In analyzing 'Quality of Earnings', which of the following patterns would be the biggest 'red flag' suggesting potential earnings manipulation?

Answer options:

Net Income is consistently higher than Cash Flow from Operations over several periods.

Cash Flow from Operations exceeds Net Income due to high depreciation charges.

Revenue growth is consistent with industry peers.

The company uses the LIFO method for inventory during a period of rising prices.

How to approach this question

Compare Accrual Income vs Cash Income. In the long run, they should converge. If Income > Cash consistently, profits may be 'paper profits'.

Full Answer

A.Net Income is consistently higher than Cash Flow from Operations over several periods.✓ Correct

High Net Income with low Operating Cash Flow indicates that earnings are supported by non-cash accruals (like rising receivables or inventory build-up), which may not be sustainable or real.

Common mistakes

Thinking LIFO is manipulative (it's actually conservative for taxes).

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