Earnings Quality Analysis

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In order to understand the concept of earnings management, one must first understand the definition of earnings quality. There are many academic studies that aim to provide a concrete definition of earnings quality, which has left the term ‘earnings quality’ with a very broad, somewhat ambiguous meaning. Most studies use proxies for earnings quality for this reason Dechow et al (2010).
The quality of a reported earnings figure depends on whether it is informative about the firm’s financial performance Dechow et al (2010). Higher quality earnings provide more information about the features of a firm’s financial performance that are relevant to a specific decision made by the management of the firm (Statement of Financial Accounting Concepts
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Are they controllable? And are they liquid (have a future cash value)?” McClure (2004). McClure (2004) highlighted the key factors which determine the quality of reported earnings, it argued that in some periods earnings may be high due to special circumstances such as sale of assets; this form of revenue cannot be repeated so it is of low quality as it is not informative of the financial performance of the firm. The Controllable feature of earnings quality outlined by McClure (2004) indicates that macroeconomic factors may also have favourable effects on a firm’s financial performance by raising earnings. An example of this may be inflation or favourable movements in the exchange rate (for businesses based in one country but operate in another). Revenues may be recognised when the relevant cash transactions have not taken place and in order to remedy the timing and matching problem caused by cash-based performance measurement, firms may use accruals Dechow (1994). However the use of accruals may outline a degree of uncertainty as to whether these deferred cash flows will be realised, this cast of doubt inevitably lowers an investor’s perception of the firm’s quality of earnings Keefe …show more content…
These incentives may include bonuses and rewards for performance as it is widely accepted that financial performance in the form of reported earnings are a ‘good’ measure of a firm’s financial performance. The word ‘good’ is abbreviated as reported earnings may not always accurately reflect the true earnings figure of the firm, therefore they may not accurately reflect the true financial and operational performance of the business.
Prior literature explains that earnings management is not a figure that appears in the financial statements therefore in order to measure it discretionary accruals are used as a proxy. “The use of accruals to temporarily boost or reduce reported income is one mechanism for earnings management” Bergstresser and Philippon (2004). Beneish and Vargus (2002) found that periods of high accruals are associated with sales of shares by insiders, and they find that low earnings and stock returns follow the periods of high accruals that are accompanied by insider sales. These findings indicate that discretionary accruals have a negative impact on the quality of earnings, therefore it is safe to assume accruals are based on management decisions, which may have incentives based on self-wealth maximising

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