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Financial Accounting Questions Finance Tutorial December 1, 2006 Define and explain the components of and relationship among the income statement, balance sheet, and cash flow statement. Discuss ways that management can manipulate earnings by using discretion in presenting financial statements. Income Smoothing: The technique of reducing earnings in good years, by deferring gains and recognizing losses. Earnings can also be inflated in bad years, by recognizing gains and deferring losses. Big Bath manipulation technique: The piling up of losses in recognized bad years in hopes of magnifying gains in the following good years. Classification of good and bad news: Bias of reporting good news about the line (part of continuing operations) and bad news below the line (extraordinary or discontinued operations). Since there are no cash flow consequences to accounting changes (e.g., changes in depreciation methods, useful lives), they must be analyzed for earnings manipulation. Identify the requirements for revenue recognition to occur. Earnings activities are substantially completed. Revenue can be measured with reasonable accuracy. The major portion of the costs has been incurred, and the remaining costs can be reasonably estimated. The eventual collection of the cash is reasonably assured. Also remember that transactions giving rise to revenue should be arms-length. How does a stock split affect the balance sheet? It does not change the amount in any asset, liability or SHE account. It does increase the number of shares of common stock issued and outstanding while proportionately decreasing the par or stated value of that common stock. There are 2 identical firms. Firm A borrowed money to build a new factory, while Firm B issued equity to build an identical factory. How will these 2 firms’ cash flow statements differ? Firm A will have a lower Cash Flows from Operations than Firm B. Why? Firm A must pay interest on the debt, which comes out of CFO. Firm B