Here is the question. I pose my question after. Which of the following statements about operating income and operating cash flow are correct or incorrect? Statement #1: If operating income is growing faster than operating cash flow over the long-term, the firm may be recognizing revenue too soon or delaying the recognition of expense. Statement #2: Operating cash flow exceeding operating income is sustainable over the long-term. A) Both are correct. B) Both are incorrect. C) Only one is correct. Your answer: B was incorrect. The correct answer was C) Only one is correct. Statement #1 is correct. If operating income and operating cash flow are growing at different rates over the long-term, the firm may be engaging in earnings manipulation. Statement #2 is incorrect. Over the long-term, operating cash flow will eventually decline without the support of operating income. I almost chose C, but if a firm recognizes revenue early or delays expenses, doesn’t this even out over the long-term? I can see if they said a firm was including non-operating income above the line or something, but I feel like CF and earnings should even out over the long-term if the only issue is rev. recognition or expenses… Help please.
If the firm continues to recognize revenue early, and delay expense recognition - its operating income would consistently be above operating cash flow. There is no “reversal” mechanism. Reversal is in the analyst’s hands, only. (and that too, only after they recognize the phenomenon).
To add to CP’s point, what they are getting at here is earnings quality. If they recognize revenue too early by say underestimating bad debt expense or drastically lowering their unearned revenue account, this cant go on for ever, eventually they will be hit with bad performances and things will even out. Also remember that cash is more persistent than earnings. You cant manipulate the magnitude of cash you receive (though you could manipulate its classification).
Recogmizing Income early or delaying Expenses : How can it even out? If a company does this consistently , it is engaging in earnings manipulation . If it does this rarely or occasionally and later corrects or reverts , it is NOT manipulation