The document discusses various definitions of earnings metrics like EBITDA, operating income, and net income. It also discusses the reliability of cash flow trends compared to earnings trends, noting that sustainable earnings growth requires growth in operating cash flows over the long run. Finally, it discusses accounting treatments for different types of hedges, as well as cash versus accrual basis accounting and how management can intervene in the external financial reporting process.

1. Various Definitions of Earnings
(EBITDA, Operating Income, Net
Income)
Operating earnings can be measured by earnings before
interest and taxes (EBITDA), operating income and operating
profit.
Operating earnings excludes the effects of financing taxes.
Earnings before extraordinary and nonrecurring items is
known as income from continuing operations.
The “bottom line” of the income statement is net income.
It includes revenues, expenses, gains, losses and below the
line items.
Study Session 7, Reading 22

2. Reliability of Cash Flow Trends and
Trends in Earnings
When a company has earnings growth greater than the
industry and economy over the long run, a sceptical view in
evaluation should be taken.
Growth in operating cash flow is important for a sustainable
growth in the earnings of a company.
Over the long run, there should be no difference in the growth
rate of operating cash flows and the operating income.
Study Session 7, Reading 22

3. Accounting Treatment of Fair Value Hedge
Derivative and hedged assets and liabilities are reported at
fair value on the balance sheet.
Unrealized gains or losses are recognized in the income
statement
The ineffective portion of the hedge is recognized in the
income statement.
Study Session 7, Reading 22

4. Accounting Treatment of a Cash Flow Hedge
This hedge is used to cover for the changes in the variable
cash flows.
The derivative is reported in the balance sheet at its fair value.
Unrealized gains/losses on a derivative are recognized in other
comprehensive income.
Unrealized gains and losses are recognized in the income
statement eventually when the transaction impacts earnings.
Ineffective hedge is recognized in the income statement.
Study Session 7, Reading 22

5. Accounting Treatment for Foreign
Currency exposure
Derivative reported at fair value.
Gains and losses are recognized in other comprehensive
income.
The ineffective hedge is recognized in the income statement.
Study Session 7, Reading 22

6. Cash vs Accrual Basis Accounting
earnings management - Opportunistic use of the accruals
system
Under a cash basis system, the revenues are recorded when
the cash is collected and expenses are recognized when the
cash is paid for the expenses.
Revenue is recognized when earned under the accruals
system.
Study Session 7, Reading 23

7. Relation Between Level of Accruals
and the Persistence of Earnings
Earnings are of high quality if the earnings are sustainable and
persistent.
The impact of accruals having an aggressive choice earlier are
cancelled out by the conservative choice later.
Earnings at extreme levels tend to revert back to normal
levels.
Future cash flows and rates of return will be lower if the
earnings are largely comprised of accruals.
Study Session 7, Reading 23

8. Intervention of Management
in the External Financial Reporting Process
Security prices are often affected when financial information
is reported to the capital markets.
This provides an incentive to management to intervene in the
accounting process and engage in earnings manipulation.
Management is focussed on releasing information meeting or
exceeding analyst expectations. It also manages future
expectations.
Study Session 7, Reading 23

9. Earnings Quality and Mean
Reversion in Earnings
Sustainable and persistent earnings are said to be of high quality.
Reporting earnings too high or too low represents an inferior
earnings measure.
Earnings cannot be sustained at extreme levels. Earnings have the
tendency to revert back to normal levels
Formula(s):
Where: NOA - net operating assets
Study Session 7, Reading 23

10. Problems Affecting the Quality
of Financial Reporting
Misstating revenue, recognizing revenue early and classifying
non-operating gains as gains from operating activities can
distort financial reports.
It impairs the sustainability and persistence of the earnings.
The problem with revenue recognition in an accruals based
system is the revenue recorded at the end of the year is the
cash collected plus increase in receivables minus increase in
unearned revenue.
A company has considerable discretion in receivables
recognition.
Study Session 7, Reading 23

11. Analysis of Financial Statements
using a Framework
Step 1: Define the purpose and context of the analysis.
Step 2: Data Collection
Step 3: Data Analysis
Step 4: Interpret Data
Step 5: The development and communication of conclusions and
recommendations
Step 6: Follow-up
Study Session 7, Reading 24

12. Financial Reporting Choices and Biases
Affecting the Quality of Financial Statements
Both US GAAP and IFRS give a certain level of independence in
making some assumptions.
Management has sufficient discretion about reporting that
they can affect the financial statements.
Management can make different assumptions about the
revenue and expense recognition due to the discretion
allowed.
This may result in earnings management by the company.
Study Session 7, Reading 24

13. Effects of Changes in Accounting Rules
The earnings quality of the company can be measured by the
accruals ratios.
The higher the ratios, the lower the quality of earnings.
Earnings are of higher quality if they are backed by the cash
flows.
Cash flow can be compared to the operating profit
Study Session 7, Reading 24