Reading 27: Evaluating Financial Reporting Quality-LOS e 习题 speed, center, 2011, class

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

LOS e: Explain mean reversion in earnings and how the accruals component of earnings affects the speed of mean reversion.

 

 

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) Normal earnings should not be expected to continue indefinitely.

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

A) relatively slower than usual.

B) relatively faster than usual.

C) at the same rate as 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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De Freitas Inc. (De Freitas) is a conglomerate. Its computer division was very profitable in the current year because it launched a successful new lightweight laptop computer. Prices in the automobile division have been rising over the years but it is engaged in a LIFO liquidation in the current year. Which of the following best describes the effect on the long-run earnings of the computer division and the automobile division compared to the most recent year?

Computer division earnings

Automobile division earnings

A) Decrease Increase

B) Decrease Decrease

C) Increase Decrease

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When examining earnings, 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. For example, capital is attracted to successful projects (i.e. the new laptop) thereby increasing competition and decreasing earnings in the long-run.

A LIFO liquidation involves selling more goods than are replaced. Thus, the automobile division penetrates the older, lower cost layers of inventory thereby increasing profit. The profitability is not sustainable, however, because the firm will eventually run out of inventory. In the long-run, the earnings will decrease.