Case 5-2 Earnings Quality

Economic income is considered to be a better predictor of future cash flows than accounting income is. A technique used by securities analysts to determine the degree of correlation between a firm's accounting earnings and its true economic income is quality of earnings assessment.

Required:

a)Discuss measures that may be used to assess the quality of a firm's reported earnings.

b)Obtain an annual report for a large corporation and perform a quality of earnings assessment.

 

Provide source of guidance

The answer is well illustrated in the explanation part.

Step-by-step explanation

Economic profit is the firm's resources above what is used by the firm. Mathematically, the net present value of earnings from the firm is estimated based on the firm's probable life period. Or it can be found on the cash generated by the firm multiplied by the PV factor for the firm's estimated life. On the other hand, accounting profit is based on accrual concepts. It is calculated by taking all the revenues and gains and deducting the expenses and losses applicable to the period concerned. It strictly follows the standards of GAAP accounting or other means prevalent across the world.

Conflicts exist between accounting and economic profit concerning how the income is realized, and once realized how to account for it, how to report it, etc. Earnings of financial revenue happen at the time of sale and at the point where manufacturing starts, transported out of the warehouse to the buyer's place, etc. An accountant will never start recognizing revenue until and unless the rules of revenue recognition are met, namely, when the goods have been delivered, the ownership title has been transferred to the buyer, etc. the need to report on ongoing accounting and periodic basis even after the fact that the business is on perpetuity, often lead the accountants to make approximations, estimations and here lies the points of conflict between accounting income and economic income.

Earnings Quality:

As measured by the accountant, income results from many assumptions, estimations, policies, and guidelines used to formulate the financial statements and so on. That means the quality of the earnings reported is mostly dependent on each of the components. Changing or amending any one of those will have a significant bearing on the figures reported in the income statement. Complicating the earnings reporting process in the accrual basis of accounting can become more complicated if it is related to more than one accounting period. For instance, a cash payment can affect numerous accounting periods, and it may take several periods before a transaction results in the collection of the amount outstanding. Earnings quality is that measurement that proves the validity and authenticity of the facts and figures reported on the financial statements' faces. Factors that contribute most to the earnings quality are as below:

• Accounting estimates
• Off-balance sheet financing and its impact
• Choice of accounting principles
• Future earnings capability
• External factors and their likely effect

Off-balance sheet financing:

This refers to various types of transactions by which a firm can continue using its resources, but it has to recognize no asset or liability. Firms' structure off-balance sheet transactions in a way to improve the balance sheet figures, thereby improving the critical ratios like debt to asset ratio, debt to equity ratio, quick ratio, etc. if these ratios are lowered, the firm can reduce the interest or borrowing costs on the same, reduce the overall weighted average cost of capital thereby leaving room for further raising of funds. This reporting requirement often changes depending on the rules followed while issuing financial statements from IFRS standards and other approved accounting standards.

Choice of accounting principles:

Management accountants have absolute discretion to choose from a set of different alternatives for a similar set of transactions, provided US GAAP permits it. If a firm follows a conservative policy, it is less likely to overstate earnings; therefore, the earnings quality is better. For example, the LIFO method is ideal when rising prices where wages will be lower and assets will be valued lower. On the contrary, if the firm is liberal, the earnings quality may not be up to the mark. In that case, accountants have to balance whether to follow a lenient or stringent policy. Both approaches may have positive and negative effects on the company's financial health and reporting.

Future earnings capability:

Management, here, also can put off some discretionary expenses to show higher earnings in a period. But the discretionary costs, which may have little bearing on the short run, can also have a burdensome effect on the business in the long run. An example can be given as repairs and maintenance. The management may decide not to show that repairs and maintenance expenditures inflate the reported earnings but have to face long-term consequences. If there continues to happen, premature deterioration of non-current assets may likely occur shortly, posing the firm in the difficulty of replacing that asset. Research and Development are to be shown judiciously because, according to GAAP, both are permissible to be charged off to revenue, thereby decreasing reported income.

Other economic forces:    

The effect of cyclical and seasonal forces on earnings is beyond the control and influence of the management. Effects of price hike due to legislation, inflationary issues, etc. may likely occur, and the prevention of these factors are nearly impossible. However, skilled management can reduce these factors' effect on the stability of sources and variability of earnings. Therefore, the higher variability of yields indicates the lower quality of earnings.