Question

explain what is the difference between earnings quality and earnings management (approx. 250- 350 words)

Answer 1

Earnings Quality

The terms “quality of earnings” and “earnings quality” have no single, agreed-upon meaning. Both terms are used when making accounting choices; considering the business cycle, including timing of transactions

Earnings Management

“Earnings management” is not a technical term in accounting or finance. However, it occurs when 1.) firm management has the opportunity to make accounting decisions that change reported income, and 2.) exploits those opportunities.

Difference

Earnings management and earnings quality are kind of two sides of the same coin. When earnings management is high, earnings quality is low and vice versa.

Positive Accounting Theory suggests that accounting choice can be driven by efficiency reasons or managerial opportunism. When management intervenes in the earnings reporting process in order to influence reported income numbers for their private gains, then managers have engaged in earnings management. A classic example is when managers make accounting choices to maximize their current compensation.

From the concept of earnings management, earnings quality can be gauged. That is, when managers do not intervene the earnings reporting process, earnings quality is high. Put formally, earnings quality measures the extent to which reported earnings numbers faithfully represent the fundamental earnings performance.