Earnings

Question 1

What is a high quality earnings number

Answer 1

• accurately reflects the companies current operating performance
• is a good indicator of future operating performance

Is a useful summary measure for assessing a firms value

Question 2

Why is earnings quality useful

Answer 2

It is useful as accounting information is to make decisions for investors, creditors and other lenders etc

A reliable high quality earnings number is a critical cornerstone of that decision making

Examples
- inter company comparison
- company valuation
-performance evaluation

Question 3

What are the two main types of earnings manipulation

Answer 3

Manipulating operating cash flow through real transactions

Manipulating accruals

Question 4

Manipulating operating cash flow through real transactions

Answer 4

Method - real economic actions are taken to influence earnings such as cutting R&D or boosting sales by offering discounts

Impact - this type of manipulation has real economic impact on the company and can seriously inhibit long term growth and the reliability of earnings

Visibility- this type may be easier to recognise over time by analysts than accrual manipulations

Question 5

Manipulating accruals

Answer 5

Method - influence accruals through the use of estimation, forecasts and other judgments in financial reporting process. For example judgements over depreciation life

Impact - in the short term can have no real economic impact on the company but it does mislead investors. Where significant can result in financial statement fraud, losses to stakeholders and company failure.

Visibility- this type is less visible than cash flow because accruals require private information from managers who hold advantages in information asymmetry.

Question 6

Possible red flags that may indicate earnings management is taking place

Answer 6

Unexpected results compared to market conditions - this could indicate earnings management strategies such as prematurely recognising revenue, this leads to questions about credibility

Changes in accounting policies - if a company changes policies such as revenue recognition it could indicate an attempt to manage earnings artificially

Profit consistently exceeds operating cash flow - this suggests that reported profits may not be supported by actual cash generating activities for example recording non cash revenue

Changes in gross margins- artificially lowering cost of sales or boosting revenue can create abnormal gross margins, may indicate improper recognition.