Question

Explain how analysts assess the quality of reported earnings.

Answer 1

Quality of Reported Earnings:

Reported earnings are the earnings of the entity reported as Profit. These are net earnings which can be calculated after deducting expenses from the revenue or earnings (sales/ professional receipts/ Income) of the entity.

Quality of reported earnings is assessed by analyst for :

• verifying and checking the correctness of the reported earnings
• the area due to which the earnings are affected or changed
• to do analysis of reported earnings for comparing it with historical data of entity and analyze the performance of the entity

Analysts assess the quality of reported earnings as follows :

• Margins : Product margin is very important to entity for earning profits and for growth of the company. These should be analyse as it directly affects the earnings of the entity. Margins can be change on higher or lower side due to :

1. Change in Price of the product
2. Change in market demand of the product
3. change in tax structure
4. change in valuation of product
5. reduction / increase in expenses

• Sales : Sales majorly affected the earnings also it is very important to the entity for its sustainability (going concern). Sales can be change on higher or lower side due to :

1. Change in market demand of the product
2. Product Quality
3. Product supply
4. After sales services of product
5. obsolescence of technology / product

• Inventory : Inventory is directly connected  to earnings as per demand production of the company running and as per production inventory maintained by entity. Here we need to analyse quantity as well as price of the inventory. Change in valuation of inventory will affect the pricing and valuation of reported earning as product price change.
• Receivables : Receivables is part of sales it helps to generates cash flow to the entity as if receivables are managed properly or recovered on time then liquidity of the company be good which can be helpful to company for future revenues and increasing product demand.
• Expenses : Expenses are important part of any reported earnings as it denoted the outflow of earnings of the company as

1. Variable Expenses : These are expenses which directly connected to the production it is a cost which is required for production and sale of the product.
2. Fixed Expenses : These are expenses which is unavoidable and required to run the company.
3. Semi variable expenses : These are expenses in which some portion is fixed and some is variable in nature.

Due to change in expenses contribution changes and it affects the profitability of the entity.

• Other factors which should be analyse for reported earnings :

1. Change in Economic Conditions
2. Change in Government Policy
3. Change in structure of the entity
4. Goodwill of the entity affected