By Tim Keefe,CFA (Contact Author | Biography)

A firm's reported earnings number has typically been the focus of Wall Street, Main Street and the media. Other aspects of financial statements get overlooked, even though these items may provide information about the quality of firms' reported earnings. This tutorial describes a process that will assist you in determining to what degree the reported earnings have been manipulated by management. The results of the analysis won't deliver a definitive thumbs-up or thumbs-down regarding the quality of earnings, but it will enable you to better understand the risks in the firm's accounting for earnings.

Here, we've examined key issues relating to earnings quality, including the attributes of a high-quality earnings number and the tradeoff between relevance and reliability. The discussion noted that earnings quality will vary even when managers follow GAAP with the best intentions. Furthermore, not every change in accounting policy and accruals signals an attempt to manipulate reported earnings.

In order to determine the degree of earnings quality, investors must look at factors outside the financial reporting system that can affect earnings quality. Investors must also identify the types of accounts companies are most likely to manage and the circumstances in which earnings management is most likely to occur. Finally, investors can use metrics to quantify the degree of earnings management and some methods used to compare these metrics over time and across firms.







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