4.2: Quality of Earnings/Information Flashcards
What are the main limitations of the statement of income/comprehensive income?
Items that cannot be reliably measured are not included (e.g., contingent gains).
Income is affected by accounting methods used (e.g., straight-line vs. accelerated depreciation).
Income measurement involves estimates, leading to potential uncertainty (e.g., asset life estimation).
What is Underlying Concept 4.3 about?
It refers to the conceptual framework that identifies qualitative characteristics of useful financial information, including relevance, representational faithfulness, comparability, verifiability, timeliness, and understandability.
What are the two aspects generally considered when analyzing the quality of earnings?
Content, which includes the integrity of the information and sustainability of earnings.
Presentation, meaning the clarity and ease of use of the information.
What does earnings management refer to?
It is the process of targeting certain earnings levels or trends and working backward to ensure these targets are met.
This may involve selecting certain accounting policies, using estimates, or even executing unnecessary transactions to boost earnings.
What is the relationship between higher-quality earnings and predictive value?
Higher-quality earnings are less likely to result in misstated financials, have greater predictive value, and are considered more reliable indicators of a company’s economic reality.
What are some characteristics of high-quality earnings according to Illustration 4.3?
Unbiased and objectively determined.
Reflect economic reality of transactions.
Primarily generated from core business activities, not one-time gains.
Closely correlate with cash flows from operations.
Based on a sound business strategy and model.
Why is the number “4” considered “The Loneliest Number” in earnings management practices?
Companies are more likely to round up earnings per share (EPS) to the next-highest cent, leading to “quadrophobia,” where the digit 4 appears less frequently in the tenths place than expected.
How can earnings management affect the quality of earnings?
It can reduce the quality by using aggressive accounting practices (e.g., prematurely recognizing sales, reducing reserves) to manipulate earnings, creating a false representation of the company’s financial health.
What is the concept of sustainability of earnings?
It refers to whether a company’s income is likely to continue over time, based on factors like the business model, industry conditions, and external societal expectations (e.g., corporate responsibility).
How does GAAP impact earnings quality?
GAAP is not always optimal, as standard-setting can be influenced by political factors.
Some relevant items, like leases or pension adjustments, may not be properly reflected in financial statements under GAAP rules.
