Question #12
Reading: Reading 12 Evaluating Quality of Financial Reports
PDF File: Reading 12 Evaluating Quality of Financial Reports.pdf
Page: 9
Status: Incorrect
Your Answer: A
Question
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
Answer Choices:
A. Increase Decrease
B. Decrease Increase
C. Decrease Decrease
Explanation
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 penetrated the older, lower cost layers of inventory thereby increasing profit. This
higher profitability is not sustainable, however, because the firm will eventually run out of
lower priced inventory. In the long-run, the earnings will decrease (to normal levels).