Question

The concept of “Quality of Earnings” is widely recognized in the relevant finance and accounting literature.

a) Explain this concept comprehensively.

b) How Earnings quality relate to Market pricing of the stocks traded based on empirical evidence available?

c) Apply this concept and its applications in the Palestinian context.

Answer 1

Solution =

a) Quality of Earning -

Quality of Earnings (QoE) represents a true picture of the company without any accounting trick, one-time item, or anomalies. Or, we can say, it refers to the income that the company generates from the core operations. Often it is seen that net income does not represent the true financial picture of a company. It may happen that a company reports a massive net income, but its operating cash flows are negative. In such a case, one can’t say that the company is financially sound. Thus, to get the true position in these cases, we calculate the quality of earnings.

• A company's real quality of earnings can only be revealed by spotting and removing any anomalies, accounting tricks, or one-time events that skew the numbers.
• Quality of earnings is the percentage of income that is due to higher sales or lower costs.
• An increase in net income without a corresponding increase in cash flow from operations is a red flag.
• Tracking activity from the income statement through to the balance sheet and cash flow statement is a good way to gauge quality of earning.

A key characteristic of high-quality earnings is that the earnings are readily repeatable over a series of reporting periods, rather than being earnings that are only reported as the result of a one-time event. In addition, an organization should routinely provide detailed reports regarding the sources of its earnings, and any changes in the future trends of these sources. Another characteristic is that the reporting entity engages in conservative accounting practices, so that all relevant expenses are appropriately recognized in the correct period, and revenues are not artificially inflated.

b) Relation between earnings quality (EQ) and the market value of equity is positive – more EQ leads to higher market values of equity (e.g. Gaio and Raposo 2011). However, several existing accounting and finance studies of firms using data on the Indonesian capital market indicate that the role of the financial reporting process in Indonesia may be different from that of other (developed) capital markets. For example, an early study by Siregar and Utama (2008) finds that earnings management in Indonesia tends to be contractually efficient rather than opportunistic. The focus in their study is on corporate governance (CG) factors in Indonesia, but setting aside CG issues, their results show that current earnings’ components (CFO, NDACC, DACC) are correlated with future profitability (CFO, EARN, ΔEARN). The most important aspect of EQ appears to be earnings timeliness, that is, the extent to which economic news is captured by the accounting system. The fact that the accounting system is generally able to reflect the economics of the firm is valued by the market

c) Palestine Exchange (PEX) was established in 1995 to promote investment in Palestine. The PEX was fully automated upon establishment-a first amongst the Arab Stock Exchanges. The PEX operates under the supervision of the Palestinian Capital Market Authority. There are 48 listed companies on the PEX as of 31/03/2014 with market capitalization of about $ 3 billion across five main economic sectors; banking and financial services, insurance, investments, industry, and services1. Most of the companies are profitable and trade in Jordanian Dinar, while others trade in US Dollars. Only stocks are currently traded on the PEX. In 2009, the PEX ranked thirty third amongst the worldwide security markets, and regionally comes in second in terms of investor protection,