relatively faster than usual.

B) at the same rate as usual.

C) relatively slower than usual.

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Earnings consist of cash flow and accruals and there is an inverse relationship between accruals and cash flow. When earnings are relatively free of accruals, mean reversion will occur at a slower rate. The opposite is true when earnings are largely comprised of accruals.

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Alex Fisher, CFA, is examining the phenomenon of mean reversion on the earnings of several firms. Which of the following statements regarding mean reversion is least accurate?

A) Low earnings should not be expected to continue indefinitely.

B) High earnings should not be expected to continue indefinitely.

C) Normal earnings should not be expected to continue indefinitely.

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When examining net income, analysts should be aware that earnings at extreme levels tend to revert back to normal levels over time. This phenomenon is known as mean reversion. As a result of mean reversion, analysts must understand that extreme earnings (high or low) should not be expected to continue indefinitely.

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Nolan Corporation (Nolan) is a successful and publicly-traded U.S. company that has operated for many years. It manufactures various sporting goods and in recent years, established three subsidiary companies, Soccer Inc. (Soccer), Hockey Inc. (Hockey), and Lacrosse Inc. (Lacrosse). Soccer and Hockey are located in the U.S. and Lacrosse is located in Canada.
Given that its stock is widely followed by analysts, Nolan regularly communicates its earnings expectations to the market.
Nolan’s most recent financial statements are provided in Exhibit 1.Exhibit 1: Consolidated financial statements for Nolan Corporation

Balance Sheet As of December 31 (in thousands)
	2008	2007
Assets
Cash	$1,230	$1,805
Accounts receivable	4,900	4,610
Inventory	7,240	4,830
Fixed assets, net	18,300	16,500
Total assets	$31,670	$27,745
Liabilities and Equity
Accounts payable	$1,860	$1,200
Current portion of long-term debt	3,306	3,095
Long-term debt	22,000	20,000
Total liabilities	$27,166	$24,295
Common stock	2,000	2,000
Retained earnings	2,504	1,450
Total Liabilities and Equity	$31,670	$27,745

Income Statement Year Ended December 31, 2008 (in thousands)
Sales	$21,500
Cost of goods sold	(13,620)
Depreciation expense	(2,100)
SG&A expense	(1,750)
Interest expense	(1,420)
Taxes	(910)
Net income	$1,700

Cash flow Statement Year Ended December 31, 2008 (in thousands)
Cash from operations	$1,760
Cash from investing	(3,900)
Cash from financing	1,565
Change in cash	$(575)

Nolan has calculated accrual ratios for its subsidiaries, Soccer and Hockey, in Exhibit 2.
Exhibit 2: Accrual ratios for Soccer and Hockey

Accrual Ratio	2008	2007
Soccer Inc.	13.5%	11.4%
Hockey Inc.	10.7%	11.2%

To protect itself from a multitude of business and financial risks, Nolan uses derivatives to manage its risks. It has engaged in several different hedges during the year, including a net investment hedge of a foreign subsidiary, a cash flow hedge, and a fair value hedge.Which of the following statements best describes the term forecast error?

A) The difference in a firm’s reported earnings and the consensus buy-side earnings forecast.

B) The difference in a firm’s reported earnings and the firm’s internal earnings forecast communicated to the market.

C) The difference in a firm’s reported earnings and the consensus sell-side earnings forecast.

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The difference in a firm’s reported earnings and the consensus sell-side earnings forecast is known as forecast error. The consensus sell-side forecast is a benchmark the firm is trying to meet. Firms periodically communicate their earnings expectations to the market in order to move the benchmark. (Study Session 7, LOS 26.c)

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Using Nolan’s consolidated balance sheet, which of the following amounts is closest to the accruals ratio for 2008.

A) 15.5%.

B) 16.6%.

C) 14.4%.

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The first step is to compute the beginning and ending balances of NOA.

	2008	2007
Total assets	$31,670	$27,745
Cash	(1,230)	(1,805)
Operating assets	$30,440	$25,940
Total liabilities	$27,166	$24,295
Current portion of long-term debt	(3,306)	(3,095)
Long-term debt	(22,000)	(20,000)
Operating liabilities	$1,860	$1,200
Net operating assets	$28,580	$24,740

Next, calculate the average NOA for 2008 of $26,660 [($28,580 ROAEND + $24,740 NOABEG) / 2].
Finally, calculate the accruals ratio for 2008: ($28,580 NOAEND − $24,740 NOABEG) / $26,660 NOAAVG = 14.4%. (Study Session 7, LOS 26.d)

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Using Nolan’s consolidated income statement and cash flow statement, which of the following amounts is closest to the accruals ratio for 2008. (Note: for the purposes of this question, assume that the average NOA is $24,000.)

A) -1.8%.

B) 9.5%.

C) 16.0%.

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The relevant equations to consider are as follows:
AccrualsCF = NI − CFO − CFI

First, calculate the aggregate accruals as follows:

Net income	$1,700
Cash from operations	(1,760)
Cash from investing	3,900
Accruals	$3,840

Next, using the average NOA of $24,000, calculate the accruals ratio for 2008: $3,840 Accruals / $24,000 NOAAVG = 16.0%. (Study Session 7, LOS 26.d)

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Using the information regarding the accrual ratios of the Soccer and Hockey subsidiaries, which of the following statements is most appropriate?

A) Hockey’s earnings quality is lower than Soccer’s and its earnings quality is deteriorating compared to Soccer’s.

B) Hockey’s earnings quality is higher than Soccer’s and its earnings quality is improving compared to Soccer’s.

C) Hockey’s earnings quality is higher than Soccer’s but its earnings quality is deteriorating compared to Soccer’s.

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Hockey’s earnings quality is higher than Soccer’s because its accrual ratios are lower in both years (10.7% and 11.2% versus 13.5% and 11.4%). And Hockey’s earnings quality is improving (accrual ratios are decreasing from 11.2% to 10.7%) while Soccer’s earnings quality is deteriorating (accrual ratios are increasing from 11.4% to 13.5%). (Study Session 7, LOS 26.d)

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In examining Nolan’s consolidated income statement for 2008, which of the following definitions of earnings result in the same amount?

A) EBIT and income from continuing operations.

B) Net income and income from continuing operations.

C) EBITDA and income from continuing operations.

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Income from continuing operations is a subtotal equal to Nolan’s earnings before any “below the line” items are considered. Only discontinued operations and extraordinary items are reported “below the line”, net of tax. In this case, there are no “below the line” items, so income from continuing operations and net income would be the same. (Study Session 7, LOS 25.a)

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With respect to a hedge undertaken in the Lacrosse subsidiary that utilizes a put option to protect one of its equity investments, which of the following best describes the accounting treatment for the hedge under U.S. GAAP?

A) Unrealized gains and losses from the derivative are recognized in the income statement.

B) Unrealized gains and losses from the derivative bypass the income statement and are reported in shareholders’ equity as part of other comprehensive income.

C) Only realized gains and losses from the derivative are recognized in the income statement.

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Lacrosse is not using the derivative to speculate. Therefore the unrealized and realized gains would NOT NECESSARILY be recognized in the income statement. Since Lacrosse is using the derivative for hedging purposes, the gain or loss recognition depends on the type of hedge.
By using the put option to hedge exposure to changes in the value of the equity investment, this is clearly an example of a fair value hedge. A fair value hedge requires unrealized gains and losses from the derivative to be recognized in the income statement. (Study Session 7, LOS 25.c)

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Costiuk Inc. (Costiuk) saw a large increase in its net operating assets (NOA) over the year. During the year, it also reported a number of nonoperating revenues and deferred revenues. Which of the following statements regarding Costiuk’s increase in NOA and the most likely item to self-correct is most accurate?

Increase in NOA

Most likely item to self-correct

A) suggests lower earning quality nonoperating revenues

B) suggests higher earning quality nonoperating revenues

C) suggests lower earning quality deferred revenues

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Deferrals and accruals are most likely to self-correct.
The large increase in net operating assets is indicative of a high accruals ratio as demonstrated by the following equation:
AccrualsBS = NOAEND − NOABEG

In interpreting the ratio, the higher the ratio, the lower the earnings quality.
Nonrecurring and nonoperating revenues do not typically self-correct like deferrals and accruals, thereby providing a greater manipulation benefit to the firm.

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The following information pertains to Morley Inc. (Morley) and Crowell Inc. (Crowell) for 2007 and 2008:

Accrual Ratio	2008	2007
Morley	16.1%	14.7%
Crowell	6.9%	8.5%

Based on the information provided, which of the following conclusions about the two companies is most appropriate?

A) Crowell’s earnings quality is higher than Morley’s.

B) Morley’s earnings quality is higher than Crowell’s.

C) Crowell’s earnings quality is deteriorating compared to Morley’s.

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Crowell’s earnings quality is higher because its accrual ratio is lower in both years. Furthermore, Crowell’s earnings quality is also improving (due to the decrease in its accrual ratio) while Morley’s is deteriorating (due to the increase in its accrual ratio).

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Jeremy Jennings is explaining the concept of earnings quality to his new colleagues. Which of the following measures is most indicative of a higher quality of earnings when attempting to forecast future earnings?

A) Higher degree of conservatism of earnings.

B) Higher degree of persistence of earnings.

C) Higher level of earnings.

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The term earnings quality usually refers to the persistence and sustainability of a firm’s earnings; that is, more persistent and sustainable earnings are considered higher quality.Measuring earnings quality based on conservative earnings is an inferior measure when attempting to forecast future earnings because most accruals will self-correct over time. For example, the lower earnings that result from accelerated depreciation will increase in the later years of the asset’s life. Focusing on accruals and deferrals is a more effective way of measuring earnings quality.
A higher level of earnings has no impact on increasing the quality of earnings since the former may be derived largely from earnings manipulation on the part of management.

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In measuring earnings quality, which of the following statements is most appropriate?

A) The higher the accruals ratio, the higher the earnings quality.

B) Accruals can be measured as the change in net operating assets (NOA) over a period of time.

C) Accruals can be measured as net income less cash flows from operations (CFO) less cash flows from financing (CFF).

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Using the balance sheet, we can measure accruals as the change in net operating assets (NOA) over a period of time. NOA is the difference in operating assets and operating liabilities. Operating assets are equal to total assets minus cash, equivalents to cash, and marketable securities. Operating liabilities are equal to total liabilities minus total debt (both short-term and long-term). In summary, the formula for balance sheet based aggregate accruals is:

AccrualsBS = NOAEND − NOABEG

We can also derive the aggregate accruals by subtracting cash flow from operating activities (CFO) and cash flow from investing activities (CFI) from reported earnings as follows:

AccrualsCF = NI − CFO − CFI

The lower the accruals ratio, the higher the earnings quality.

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MSH Corporation uses gold to manufacture jewelry. MSH anticipates the need for gold on June 30th for goods that will be sold on September 30th. Concerned that the price of gold will increase, MSH purchases a futures contract and designates the contract as a cash flow hedge. As it turns out, the spot price of gold was lower at the end of June when the contract was settled. When should MSH recognize the loss on the futures contract in the income statement and should the loss be included in income from continuing operations (IFCO)?

Date loss is recognized

Loss included in IFCO

A) September 30th No

B) June 30th Yes

C) September 30th Yes

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On June 30th, the loss on the futures contract should be reported in other comprehensive income. When the goods are sold on September 30th, the loss should be recognized in the income statement along with the cost of goods sold which is lower since the price of gold declined. The loss is neither extraordinary nor related to a discontinued operation. Thus, the loss is reported “above the line” as a part of income from continued operations.

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Recently, Firebird Corporation purchased 1,000 shares of GTO Corporation for $50 per share. GTO is a non-dividend paying stock and Firebird expects to sell the investment in the near term. To hedge the investment, Firebird purchases put options and designates the options as a fair value hedge. Ignoring the premium paid for the options, what is the net effect on Firebird’s total assets and net income if GTO declines $5 per share at year-end?

Total assets

Net income

A) No net effect No net effect

B) Decrease No net effect

C) No net effect Decrease

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Total assets do not change. The decrease in the value of the investment is exactly offset by the increase in value of the options. Net income is also unaffected. The unrealized loss on the investment is offset by the unrealized gain on the options.

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Recently, Firebird Corporation purchased 1,000 shares of GTO Corporation for $50 per share. GTO is a non-dividend paying stock and Firebird expects to sell the investment in the near term. To hedge the investment, Firebird purchases put options and designates the options as a fair value hedge. Ignoring the premium paid for the options, what is the net effect on Firebird’s total assets and net income if GTO declines $5 per share at year-end?

Total assets

Net income

A) No net effect No net effect

B) Decrease No net effect

C) No net effect Decrease

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Total assets do not change. The decrease in the value of the investment is exactly offset by the increase in value of the options. Net income is also unaffected. The unrealized loss on the investment is offset by the unrealized gain on the options.