LOS b: Illustrate how trends in cash flow from operations can be more reliable than earnings trends.

Q1. Which of the following statements about operating income and operating cash flow are correct or incorrect?

Statement #1: If operating income is growing faster than operating cash flow over the long-term, the firm may be recognizing revenue too soon or delaying the recognition of expense.

Statement #2:      Operating cash flow exceeding operating income is sustainable over the long-term.

A)   Only one is correct.

B)   Both are correct.

C)   Both are incorrect.

Q2. Which of the following statements about operating income and operating cash flow is most accurate?

A)     Operating income is more reliable than operating cash flow because of the judgments and estimates involved with accrual accounting.

B)     Operating cash flow usually increases faster than operating income when the firm is growing.

C)     Operating income is confirmed by operating cash flow when the growth rates of the two measures are relatively stable over time.

Q3. Recently, Galaxy Corporation lowered its allowance for doubtful accounts by reducing bad debt expense from 2 percent of sales

    to 1 percent of sales. Ignoring taxes, what are the immediate effects on Galaxy’s operating income and operating cash flow?

Operating income          Operating cash flow

A)      No effect           No effect

B)     Higher               No effect

C)     Higher             Lower

LOS b: Illustrate how trends in cash flow from operations can be more reliable than earnings trends. fficeffice" />

Q1. Which of the following statements about operating income and operating cash flow are correct or incorrect?

Statement #1: If operating income is growing faster than operating cash flow over the long-term, the firm may be recognizing revenue too soon or delaying the recognition of expense.

Statement #2:      Operating cash flow exceeding operating income is sustainable over the long-term.

A)   Only one is correct.

B)   Both are correct.

C)   Both are incorrect.

Correct answer is A)

Statement #1 is correct. If operating income and operating cash flow are growing at different rates over the long-term, the firm may be engaging in earnings manipulation. Statement #2 is incorrect. Over the long-term, operating cash flow will eventually decline without the support of operating income.

Q2. Which of the following statements about operating income and operating cash flow is most accurate?

A)     Operating income is more reliable than operating cash flow because of the judgments and estimates involved with accrual accounting.

B)     Operating cash flow usually increases faster than operating income when the firm is growing.

C)     Operating income is confirmed by operating cash flow when the growth rates of the two measures are relatively stable over time.

Correct answer is C)

When the growth rates of operating income and operating cash flow are stable over time, operating income is being confirmed by operating cash flow. Operating cash flow is more reliable than operating income. During growth, operating cash flow is usually lower than operating income as the firm uses cash to increase inventories and receivables.

Q3. Recently, Galaxy Corporation lowered its allowance for doubtful accounts by reducing bad debt expense from 2 percent of sales

    to 1 percent of sales. Ignoring taxes, what are the immediate effects on Galaxy’s operating income and operating cash flow?

Operating income          Operating cash flow

A)      No effect           No effect

B)     Higher               No effect

C)     Higher             Lower

Correct answer is B)

Lower bad debt expense will result in higher operating income. Operating cash flow is not affected until Galaxy actually collects the receivables.