Understanding Financial Statements - A Comprehensive Guide

1. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 1 1 Understanding Financial Statements NINTH EDITION Understanding Financial Statements NINTH EDITION Lyn M. Fraser Lyn M. Fraser Aileen Ormiston Aileen Ormiston

2. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-2 Copyright Notice Copyright Notice All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America.

3. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-3 Chapter 5: A Guide to Earnings and Financial Reporting Quality Chapter 5: A Guide to Earnings and Financial Reporting Quality Quality of reported financial information is a critical element in evaluating financial statement data. The higher the quality of financial reporting, the more useful the information is for business decision making.

4. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-4 A Guide to Earnings and Financial Reporting Quality A Guide to Earnings and Financial Reporting Quality There are a number of areas on the earnings statement that provide management with opportunities for influencing the outcome of reported earnings.

5. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-5 A Guide to Earnings and Financial Reporting Quality A Guide to Earnings and Financial Reporting Quality These areas include accounting choices, estimates, and judgments changes in accounting methods and assumptions discretionary expenditures nonrecurring transactions nonoperating gains and losses revenue and expense recognitions that do not match cash flow

6. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-6 A Guide to Earnings and Financial Reporting Quality A Guide to Earnings and Financial Reporting Quality The financial statement analyst should consider the qualitative as well as the quantitative components of earnings for an accounting period develop an earnings figure that reflects the future ongoing potential of the firm

7. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-7 A Guide to Earnings and Financial Reporting Quality A Guide to Earnings and Financial Reporting Quality In addition to earnings quality, the quality of information on the balance sheet and statement of cash flows is equally important. Because these financial statements are interrelated, quality of financial reporting issues often affects more than one financial statement.

8. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-8 A Checklist for Earnings Quality A Checklist for Earnings Quality I. Sales I. Sales II. Cost of Goods Sold II. Cost of Goods Sold III. Operating Expenses III. Operating Expenses IV. Nonoperating Revenue and Expense IV. Nonoperating Revenue and Expense V. Other Issues V. Other Issues

9. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-9 A Checklist for Earnings Quality Sales A Checklist for Earnings Quality Sales 1. Premature revenue recognition 1. Premature revenue recognition 2. Gross vs. net basis 2. Gross vs. net basis 3. Allowance for doubtful accounts 3. Allowance for doubtful accounts 4. Price vs. volume changes 4. Price vs. volume changes 5. Real vs. nominal growth 5. Real vs. nominal growth Key areas that affect earnings quality

10. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-10 Sales Premature revenue recognition Sales Premature revenue recognition Revenue should not be recognized until there is evidence that a true sale has taken place. Revenue should not be recognized until there is evidence that a true sale has taken place. Many firms record revenue before the conditions for a true sale have been met. Many firms record revenue before the conditions for a true sale have been met.

11. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-11 Sales Premature revenue recognition Sales Premature revenue recognition Analysts should Analysts should look at revenue recognition policy look at revenue recognition policy evaluate any changes in revenue recognition policies evaluate any changes in revenue recognition policies study the relationship among sales, accounts receivable, and inventory study the relationship among sales, accounts receivable, and inventory

12. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-12 Another tactic to boost revenues is to record sales at the gross rather than the net price. Another tactic to boost revenues is to record sales at the gross rather than the net price. Gross refers to the total amount that the final customer pays for an item. Gross refers to the total amount that the final customer pays for an item. Net refers to the gross amount less the cost of the sale. Net refers to the gross amount less the cost of the sale. Sales Gross versus net basis Sales Gross versus net basis

13. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-13 Revenues appear larger when reported at gross amounts. Revenues appear larger when reported at gross amounts. Gross profit margins appear better when revenues are reported at net amounts. Gross profit margins appear better when revenues are reported at net amounts. Analysts should read the notes to determine how revenue is recorded. Analysts should read the notes to determine how revenue is recorded. Sales Gross versus net basis Sales Gross versus net basis

14. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-14 There should be a consistent relationship between the rate of change in sales, accounts receivable, and allowance for doubtful accounts. There should be a consistent relationship between the rate of change in sales, accounts receivable, and allowance for doubtful accounts. Analyst should be alert to the potential for manipulation through the allowance account. Analyst should be alert to the potential for manipulation through the allowance account. Sales Allowance for doubtful accounts Sales Allowance for doubtful accounts

15. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-15 If sales are changing, it is important to determine whether the change is a result of price, volume, or both. If sales are changing, it is important to determine whether the change is a result of price, volume, or both. In general, higher quality earnings would be the product of both volume and price increases (during inflation). In general, higher quality earnings would be the product of both volume and price increases (during inflation). Sales Price versus volume changes Sales Price versus volume changes

16. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-16 It is important to determine if sales are growing in real (inflation-adjusted) as well as nominal (as reported) terms. It is important to determine if sales are growing in real (inflation-adjusted) as well as nominal (as reported) terms. Change in sales in nominal terms can be readily calculated from figures on the income statement. Change in sales in nominal terms can be readily calculated from figures on the income statement. Sales Real versus nominal growth Sales Real versus nominal growth

17. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-17 An adjustment of the reported sales figure with the Consumer Price Index (or some other measure of general inflation) will enable the analyst to make a comparison of the changes in real and nominal terms. An adjustment of the reported sales figure with the Consumer Price Index (or some other measure of general inflation) will enable the analyst to make a comparison of the changes in real and nominal terms. Sales Real versus nominal growth Sales Real versus nominal growth

18. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-18 To make the calculation, begin with the sales figure from the income statement, and adjust years prior to the current year with the CPI (or other price index). To make the calculation, begin with the sales figure from the income statement, and adjust years prior to the current year with the CPI (or other price index). Sales Real versus nominal growth Sales Real versus nominal growth

19. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-19 Using base period CPI (1982-1984=100) Using base period CPI (1982-1984=100) (2007CPI/2006CPI) x 2006 Sales = Adjusted Sales (2007CPI/2006CPI) x 2006 Sales = Adjusted Sales (207.3/201.6) x $171,179 = $176,019 (207.3/201.6) x $171,179 = $176,019 When adjusted for inflation, sales grew at a rate of 1.24%, which means that sales growth has kept pace with general inflation. When adjusted for inflation, sales grew at a rate of 1.24%, which means that sales growth has kept pace with general inflation. Sales Real versus nominal growth Sales Real versus nominal growth Sales (in millions) Sales (in millions) 2007 2007 2006 2006 % Change % Change As reported (nominal) As reported (nominal) $178,199 $178,199 $171,179 $171,179 4.10 4.10 Adjusted (real) Adjusted (real) $178,199 $178,199 $176,019 $176,019 1.24 1.24

20. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-20 Cost of Goods Sold Cost of Goods Sold 6. Cost-flow assumption for inventory 6. Cost-flow assumption for inventory 7. Base LIFO layer liquidations 7. Base LIFO layer liquidations 8. Loss recognitions on write-downs of inventories 8. Loss recognitions on write-downs of inventories Key areas that affect earnings quality

21. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-21 LIFO results in the matching of current costs with current revenues and produces higher quality earnings than either FIFO or average cost. LIFO results in the matching of current costs with current revenues and produces higher quality earnings than either FIFO or average cost. Inventory accounting system used is described in the note that details accounting policies or the note that discusses inventory. Inventory accounting system used is described in the note that details accounting policies or the note that discusses inventory. Cost of Goods Sold Cost-flow assumption for inventory Cost of Goods Sold Cost-flow assumption for inventory

22. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-22 Base LIFO layer liquidation occurs when companies are shrinking rather than increasing inventories. Base LIFO layer liquidation occurs when companies are shrinking rather than increasing inventories. There is an actual reduction of inventory levels, but the earnings boost stems from the cost flow assumption that the older and lower-priced products are being sold. There is an actual reduction of inventory levels, but the earnings boost stems from the cost flow assumption that the older and lower-priced products are being sold. Cost of Goods Sold Base LIFO layer liquidation Cost of Goods Sold Base LIFO layer liquidation

23. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-23 Effects of LIFO reductions are disclosed in the notes and can be substantial. Effects of LIFO reductions are disclosed in the notes and can be substantial. Reduces the quality of earnings, because there is an improvement in operating profit from what would generally be considered a negative occurrence: inventory reductions. Reduces the quality of earnings, because there is an improvement in operating profit from what would generally be considered a negative occurrence: inventory reductions. Cost of Goods Sold Base LIFO layer liquidation Cost of Goods Sold Base LIFO layer liquidation

24. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-24 If the value of inventory falls below its original cost, the inventory is written down to market value. If the value of inventory falls below its original cost, the inventory is written down to market value. Amount of the write-down will affect comparability and quality of profit margins. Amount of the write-down will affect comparability and quality of profit margins. Cost of Goods Sold Loss recognitions on write-downs of inventories Cost of Goods Sold Loss recognitions on write-downs of inventories

25. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-25 When write-down is included in cost of goods sold, the gross profit margin is affected. When write-down is included in cost of goods sold, the gross profit margin is affected. Analyst should be aware of the impact of write-downs on the gross profit margin when comparing between periods. Analyst should be aware of the impact of write-downs on the gross profit margin when comparing between periods. Cost of Goods Sold Loss recognitions on write-downs of inventories Cost of Goods Sold Loss recognitions on write-downs of inventories

26. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-26 A Checklist for Earnings Quality Operating Expenses A Checklist for Earnings Quality Operating Expenses 9. Discretionary expenses 9. Discretionary expenses 10. Depreciation 10. Depreciation 11. Asset impairment 11. Asset impairment 12. Reserves 12. Reserves 13. In-process research and development 13. In-process research and development 14. Pension accounting-interest rate assumptions 14. Pension accounting-interest rate assumptions Key areas that affect earnings quality

27. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-27 Operating Expenses Discretionary expenses Operating Expenses Discretionary expenses A company can increase earnings by reducing variable operating expenses in a number of areas such as A company can increase earnings by reducing variable operating expenses in a number of areas such as repair and maintenance of capital assets repair and maintenance of capital assets research and development research and development advertising and marketing advertising and marketing

28. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-28 Operating Expenses Discretionary expenses Operating Expenses Discretionary expenses If such discretionary expenses are reduced to benefit the current years reported earnings, the long-run impact on the firms operating profit may be detrimental and thus the quality lowered. If such discretionary expenses are reduced to benefit the current years reported earnings, the long-run impact on the firms operating profit may be detrimental and thus the quality lowered.

29. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-29 Operating Expenses Depreciation Operating Expenses Depreciation Amount of depreciation expense depends on Amount of depreciation expense depends on the choice of depreciation method (straight-line or accelerated) the choice of depreciation method (straight-line or accelerated) estimates regarding the useful life and salvage value estimates regarding the useful life and salvage value

30. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-30 Operating Expenses Depreciation Operating Expenses Depreciation Straight-line method Straight-line method is used more often is used more often produces a smoother earnings stream and higher earnings in the early years of the depreciation period produces a smoother earnings stream and higher earnings in the early years of the depreciation period does not reflect the economic reality of product usefulness does not reflect the economic reality of product usefulness is lower in quality is lower in quality

31. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-31 Operating Expenses Depreciation Operating Expenses Depreciation Misclassification of operating expenses as capital expenditures creates poor quality of financial reporting on all financial statements. Misclassification of operating expenses as capital expenditures creates poor quality of financial reporting on all financial statements. Comparing companies is difficult when they use different depreciation methods and different estimates for the lives of their long-lived assets. Comparing companies is difficult when they use different depreciation methods and different estimates for the lives of their long-lived assets.

32. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-32 The write-down of asset values affects the comparability and thus the quality. The write-down of asset values affects the comparability and thus the quality. Reasons for write-downs are also important in assessing quality. Reasons for write-downs are also important in assessing quality. Information on asset write-downs is presented in the notes. Information on asset write-downs is presented in the notes. Operating Expenses Asset impairment Operating Expenses Asset impairment

33. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-33 Creation and use of reserve accounts is required to properly match revenues and expenses. Creation and use of reserve accounts is required to properly match revenues and expenses. Abuse of reserve accounts has been an ongoing issue. Abuse of reserve accounts has been an ongoing issue. Operating Expenses Reserves Operating Expenses Reserves

34. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-34 Cookie-jar accounting occurs when companies create or use reserve accounts for setting aside funds in good years and reducing or reversing charges in poor years. Cookie-jar accounting occurs when companies create or use reserve accounts for setting aside funds in good years and reducing or reversing charges in poor years. Firms often take enormous write-offs in one period (big bath charges) to clean up balance sheets. Firms often take enormous write-offs in one period (big bath charges) to clean up balance sheets. Operating Expenses Reserves Operating Expenses Reserves

35. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-35 Operating Expenses In-process research and development Operating Expenses In-process research and development One-time charges taken at the time of an acquisition One-time charges taken at the time of an acquisition Can be written off immediately Can be written off immediately Can increase earnings in later years due to revenue gains from the research Can increase earnings in later years due to revenue gains from the research

36. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-36 Operating Expenses Pension accounting interest rate assumptions Operating Expenses Pension accounting interest rate assumptions A change in the pension interest rate assumption can impact earnings equality. A change in the pension interest rate assumption can impact earnings equality. If the rate is decreased, the annual pension cost and the present value of the benefits will increase. If the rate is decreased, the annual pension cost and the present value of the benefits will increase. If the rate is increased, pension cost and the present value of the benefits will decrease. If the rate is increased, pension cost and the present value of the benefits will decrease.

37. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-37 A Checklist for Earnings Quality Nonoperating Revenue and Expense A Checklist for Earnings Quality Nonoperating Revenue and Expense 15. Gains (losses) from sales of assets 15. Gains (losses) from sales of assets 16. Interest income 16. Interest income 17. Equity income 17. Equity income 18. Income taxes 18. Income taxes 19. Unusual items 19. Unusual items 20. Discontinued operations 20. Discontinued operations 21. Extraordinary items 21. Extraordinary items Key areas that affect earnings quality

38. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-38 Nonoperating Revenue and Expense Gains (losses) from sales of assets Nonoperating Revenue and Expense Gains (losses) from sales of assets The sale of a major asset is sometimes made to increase earnings and/or to generate needed cash when the firm is performing poorly. The sale of a major asset is sometimes made to increase earnings and/or to generate needed cash when the firm is performing poorly. Such transactions are not part of the normal operations of the firm and should be excluded from net income when considering the future operating potential of the company. Such transactions are not part of the normal operations of the firm and should be excluded from net income when considering the future operating potential of the company.

39. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-39 Nonoperating Revenue and Expense Interest Income Nonoperating Revenue and Expense Interest Income Results primarily from short-term temporary investments in marketable securities to earn a return on cash not immediately needed. Results primarily from short-term temporary investments in marketable securities to earn a return on cash not immediately needed. Analyst should be alert to the materiality and variability in the amount of interest income because it is not part of operating income. Analyst should be alert to the materiality and variability in the amount of interest income because it is not part of operating income.

40. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-40 Nonoperating Revenue and Expense Equity income Nonoperating Revenue and Expense Equity income Use of equity method permits the investor to recognize as investment income the investors percentage ownership share of the investees reported income. Use of equity method permits the investor to recognize as investment income the investors percentage ownership share of the investees reported income. Net effect is that the investor, in most cases, records more income than is received in cash. Net effect is that the investor, in most cases, records more income than is received in cash.

41. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-41 Nonoperating Revenue and Expense Income taxes Nonoperating Revenue and Expense Income taxes Provision for income tax expense on the income statement differs from the tax actually paid. Provision for income tax expense on the income statement differs from the tax actually paid. It is important to differentiate between increases and decreases to net earnings caused by tax events. It is important to differentiate between increases and decreases to net earnings caused by tax events. Significant change in effective tax rate may be a one-time nonrecurring item. Significant change in effective tax rate may be a one-time nonrecurring item. Income tax notes reveal year-to-year changes in deferred tax accounts. Income tax notes reveal year-to-year changes in deferred tax accounts.

42. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-42 Nonoperating Revenue and Expense Unusual items Nonoperating Revenue and Expense Unusual items Some companies will create a line item on the income statement for unusual items or special charges. Some companies will create a line item on the income statement for unusual items or special charges. Analyst should always investigate these items to determine if these items are nonoperating and/or nonrecurring. Analyst should always investigate these items to determine if these items are nonoperating and/or nonrecurring.

43. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-43 Nonoperating Revenue and Expense Discontinued Operations Nonoperating Revenue and Expense Discontinued Operations Should be excluded in considering future earnings Should be excluded in considering future earnings Two items recorded if discontinued operations have been sold Two items recorded if discontinued operations have been sold Gain (loss) from operations of the division up to the time of sale Gain (loss) from operations of the division up to the time of sale Gain (loss) as a result of the sale, both net of tax Gain (loss) as a result of the sale, both net of tax

44. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-44 Nonoperating Revenue and Expense Extraordinary items Nonoperating Revenue and Expense Extraordinary items Gains and losses that are both unusual and infrequent in nature Gains and losses that are both unusual and infrequent in nature Should be eliminated from earnings when evaluating a firms future earnings potential Should be eliminated from earnings when evaluating a firms future earnings potential

45. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-45 A Checklist for Earnings Quality Other Issues A Checklist for Earnings Quality Other Issues 22. Material changes in number of shares 22. Material changes in number of shares outstanding outstanding 23. Operating earnings, a.k.a. core earnings, pro forma earnings, or EBITDA 23. Operating earnings, a.k.a. core earnings, pro forma earnings, or EBITDA Key areas that affect earnings quality

46. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-46 Other Issues Material Changes in Number of Shares Outstanding Other Issues Material Changes in Number of Shares Outstanding Changes can result from treasury stock purchases and the purchase and retirement of common stock. Changes can result from treasury stock purchases and the purchase and retirement of common stock. Reasons for the repurchase of common stock should be determined if possible to see if firm is spending scarce resources to merely increase earnings per share. Reasons for the repurchase of common stock should be determined if possible to see if firm is spending scarce resources to merely increase earnings per share.

47. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-47 Other Issues Operating earnings, a.k.a. core earnings, pro forma earnings, or EBITDA Other Issues Operating earnings, a.k.a. core earnings, pro forma earnings, or EBITDA Operating earnings are important for assessing the ongoing potential of a firm. Operating earnings are important for assessing the ongoing potential of a firm. Companies have created their own operating profit numbers and tried to convince users that these figures are the ones to focus on. Companies have created their own operating profit numbers and tried to convince users that these figures are the ones to focus on.

48. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-48 Other Issues Operating earnings, a.k.a. core earnings, pro forma earnings, or EBITDA Other Issues Operating earnings, a.k.a. core earnings, pro forma earnings, or EBITDA Company created numbers go by a variety of names such as core earnings, pro forma earnings, or EBITDA (operating earnings before interest, tax, depreciation, and amortization expenses are deducted). Company created numbers go by a variety of names such as core earnings, pro forma earnings, or EBITDA (operating earnings before interest, tax, depreciation, and amortization expenses are deducted). SEC requires companies that report pro forma financial information to do so in a manner that is not misleading. SEC requires companies that report pro forma financial information to do so in a manner that is not misleading.

49. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-49 What are the Real Earnings? What are the Real Earnings? Each individual user of financial statements should adjust the earnings figure to reflect what they believe is relevant to the decision at hand. Each individual user of financial statements should adjust the earnings figure to reflect what they believe is relevant to the decision at hand.

50. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-50 Quality of Financial Reporting The Balance Sheet Quality of Financial Reporting The Balance Sheet Items discussed in the earnings quality section also impact balance sheet quality. Items discussed in the earnings quality section also impact balance sheet quality. When evaluating balance sheet several other items should also be assessed: When evaluating balance sheet several other items should also be assessed:

51. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-51 Quality of Financial Reporting The Balance Sheet Quality of Financial Reporting The Balance Sheet Type of debt used to finance assets should generally be matched (short-term debt for current assets and long-term debt/equity for long-term assets). Type of debt used to finance assets should generally be matched (short-term debt for current assets and long-term debt/equity for long-term assets). Commitments and Contingencies disclosures in the notes should be carefully evaluated as information on off-balance-sheet financing and other complex financing arrangements are located here. Commitments and Contingencies disclosures in the notes should be carefully evaluated as information on off-balance-sheet financing and other complex financing arrangements are located here.

52. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-52 Quality of Financial Reporting The Statement of Cash Flows Quality of Financial Reporting The Statement of Cash Flows from operations (CFO) figure, while highly useful, can be manipulated by The cash flows from operations (CFO) figure, while highly useful, can be manipulated by recording operating expenses as capital expenditures recording operating expenses as capital expenditures managing current asset and liability accounts to cause increases to CFO managing current asset and liability accounts to cause increases to CFO

53. Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-53 Quality of Financial Reporting The Statement of Cash Flows Quality of Financial Reporting The Statement of Cash Flows Cash flows from the following types of items should be removed from CFO for analytical purposes: Investments in trading securities Investments in trading securities Discontinued operations Discontinued operations Nonrecurring expenses or income Nonrecurring expenses or income