Question

The financial community in the United States has become increasingly concerned with the quality of reported company earnings.

Required:
1. Define the term earnings quality.
2. Explain the distinction between permanent and transitory earnings as it relates to the concept of earnings quality.
3. How do earnings management practices affect the quality of earnings?
4. Assume that a manufacturing company's annual income statement included a large gain from the sale of investment securities. What factors would you consider in determining whether or not this gain should be included in an assessment of the company's permanent earnings?

Answer 1

Requirement 1

The term earnings quality refers to the ability of reported earnings (income) to predict a company's future earnings. After all, an income statement simply reports on events that already have occurred. The relevance of any historical-based financial statement hinges on its predictive value.

 

Requirement 2

To enhance predictive value, analysts try to separate a company's transitory earnings effects from its permanent earnings. Transitory earnings effects result from transactions or events that are not likely to occur again in the foreseeable future, or that are likely to have a different impact on earnings in the future.

 

Requirement 3

An often-debated contention is that, within GAAP, managers have the power, to a limited degree, to manipulate reported company income. And the manipulation is not always in the direction of higher income. Many believe that manipulating income reduces earnings quality because it can mask permanent earnings.

 

Requirement 4

You would consider the size of the gain in relation to net income, the size of the company's investment portfolio, and the frequency of gains and losses from the sale of investment securities in past years. The main objective is to determine the likelihood of this type of gain occurring again in the future.

The term earnings quality refers to the ability of reported earnings (income) to predict a company's future earnings