Question #9 - Reading 13 Integration of Financial Statement Analysis Techniques

Reading: Reading 13 Integration of Financial Statement Analysis Techniques

PDF File: Reading 13 Integration of Financial Statement Analysis Techniques.pdf

Page: 5

Status: Correct

Correct Answer: A

Shared Context

- Compared to aggregate accruals, the accrual ratio is especially useful when: A) comparing across companies. B) comparing year-over-year accruals. C) the cash component is large.

Question

Based on her calculations of accruals, Howard believes that NetPhoto has a higher accruals ratio over the recent past compared with SnapPrints. If both companies have recently had extreme earnings, Howard would most likely conclude that:

Answer Choices:

A. NetPhoto’s income will revert to its mean more quickly than SnapPrints’

B. SnapPrints’ income will revert to its mean more quickly than NetPhoto’s

C. SnapPrints’ income will revert to its mean, but NetPhoto’s income will not

Explanation

Analysts should be aware that extreme earnings levels will not persist and that earnings will typically revert to normal levels over time. Additionally, the larger the accruals component of earnings relative to the cash component, the more rapidly earnings will revert to their mean. All else equal, if NetPhoto has a higher accruals ratio than SnapPrints, NetPhoto's earnings should revert to the mean more rapidly.

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