Question

1.1)State and discuss three potential sources of noise and bias in the accounting data reported by companies, and explain the concept of earnings quality within the context of equity research.

1.2)Critically assess the following statement made by an equity analyst: “There is no need to pay attention to accounting earnings numbers, given that a ‘clean’ number like cash from operations is readily available.”

Answer 1

1.

Whistle blowing is one of the most important noise that happens in company.PWC is the best example for this type of noise.Restructuring cost should not be included when calculating EPS but most of the companies includes it and this makes a biases in an analyst min about the quality of the report.Also most of the institutional investors are sufferes from survivorship bias and backfill bias as they report the return only from the fund which performed better.So,all these are the biases and noise that occurs in company and one should be caveat about this.

2.

Its true that there is no need to focus on accounting numbers.As,accounting numbers does not reflect economic reality.To reflect economic reality,one should see whether company has taken FIFO or LIFO to calculate inventory.If it is FIFO,then it is fine else adjust the numbers.ALso,calculate economic profit or residual income to know how much company has earned in reality because accounting profits shows the profit left for shareholders but in actual how much company has earned after paying to investors reflects true picture of the company performance.Also one should check the corporate governance of the company and analyze the quality of the report.