SOLUTION TO THE CASEa) Qualityof earnings assessment is typically outlined to the ration of the certainty inwhich present earnings and/or cash-flow can be projected to remain in theprospective years. Quality of earning assessment is also associated with thelevel of assurance a buyer feels it can be placed in the past financialinformation 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 degreeto which reported earnings indicate operating fundamental of an entity”. Thismeasure of quality is concerned about the ability of reported earnings topredict future performance of a firm.Dechow et al. (2010) defined the quality of earnings as “relevantof the fundamental earnings reported to the decision context of users”.Vincent (2004) defined the quality of earnings as “decisionusefulness of the reported earnings to the users”. Both Dechow et al. (2010)and Vincent (2004) defined quality of earnings in the context that earnings informationis essential to markets participants in making decision of resources allocationin the capital markets.Srinidhi et al.
(2011), also describes earnings quality as “theability of current reported earnings to reflect the future cash flow and earnings”.In this definition, earnings quality refers to how best current reportedearnings can predict future performance of a firm.Earningquality refers to the persistence or lack of variability or stability ofusefulness reported earnings to predict future earnings. That is, reduction of the market’s uncertainty about the firm’speriodical value due to the earnings report and match this measure with valuerelevance, persistence, predictability, smoothness, and accrual quality.Fromthe case, it was argued that economic income is considered to be a betterpredictor of future cash flows than accounting income. In recent years, earningsquality has emerged issue of interest to analyst, investors, managers and othermarket participants (Lipe 1990; Chan et al. 2006; and Cahan et al.
2009).Thus, managers are now much concerned about meetinganalyst forecast by preserving sustainable growth of the firms as means tosafeguard their office or work. However, analysts are interested on how best tomeasure the quality of earnings so as to maximize portfolio of investors. Therefore, it is becoming nowdifficult for analyst, managers and investors in general to ignore the role ofquality of earnings in resources allocation.
A number of researchhave established the influence of earnings quality inresources allocation. Example, according to Francis et al. (2004), higher earnings quality isassociated with low cost of capital in USA. Inthe same way, Setterberg (2011) examined the relation between earnings qualitymeasured by timelines and values relevance and cost of capital for Swedishlisted firms from 1994 to 2008.
His findings outlined substantial adversecorrelation between the qualities of earnings and the implied cost of capitalof firms. Chan et al. (2006) alsoinvestigated the relation of earnings quality and stock returns in USA. It wasrevealed that poor earnings quality is associated with poor future returns.
The quality of earning assessment is thetechnique that help to associate the degree of both firms’ reported accountingearning (thus only realized revenue/gains and/or expenses ascertain forfinancial analysis or report) and economic earnings (thus earnings whichconsiders both unrealized or realized gains and losses). According to Dechow et al.(2010), recent interests in earnings quality and involvement of both standardsetters (example, International Accounting Standards Board, IASB, International Forum of Accounting Standard Setters,IFASS,and Financial Accounting Standards Board, FASB) and management of firms haveinfluenced the process of measuring earnings quality.Standard setters such as IASB, IFASS and FASB establish methods to be used andmanagers of firms have option to make estimation and select the method to use.
The recent interest and involvements of these two actors have resulted intomany indicators to measure the quality of reported earnings. Notable indicators that arecommonly used in assessing quality of reported earnings include predictability,accrual quality, earnings surprise, persistence measure, smoothness,timeliness, and conservatism.INDICATORS OF MEASURING THEQUALITY OF EARNINGS· PredictabilityThisdenotes the ability of the current stated or reported earnings to forecastfuture component of operating earnings. Lower ability predictor of subsequentearnings implies that; the earnings has a lower earnings quality. Higher abilityto predict future earnings indicates high earnings quality. · Accrual QualityAccrual quality is the variancebetween cash from operating and recorded earnings generated by business.
The higher the ratio of accrual qualityimplies poor earnings quality and smaller ratio or value indicates high qualityearnings.It is calculated by using the formula:Accrual quality = (Earnings (beforeextraordinary)-cash flow from operation) AverageAssets.· Earnings Surprise IndicatorThisis stated as the value of net operating assets at the beginning of businessoperations by the total sales. A higher ratio of earnings surprise shows poorearnings quality. Therefore, the higher the ratio, the poorest the earningsquality, and the lesser the ratio, the healthier the firm’s reported earnings.Earnings Surprise = Net operating assets atbeginning earnings generated forthe period.· Persistence MeasureThisis usually used as a measure of quality earnings assessment.
It measures thesustainability of firm’s reported earnings. This indicates that, earnings whichare more firm and persistent are more sustainable and are of high quality. Butif it not persistent, it is more fleeting and thensuch earning is of low quality. · SmoothnessThe termincome smoothing is used to describe efforts put up by managers of firms toreduce irregular or inconsistent variation in earnings. Smoothnessis the use of accounting techniques to level out net earnings variationsresulting from one accounting period to another.
Management sometimes exercisetheir power to reduce abnormality on the reported earnings to inform interestedusers about their assessment of the future earnings to the level accepted bythe accounting standard. According to Francis etal. (2004), the formula below is used to assess the smoothness of earningsquality:SM = sd(NP/TAB) sd(CF/TAB), Where: SM= Smoothnesssd = Standard deviation, NP = Net income before extra-ordinary activitiesTAB = Total assets at the beginning of the year.CF = Cash flow from operation.Earningsthat are smoothened (for example where firms may defer revenue or overstatementof expenses provision to create a cushion for future results) indicates high earningsquality.
