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Reading 27: Evaluating Financial Reporting Quality-LOS b 习题

Session 7: Financial Reporting and Analysis: Earnings Quality Issues and Financial Ratio Analysis
Reading 27: Evaluating Financial Reporting Quality

LOS b: Describe the relation between the level of accruals and the persistence of earnings and the relative multiples that the cash and accrual components of earnings should rationally receive in valuation.

 

 

Complete the following sentence. An analyst would apply _________ to the cash component of income compared to the accrual component when evaluating company performance.

A)
a higher weighting.
B)
a lower weighting.
C)
the same weighting.


 

Since the cash component has more sustainability in the future than the accrual component, an analyst would apply a higher weighting to the cash component of income than the accrual component when evaluating company performance.

Holding everything else constant, the existence of which of the following items will most likely result in direct cash inflows or outflows for a firm in the future?

A)
Accrued expenses.
B)
Unearned revenue.
C)
Deferred expenses.


Accrued expenses are expenses that have been incurred but not yet paid. For example, a firm may recognize wage expense in one period but actually pay the wages in a later period. In this case, when the expense is recognized in the income statement, a liability is increased on the balance sheet (i.e., wages payable). When the wages are paid, the liabilities decrease as does the firm’s cash (cash outflow occurs in the future).

Unearned (deferred) revenue occurs when payment is received in advance of providing goods or services. Unearned revenue is reported as a liability on the balance sheet. Once the revenue is earned, the liability decreases. For example, a magazine subscription is usually paid in advance. When received, the publisher increases its cash and records a liability for its obligation to deliver (cash inflow occurs now). Once delivery occurs, revenue is recognized and the liability decreases.

Deferred expenses are costs that will benefit future periods. These costs usually involve noncurrent assets and prepaid assets. For example, a tenant must usually pay his rent in advance. The result is a decrease in the tenant’s cash and an increase in a prepaid asset (cash outflow occurs now). Once the rent expires, expense is recognized and the asset decreases.

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Complete the following sentence. The cash component of income is ___________ than the accrual component.

A)
less persistent.
B)
the same persistence.
C)
more persistent.


The accrual component of income (accruals) is less persistent than the cash component. By persistent we mean the income is sustainable; that is, a dollar of earnings today implies a dollar of earnings in future periods. Lower persistency is partially due to the estimates involved with accrual accounting.

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