Important determinants of earnings quality are management’s selection and application of accounting principles. This section focuses on several important discretionary accounting expenditures to help us to assess earnings quality. Discretionary expenditures are outlays that management can vary across periods to conserve resources and/or influence reported earnings. For this reason, they deserve special attention in our analysis. These expenditures are often reported in the income statement or its notes, and hence, evaluation of these items is referred to as an income statement analysis of earnings quality. Two important examples are:
1. Advertising expense. A major portion of advertising outlays has effects beyond the current period. This yields a weak relation between advertising outlays and short-term performance. This also implies management can in certain cases cut advertising costs with no immediate effects on sales. However, long-run sales are likely to suffer. Analysis must look at year-to-year variations in advertising expenses to assess their impact on future sales and earnings quality.
2. Research and development expense. Research and development costs are among the most difficult expenditures in financial statements to analyze and interpret. Yet they are important, not necessarily because of their amount but because of their effect on future performance. Interestingly, research and development costs have acquired an aura of productive potential in analysis exceeding what is often warranted by experience. There exist numerous cases of successful research and development activities in areas like genetics, chemistry, electronics, photography, and biology. But for each successful project there are countless failures. These research failures represent vast sums expensed or written off without measurable benefits. Our intent is to determine the amount of current research and development costs having future benefits. These benefits are often measured by relating research and development outlays to sales growth and new product development
Analysis of Other Discretionary Costs
There are other discretionary future-directed outlays. Examples are costs of training, selling, managerial development, and repairs and maintenance. While these costs are usually expensed in the period incurred, they often have future utility. To the extent that these costs are separately disclosed in the income statement or the notes to the financial statements, analysis should recognize their effects in assessing current earnings and future prospects.
1. Advertising expense. A major portion of advertising outlays has effects beyond the current period. This yields a weak relation between advertising outlays and short-term performance. This also implies management can in certain cases cut advertising costs with no immediate effects on sales. However, long-run sales are likely to suffer. Analysis must look at year-to-year variations in advertising expenses to assess their impact on future sales and earnings quality.
2. Research and development expense. Research and development costs are among the most difficult expenditures in financial statements to analyze and interpret. Yet they are important, not necessarily because of their amount but because of their effect on future performance. Interestingly, research and development costs have acquired an aura of productive potential in analysis exceeding what is often warranted by experience. There exist numerous cases of successful research and development activities in areas like genetics, chemistry, electronics, photography, and biology. But for each successful project there are countless failures. These research failures represent vast sums expensed or written off without measurable benefits. Our intent is to determine the amount of current research and development costs having future benefits. These benefits are often measured by relating research and development outlays to sales growth and new product development
Analysis of Other Discretionary Costs
There are other discretionary future-directed outlays. Examples are costs of training, selling, managerial development, and repairs and maintenance. While these costs are usually expensed in the period incurred, they often have future utility. To the extent that these costs are separately disclosed in the income statement or the notes to the financial statements, analysis should recognize their effects in assessing current earnings and future prospects.
Balance sheet analysis of earning quality
Conservatism in Reported Assets
Conservatism in Reported Assets
The relevance of reported asset values is linked (with few exceptions like cash, held-tomaturity investments, and land) with their ultimate recognition as reported expenses. We can state this as a general proposition
This is true because earnings are relieved of charges necessary to bring these assets down to realizable values. Examples include the delay in recognizing impaired assets, such as obsolete inventories or unproductive plant and equipment, and the understatement of allowance for uncollectible accounts receivable. The converse is also true: when assets are understated, cumulative earnings are understated. An example is the unrecognized appreciation on an acquired business that is recorded at original purchase price.
Conservatism in Reported Provisions and Liabilities
Our analysis must be alert to the proposition relating provisions and liability values to earnings. In general, When provisions and liabilities are understated, cumulative earnings are overstated. This is true because earnings are relieved of charges necessary to bring the provisions or liabilities up to their market values. Examples are understatements in provisions for product warranties and environmental liabilities that yield overstatement in cumulative earnings. Conversely, an overprovision for current and future liabilities or losses yields an understatement of earnings (or overstatement of losses). An example is overestimation of severance costs of a planned restructuring. We will describe in Chapter 6 how provisions for future costs and losses that are excessive shift the burden of costs and expenses from future income statements to the current period. Bearing in mind our propositions regarding the earnings effects from reported values of assets and liabilities, the critical analysis of these values represents an important factor in assessing earnings quality.
This is true because earnings are relieved of charges necessary to bring these assets down to realizable values. Examples include the delay in recognizing impaired assets, such as obsolete inventories or unproductive plant and equipment, and the understatement of allowance for uncollectible accounts receivable. The converse is also true: when assets are understated, cumulative earnings are understated. An example is the unrecognized appreciation on an acquired business that is recorded at original purchase price.
Conservatism in Reported Provisions and Liabilities
Our analysis must be alert to the proposition relating provisions and liability values to earnings. In general, When provisions and liabilities are understated, cumulative earnings are overstated. This is true because earnings are relieved of charges necessary to bring the provisions or liabilities up to their market values. Examples are understatements in provisions for product warranties and environmental liabilities that yield overstatement in cumulative earnings. Conversely, an overprovision for current and future liabilities or losses yields an understatement of earnings (or overstatement of losses). An example is overestimation of severance costs of a planned restructuring. We will describe in Chapter 6 how provisions for future costs and losses that are excessive shift the burden of costs and expenses from future income statements to the current period. Bearing in mind our propositions regarding the earnings effects from reported values of assets and liabilities, the critical analysis of these values represents an important factor in assessing earnings quality.
Earnings quality is affected by factors external to a company.
These external factors make earnings more or less reliable. One factor is the quality of foreign earnings. Foreign earnings quality is affected by the difficulties and uncertainties in repatriation of funds, currency fluctuations, political and social conditions, and local customs and regulation. In certain countries, companies lack flexibility in dismissing personnel, which essentially converts labor into a fixed cost. Another factor affecting earnings quality is regulation. For example, the regulatory environment confronting a public utility affects its earnings quality. An unsympathetic or hostile regulatory environment can affect costs and selling prices and thereby diminish earnings quality due
to increased uncertainty of future profits. Also, the stability and reliability of earnings sources affect earnings quality. Government defense-related revenues are dependable in times of high international tensions, but affected by political events in peacetime. Changing price levels affect earnings quality. When price levels are rising, “inventory profits” or understatements in expenses like depreciation lower earnings quality. Finally, because of uncertainties due to complexities of operations, earnings of certain conglomerates are considered of lower quality.
to increased uncertainty of future profits. Also, the stability and reliability of earnings sources affect earnings quality. Government defense-related revenues are dependable in times of high international tensions, but affected by political events in peacetime. Changing price levels affect earnings quality. When price levels are rising, “inventory profits” or understatements in expenses like depreciation lower earnings quality. Finally, because of uncertainties due to complexities of operations, earnings of certain conglomerates are considered of lower quality.
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