We know earnings (income) measurement and recognition involve estimation and interpretation of business transactions and events. Our prior analysis of earnings emphasized that accounting earnings is not a unique amount but depends on the assumptions used and principles applied. The need for estimation and interpretation in accrual accounting has led some individuals to question the reliability of all accrual measures. This is an extreme and unwise reaction because of the considerable wealth of relevant information communicated in accrual measures.
We know accrual accounting consists of adjusting cash flows to reflect universally accepted concepts: earned revenue and incurred expenses. What our analysis must focus on are the assumptions and principles applied, and the adjustments appropriate for our analysis objectives. We should use the information in accruals to our competitive advantage and to help us better understand current and future company performance. We must also be aware of both accounting and audit risks to rely on earnings. Improvements in both accounting and auditing have decreased the incidence of fraud and misinterpretation in financial statements. Nevertheless, management fraud and misrepresentation is far from eliminated, and audit failures do occur (e.g., Enron, WorldCom, and Xerox). Our analysis must always evaluate accounting and audit risk, including the character and propensities of management, in assessing earnings.
Measuring earnings quality arose out of a need to compare earnings of different companies and a desire to recognize differences in quality for valuation purposes. There is not complete agreement on what constitutes earnings quality. This section considers three factors typically identified as determinants of earnings quality and some examples of their assessment.
1. Accounting principles. One determinant of earnings quality is the discretion of management in selecting accepted accounting principles. This discretion can be aggressive (optimistic) or conservative. The quality of conservatively determined earnings is perceived to be higher because they are less likely to overstate currentand future performance expectations compared with those determined in an aggressive manner. Conservatism reduces the likelihood of earnings overstatement and retrospective changes. However, excessive conservatism, while contributing temporarily to earnings quality, reduces the reliability and relevance of earnings in the longer run. Examining the accounting principles selected can provide clues to management’s propensities and attitudes.
2. Accounting application. Another determinant of earnings quality is management’s discretion in applying accepted accounting principles. Management has discretion over the amount of earnings through their application of accounting principles determining revenues and expenses. Discretionary expenses like advertising, marketing, repairs, maintenance, research, and development can be timed to manage the level of reported earnings (or loss). Earnings reflecting timing elements unrelated to operating or business conditions can detract from earnings quality. Our analysis task is to identify the implications of management’s accounting application and assess its motivations.
We know accrual accounting consists of adjusting cash flows to reflect universally accepted concepts: earned revenue and incurred expenses. What our analysis must focus on are the assumptions and principles applied, and the adjustments appropriate for our analysis objectives. We should use the information in accruals to our competitive advantage and to help us better understand current and future company performance. We must also be aware of both accounting and audit risks to rely on earnings. Improvements in both accounting and auditing have decreased the incidence of fraud and misinterpretation in financial statements. Nevertheless, management fraud and misrepresentation is far from eliminated, and audit failures do occur (e.g., Enron, WorldCom, and Xerox). Our analysis must always evaluate accounting and audit risk, including the character and propensities of management, in assessing earnings.
Measuring earnings quality arose out of a need to compare earnings of different companies and a desire to recognize differences in quality for valuation purposes. There is not complete agreement on what constitutes earnings quality. This section considers three factors typically identified as determinants of earnings quality and some examples of their assessment.
1. Accounting principles. One determinant of earnings quality is the discretion of management in selecting accepted accounting principles. This discretion can be aggressive (optimistic) or conservative. The quality of conservatively determined earnings is perceived to be higher because they are less likely to overstate currentand future performance expectations compared with those determined in an aggressive manner. Conservatism reduces the likelihood of earnings overstatement and retrospective changes. However, excessive conservatism, while contributing temporarily to earnings quality, reduces the reliability and relevance of earnings in the longer run. Examining the accounting principles selected can provide clues to management’s propensities and attitudes.
2. Accounting application. Another determinant of earnings quality is management’s discretion in applying accepted accounting principles. Management has discretion over the amount of earnings through their application of accounting principles determining revenues and expenses. Discretionary expenses like advertising, marketing, repairs, maintenance, research, and development can be timed to manage the level of reported earnings (or loss). Earnings reflecting timing elements unrelated to operating or business conditions can detract from earnings quality. Our analysis task is to identify the implications of management’s accounting application and assess its motivations.
3. Business risk. A third determinant of earnings quality is the relation between earnings and business risk. It includes the effect of cyclical and other business forces on earnings level, stability, sources, and variability. For example, earnings variability is generally undesirable and its increase harms earnings quality. Higher earnings quality is linked with companies more insulated from business risk. While business risk is not primarily a result of management’s discretionary actions, this risk can be lowered by skillful management strategies.
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