Question

4 ways how earnings Management can affect the quality of earnings

Answer 1

Earnings refers to a company's net income or profit for a certain period, such as a fiscal quarter or year. Companies use earnings management to smooth out fluctuations in earnings and present more consistent profits each month, quarter, or year. Quality of earnings are affected by policies used by management to recognise earnings.

Four ways in which earnings management can affect quality of earnings:

1. Company recognises high sales by giving higher credit to customers will have bad quality of earnings in compared to companies whose sales are on cash basis or whose credit sales are very small part of overall sales. This will result in higher bad debts in books of the company. So, here earings management is affecting the quality of earnings.

2. If company to boost it's sales figure near end of year starting sending goods to wholesalers or retailers even without orders from them will have higher sales but quality of earnings won't be good becuase there will be higher sales return figure in next financial year. So, here also earings management is affecting the quality of earnings.

3. Method of inventory valuation also effects the quality of earnings. In inflationary environment if company uses LIFO method instead of FIFO method of inventory valuation, then it's profit will be overstated. In this case due to wrong earnings management quality of earnings is not good.  

4. If company uses conservative estimates, then it's quality of earnings is good. Like in estimating allowance for bad debts if company takes reasonable percentage instead of very low percentage then Profits reported will be correct. So, here effective management will ensure quality of earnings.