Question

please discuss earnings management and the importance of comparing net income to cash flow from operations.

Answer 1

Earnings management is a technique by which management of the firm manipulates accounting practices and financial statements so as to present the financial position of the company in a lucrative manner. Earnings management is an unethical practice but may be legal if done within the boundaries of law. Reason for earnings management is to pretend to stakeholders that the price of stock is going well in the market.

Sometimes, to fulfill the needs of the management and firm, like to get loans, management may use earnings management to present better financial position.

Comparison of net income to cash flow from operations-

Cash flow from operations is basically, operating in nature. That is, only those income and expenses are considered which are operating in nature or we can say, directly related to the manufacturing of product.

But while calculating net income, all the incomes of different types and all the expenses, whether direct or indirect are taken.

Sales - direct material - direct labour - manufacturing overhead = cash flow from operations

And

Net income = Cash flow from operations + Other income - selling and administrative expense - interest expense - loss on sale of asset

If we want to know the profitability of the product, then cash flow from operations is reviewed. And if we want to know the overall performance of the business, net income is reviewed.

In other words, we can say, it is the difference of direct and indirect income and expenses.