Mike Martinez is an equity analyst who has been asked to analyze Stellar, Inc. by his supervisor, Dominic Anderson. Stellar exhibited strong earnings growth last year; however, Anderson is skeptical about the sustainability of the company’s earnings. He wants Martinez to focus on Stellar’s financial reporting quality and earnings quality. After conducting a thorough review of the company’s financial statements, Martinez concludes the following:
Conclusion 1 Although Stellar’s financial statements adhere to generally accepted accounting principles (GAAP), Stellar understates earnings in periods when the company is performing well and overstates earnings in periods when the company is struggling.
Conclusion 2 Stellar most likely understated the value of amortizable intangibles when recording the acquisition of Solar, Inc. last year. No goodwill impairment charges have been taken since the acquisition.
Conclusion 3 Over time, the accruals component of Stellar’s earnings is large relative to the cash component.
Conclusion 4 Stellar reported an unusually sharp decline in accounts receivable in the current year, and an increase in long-term trade receivables.
In his follow-up analysis relating to Conclusion 3, Martinez should focus on Stellar’s:
A. total accruals.
B. discretionary accruals.
C. non-discretionary accruals.