Home Research PapersSOLUTION lack of variability or stability of usefulness reported

SOLUTION lack of variability or stability of usefulness reported

 

SOLUTION TO THE CASE

a)     
 

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Quality
of earnings assessment is typically outlined to the ration of the certainty in
which present earnings and/or cash-flow can be projected to remain in the
prospective years. Quality of earning assessment is also associated with the
level of assurance a buyer feels it can be placed in the past financial
information of a firm while selecting an investment vehicle.

Some notable definitions of earning quality.

Chan et al. (2006) defined the quality of earnings as “the degree
to which reported earnings indicate operating fundamental of an entity”. This
measure of quality is concerned about the ability of reported earnings to
predict future performance of a firm.

Dechow et al. (2010) defined the quality of earnings as “relevant
of the fundamental earnings reported to the decision context of users”.

Vincent (2004) defined the quality of earnings as “decision
usefulness of the reported earnings to the users”. Both Dechow et al. (2010)
and Vincent (2004) defined quality of earnings in the context that earnings information
is essential to markets participants in making decision of resources allocation
in the capital markets.

Srinidhi et al. (2011), also describes earnings quality as “the
ability of current reported earnings to reflect the future cash flow and earnings”.
In this definition, earnings quality refers to how best current reported
earnings can predict future performance of a firm.

Earning
quality refers to the persistence or lack of variability or stability of
usefulness reported earnings to predict future earnings. That is, reduction of the market’s uncertainty about the firm’s
periodical value due to the earnings report and match this measure with value
relevance, persistence, predictability, smoothness, and accrual quality.

From
the case, it was argued that economic income is considered to be a better
predictor of future cash flows than accounting income.

In recent years, earnings
quality has emerged issue of interest to analyst, investors, managers and other
market participants (Lipe 1990; Chan et al. 2006; and Cahan et al. 2009).
Thus, managers are now much concerned about meeting
analyst forecast by preserving sustainable growth of the firms as means to
safeguard their office or work. However, analysts are interested on how best to
measure the quality of earnings so as to maximize portfolio of investors.

Therefore, it is becoming now
difficult for analyst, managers and investors in general to ignore the role of
quality of earnings in resources allocation. A number of research
have established the influence of earnings quality in
resources allocation.

Example, according to Francis et al. (2004), higher earnings quality is
associated with low cost of capital in USA. In
the same way, Setterberg (2011) examined the relation between earnings quality
measured by timelines and values relevance and cost of capital for Swedish
listed firms from 1994 to 2008. His findings outlined substantial adverse
correlation between the qualities of earnings and the implied cost of capital
of firms.

Chan et al. (2006) also
investigated the relation of earnings quality and stock returns in USA. It was
revealed that poor earnings quality is associated with poor future returns.

The quality of earning assessment is the
technique that help to associate the degree of both firms’ reported accounting
earning (thus only realized revenue/gains and/or expenses ascertain for
financial analysis or report) and economic earnings (thus earnings which
considers both unrealized or realized gains and losses).

According to Dechow et al.
(2010), recent interests in earnings quality and involvement of both standard
setters (example, International Accounting Standards Board, IASB, International Forum of Accounting Standard Setters,
IFASS,
and Financial Accounting Standards Board, FASB) and management of firms have
influenced the process of measuring earnings quality.
Standard setters such as IASB, IFASS and FASB establish methods to be used and
managers of firms have option to make estimation and select the method to use.
The recent interest and involvements of these two actors have resulted into
many indicators to measure the quality of reported earnings.

Notable indicators that are
commonly used in assessing quality of reported earnings include predictability,
accrual quality, earnings surprise, persistence measure, smoothness,
timeliness, and conservatism.

INDICATORS OF MEASURING THE
QUALITY OF EARNINGS

·        
Predictability

This
denotes the ability of the current stated or reported earnings to forecast
future component of operating earnings. Lower ability predictor of subsequent
earnings implies that; the earnings has a lower earnings quality. Higher ability
to predict future earnings indicates high earnings quality.

·        
Accrual Quality

Accrual quality is the variance
between cash from operating and recorded earnings generated by business. The higher the ratio of accrual quality
implies poor earnings quality and smaller ratio or value indicates high quality
earnings.

It is calculated by using the formula:

Accrual quality            =
         (Earnings (before
extraordinary)-cash flow from operation)                                                                                      Average
Assets.

·        
Earnings Surprise Indicator

This
is stated as the value of net operating assets at the beginning of business
operations by the total sales. A higher ratio of earnings surprise shows poor
earnings quality. Therefore, the higher the ratio, the poorest the earnings
quality, and the lesser the ratio, the healthier the firm’s reported earnings.

Earnings Surprise        =
         Net operating assets at
beginning                                                                                           earnings generated for
the period.

·        
Persistence Measure

This
is usually used as a measure of quality earnings assessment. It measures the
sustainability of firm’s reported earnings. This indicates that, earnings which
are more firm and persistent are more sustainable and are of high quality. But
if it not persistent, it is more fleeting and then
such earning is of low quality.

·        
Smoothness

The term
income smoothing is used to describe efforts put up by managers of firms to
reduce irregular or inconsistent variation in earnings. Smoothness
is the use of accounting techniques to level out net earnings variations
resulting from one accounting period to another. Management sometimes exercise
their power to reduce abnormality on the reported earnings to inform interested
users about their assessment of the future earnings to the level accepted by
the accounting standard.

According to Francis et
al. (2004), the formula below is used to assess the smoothness of earnings
quality:

SM      =          sd
(NP/TAB)                                                                                                                           sd
(CF/TAB),

 Where:            SM
= Smoothness

sd = Standard deviation,

NP = Net income before extra-ordinary activities

TAB = Total assets at the beginning of the year.

CF = Cash flow from operation.

Earnings
that are smoothened (for example where firms may defer revenue or overstatement
of expenses provision to create a cushion for future results) indicates high earnings
quality.

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