[ 2016-03-29 ]

What Constitutes Quality Earnings?
Earnings represent a key component in valuing an
enterprise. This is most often seen in a commonly
and widely used measure: the price/earnings
multiple. As earnings represent a large driver of
value, it needs to be examined properly as the
numbers appear in financial reports. Earnings are
merely the difference between revenues in a period
and the expenses incurred in earning those
revenues.

Earnings of a business are the most studied
number, since it determines the profitability of a
business. Earnings are a key determinant of a
business’s share price. Investors therefore rely
on profitability measures to make informed
investment decisions regarding the acquisition or
disposition of shares of a company.

Earnings Quality from the perspective of
forecasting future earnings is viewed as a
firm’s reported earnings, which are purged of
extraordinary items as being good quality if it is
a good indicator of future earnings. Higher
quality earnings more faithfully represent the
features of the firm’s fundamental earnings
process that are relevant to a specific decision
made by a specific decision-maker. Quality
earnings are therefore irrelevant unless they are
linked to a specific decision, because
stakeholders, particularly investors rely on the
earnings numbers to make their decisions.

Conservatism in the practice of accounting is
claimed to yield higher quality earnings.
Conservatism is an accounting practice that tends
to consistently maintain the book values of net
assets relatively low. Conservatism yields lower
earnings, because both revenues and expenses
(costs) are kept low which presumes that
conservative earnings are of a higher quality.
That is, faced with two methods to present items
financially, the company and auditor are to choose
the more conservative measure.

Earnings management and earnings quality share a
lot of features. Highly managed earnings have low
quality. However, the absence of earnings
management is not sufficient to guarantee high
quality earnings as several factors determine the
quality of earnings reported by an entity.

From the perspective of value relevance or its
usefulness for decision-making, and measurement,
earnings quality is examined in connection with
capital markets. This draws a relationship between
earnings and share price as capital markets will
react depending on the quality of earnings
reported within a particular period. High quality
earnings determine a better index of future
earnings.

Accounting earnings are made up of two components,
that is a cash component that provides relevant
information, reliable and less subjective to
distortions; and an accrual component that
provides relevant information, but which
reliability has potentially been compromised. The
accrual component of earnings is less persistent
than the cash component. It means that management
could use the accrual principle in accounting to
reduce the quality of reported earnings in a
particular reporting period, as reported earnings
under accrual accounting deviates from the cash
generated from operations.

Accrual accounting recognizes financial
transactions of a firm in the period in which they
occurred (or were incurred) rather than when cash
is received or paid by the firm. This tends to
provide a stronger indication of a firm’s
performance than current cash receipts and
payments. Increases in accruals that are
attributable to reductions in the efficiency of
asset usage are consistent with a reduction in
earnings quality. The size of accruals in reported
earnings has implications on the quality of the
particular earnings.

The critical determinants of earnings quality
includes the firm’s characteristics, financial
reporting practices, governance and control,
auditors, equity market incentives and external
factors.

Quality earnings therefore, are relevant in a
firm’s growth as well as the growth of
shareholders wealth, and the development of
capital markets. Individual shareholders
decisions’ emanating from quality earnings has a
larger impact on the capital market and
subsequently the economy. Quality earnings should
therefore provide the springboard for investors to
foresee future earnings. To ensure pure quality
earnings, firms should desist from managing their
earnings to soar up their performance.

WRITTEN BY:



DR WAYO MAHAMA

HEAD OF FINANCE

TAMALE POLYTECHNIC

Source - Ultimate1069.com

... go Back