Earnings Quality versus Balance Sheet Quality
Given that accounting quality is a property of all financial statements, it is useful to distinguish between the concept of earnings quality (an income statement concept) and the concept of balance sheet quality. While earnings quality permits an accurate assessment of current performance and a foundation for predicting future performance, balance sheet quality permits an accurate assessment of key descriptions of risk: liquidity, financial flexibility, and solvency. The ratios used to measure each element of risk require proper measurement and inclusion of assets and liabilities.5 The ratios’ descriptive power suffers when balance sheet quality is low.
One can measure how balance sheet assets and liabilities change and reflect that change (with few exceptions) on the income statement as revenues and expenses. Alternatively, one can measure revenues and expenses on the income statement using revenue recognition rules and expense recognition conventions and then reflect the associated changes in assets and liabilities on the balance sheet. A good example of the option to start with either statement and then reflect the effect on the other statement is given by conceptual alternatives in the accounting for machinery depreciation. Conceptually, one could measure and report the fair value of the remaining service potential of machinery on the balance sheet, reflecting any service potential decline as an expense on the income statement. Or, one could use an expense recognition convention designed to systematically allocate the original cost of the machine to depreciation expense on the income statement, reflecting the depreciation as a reduction of the book value of the machine asset on the balance sheet. Whatever the choice, judgment, or estimate used by management to account for machinery, the effects of the accounting will be reflected in both the income statement and the balance sheet. Thus, an unrealistic estimate, bad judgment, or unjustifiable choice can affect both balance sheet quality and earnings quality.
Earnings and Balance Sheet Quality Can Differ Due to the Different Objectives of the Income Statement and the Balance Sheet
The strong correspondence of earnings and balance sheet quality created by financial statement articulation is affected to some extent by the fact that, in financial statement analysis, balance sheets and income statements can be used for different objectives. Thus, it is possible that accounting standards and management choices leading to, say, a high-quality balance sheet might have no effect or even a negative effect on earnings quality. Continuing with the machinery example, fair valuing a machine on the balance sheet might result in a high-quality balance sheet in that the machine asset is not based on an outdated historical cost. Given that balance sheet values are useful in credit analysis, fair value gives a better picture of the liquidity, financial flexibility, and solvency of a company. However, changes in machine fair value reflected on the income statement might be caused by outside forces that are less controllable by management and less predictive of future performance. If the fair value changes are a transitory (i.e., not a persistent) indicator of future performance, the prediction of future earnings for valuation purposes would be more difficult. Earnings quality remains high, however, if the firm adequately discloses the transitivity of the change in fair value. But, fair values have to be estimated, which creates greater exposure to unintentional error or bias. Another example is provided by management’s choice of whether to use the lastin, first-out (LIFO) or first-in, first-out (FIFO) inventory method.
Given that accounting quality is a property of all financial statements, it is useful to distinguish between the concept of earnings quality (an income statement concept) and the concept of balance sheet quality. While earnings quality permits an accurate assessment of current performance and a foundation for predicting future performance, balance sheet quality permits an accurate assessment of key descriptions of risk: liquidity, financial flexibility, and solvency. The ratios used to measure each element of risk require proper measurement and inclusion of assets and liabilities.5 The ratios’ descriptive power suffers when balance sheet quality is low.
One can measure how balance sheet assets and liabilities change and reflect that change (with few exceptions) on the income statement as revenues and expenses. Alternatively, one can measure revenues and expenses on the income statement using revenue recognition rules and expense recognition conventions and then reflect the associated changes in assets and liabilities on the balance sheet. A good example of the option to start with either statement and then reflect the effect on the other statement is given by conceptual alternatives in the accounting for machinery depreciation. Conceptually, one could measure and report the fair value of the remaining service potential of machinery on the balance sheet, reflecting any service potential decline as an expense on the income statement. Or, one could use an expense recognition convention designed to systematically allocate the original cost of the machine to depreciation expense on the income statement, reflecting the depreciation as a reduction of the book value of the machine asset on the balance sheet. Whatever the choice, judgment, or estimate used by management to account for machinery, the effects of the accounting will be reflected in both the income statement and the balance sheet. Thus, an unrealistic estimate, bad judgment, or unjustifiable choice can affect both balance sheet quality and earnings quality.
Earnings and Balance Sheet Quality Can Differ Due to the Different Objectives of the Income Statement and the Balance Sheet
The strong correspondence of earnings and balance sheet quality created by financial statement articulation is affected to some extent by the fact that, in financial statement analysis, balance sheets and income statements can be used for different objectives. Thus, it is possible that accounting standards and management choices leading to, say, a high-quality balance sheet might have no effect or even a negative effect on earnings quality. Continuing with the machinery example, fair valuing a machine on the balance sheet might result in a high-quality balance sheet in that the machine asset is not based on an outdated historical cost. Given that balance sheet values are useful in credit analysis, fair value gives a better picture of the liquidity, financial flexibility, and solvency of a company. However, changes in machine fair value reflected on the income statement might be caused by outside forces that are less controllable by management and less predictive of future performance. If the fair value changes are a transitory (i.e., not a persistent) indicator of future performance, the prediction of future earnings for valuation purposes would be more difficult. Earnings quality remains high, however, if the firm adequately discloses the transitivity of the change in fair value. But, fair values have to be estimated, which creates greater exposure to unintentional error or bias. Another example is provided by management’s choice of whether to use the lastin, first-out (LIFO) or first-in, first-out (FIFO) inventory method.
If inventory acquisition prices have been rising over time, measuring the balance sheet inventory amount using LIFO yields out-of-date costs on the balance sheet. LIFO assumes that recently purchased inventory (at higher acquisition prices) are sold first and that inventory purchased in previous periods (at lower acquisition prices) remain in inventory. Thus, balance sheet inventory is reported at older costs that understate the future cash flow potential from selling the inventory. Balance sheet quality is impaired because the balance sheet does not capture liquidity adequately. However, gross margins on the income statement are equal to a recent selling price minus a recent acquisition cost, and thus capture economic content and yield a more persistent earnings number. These are characteristics of a high-quality income statement. If management chose to use the FIFO method under these circumstances, then liquidity measurement would be improved on the balance sheet, but income statement quality might suffer
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