LOS e: Explain mean reversion in earnings and the expected relations between the speed of mean reversion and the accruals component of earnings.

Q1. 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)   Normal earnings should not be expected to continue indefinitely.

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

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

Q2. 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.

Q3. 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) Increase                                         Decrease

C) Decrease                                       Decrease

LOS e: Explain mean reversion in earnings and the expected relations between the speed of mean reversion and the accruals component of earnings. fficeffice" />

Q1. 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)   Normal earnings should not be expected to continue indefinitely.

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

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

Correct answer is A)

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.

Q2. 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.

Correct answer is C)        

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.

Q3. 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) Increase                                         Decrease

C) Decrease                                       Decrease

Correct answer is C)

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.