By Tim Keefe,CFA (Contact Author | Biography)

In order to understand a company's financial report, you need to understand the accounting concepts that are used to justify the accounting rules. Basically, these accounting concepts provide rulemakers with guidance that will result in financial reports that best help investors, creditors and other financial-report users assess:

You can gain a better understanding of the financial guidelines involved on the U.S. GAAP website. Alternatively, the Financial Accounting Standards Board (FASB) has produced the Statements of Financial Accounting Concepts for your review.

Now let's begin looking into how accounting rules relate to earnings quality. First, we need to define what we mean when we say "quality", as earnings quality means different things to different users of financial statements. For example, regulators would view earnings quality as being high if the accounting had adhered to generally accepted accounting principles (GAAP), as GAAP is used by regulators to help ensure high quality in financial statements. For our purposes, we want reported earnings to do two things: to accurately represent current operating performance and to aid in accurately forecasting future operating performance. These requirements for high-quality earnings mean that the reported earnings amounts for a particular period should:
  • Represent the underlying economics of the business
  • Be both persistent and predictable (the metric should be stable over time)
If the reported earnings keep true to these two concerns, this information will provide a reasonable basis for valuing the company. Thus, we should see a high correlation between the prices calculated by valuation models using the reported earnings amount and actual stock prices. (For more insight, see Earnings: Quality Means Everything.)

Methods for Measuring Earnings Quality
In order to develop a way to measure earnings that meets our criteria for high quality, we need a metric that honors the fundamental qualities of GAAP. These features are reliability and relevance.

Reliability - The metric is verifiable, free from error or bias and accurately represents the transaction.

Relevance - The metric is timely and has predictive power; it can confirm or reject prior predictions and has value when making new predictions.

There are two basic ways to present a company's operating performance and measure earnings during a given period - cash accounting and accrual accounting. If you haven't already guessed, each has tradeoffs in terms of relevance and reliability. Furthermore, there is debate as to whether the increased relevance produced by accrual accounting is sufficient to overcome its relative lack of reliability.

Cash Accounting
The first method for measuring operating performance is based on cash accounting. Cash accounting involves recording transactions whenever cash enters or leaves the firm. The advantage of this accounting method is that the transactions recorded have been completed and the amounts involved are certain, making it highly reliable. The downside to cash accounting is that the earnings measurement is not very stable, which gives it low relevance. Think about how cash accounting for new equipment, expected to be used over several years, would make reported cash earnings volatile across multiple periods. The immediate cash outlay would reduce cash earnings early on and the lack of any cash outlay in the latter periods would increase cash earnings even though the firm used the equipment equally across all the periods. The following table illustrates this point:

- Sales Labor Cost Equipment Cost Earnings
Period 1 $100 $20 $30 $50
Period 2 $100 $20 $0 $80
Period 3 $100 $20 $0 $80
Total $300 $60 $30 $210

Figure 2: Cash accounting equipment example

Accrual Accounting
In order to create an accounting method that has higher relevance than cash accounting, accrual accounting introduces the idea of periodicity. Periodicity states that each transaction should be assigned to a given period and split accordingly if it covers several periods. This is an attempt to recognize revenues in the period in which they were actually earned (GAAP's revenue-recognition principle) as well as to match the related expenses to the earned revenue (GAAP's matching principle).

The upside to the accrual method is that it results in a metric that is more relevant than cash flow. You can see this by comparing Figure 2 to Figure 3. In Figure 3, the accrual earnings amount of $70 in Period 1 is persistent over time and thus has more predictive power about future periods' earnings. Stock prices calculated by valuation models using accrual earnings also appear to be more closely correlated to the market price than when modeled with cash flow.

- Sales Labor Cost Equipment Cost Earnings
Period 1 $100 $20 $10 $70
Period 2 $100 $20 $10 $70
Period 3 $100 $20 $10 $70
Total $300 $60 $30 $210

Figure 3: Accrual accounting equipment example

Note: Management made judgment calls on the residual value of the $30 equipment (here $0) and the useful life of the equipment (here 3 periods) so the equipment cost per period is ($30 - 0)/3 = $10 per period.

The disadvantage of accrual earnings is the obvious result that reliability is lower than for cash earnings. The use of accruals exposes the recording of the transaction to uncertainty related to the principles of revenue recognition and matching. This is because management's expectations and judgment are called upon to record transactions. The process of recognizing and matching creates holding accounts called accruals (accounts receivable) and allowances (allowance for bad debts) on the balance sheet. The amounts booked into these accounts are based on management estimates governed by accounting rules, which at times provide considerable latitude. (To learn more, see Reading The Balance Sheet.)

The following chart shows how cash and accrual accounting compare with respect to relevance and reliability:

- Relevance Reliability

Cash Accounting
Low, due to instability of earnings measurement High, because deals with completed transactions

Accrual Accounting

High, due to periodicity
Low, because it relies on management\'s expectations

Figure 4

Accruals In Action
Let's puts some life into this concept of accruals with an example. Suppose that you hire someone to draw water from the public well and carry it to 10 of your neighbors for $50 a day. Your neighbors pay you $10 a day each for the service - a $100 total per day. Everyone agrees that payday will be on Friday night, so no cash will change hands until then. You expect that one of your neighbors, Joe, will fail to pay you for your services. On Monday night, your water-service business will have an income statement and balance sheet that look something like Table 3 below. The bold and italicized items on the balance sheet are the holding accounts created to represent the amounts of cash that you, the manager, expect will change hands in the future.

Figure 5: Accrual accounting example for a business

It is important to note that eventually, usually within an operating cycle, the accuracy of management's estimates is put to the test. For your water-service business, this would be on Friday night. Upon completion of the terms of the transaction, there is a true-up for the total cash in and out related to the transaction. If management correctly estimated the accruals, then earnings will have been accurately reported over the transaction period. On the other hand, if management estimates were wrong due to chance, optimism or fraud, then earnings would have been inaccurately reported. (For more insight, read Earnings Forecasts: A Primer.)

The fact that management's judgment can lead to inaccurate accrual amounts, and therefore inaccurately reported earnings, can be seen in a continuation of the previous example about a water service business. Let's say that you make a bet with a friend that you can make $150 before Thursday (this is sort of like a performance incentive, no?). Because of this bet, you estimate that all your customers will pay you on Friday night - even though you know Joe is a deadbeat, and probably won't pay you for delivering his water.

In this case, you make no entries for uncollectible account expenses or allowance for bad debt. As such, net income is stated as $50 - an overstatement of $10 per day. You send off your financial reports showing $150 profit ($50 per day for three days) to your friend (who doesn't know Joe or realize that he is unlikely to pay) on Wednesday night and collect on your bet. As expected, on Friday night you discover that Joe doesn't intend to ever pay you for your services. As the manager, you had unique insight into the economics of your business, but you chose to low ball your allowance for bad debts and overstate your true expectations for earnings in order to win a bet.

Next: Earnings Quality: Why Aren't All Earnings Equal? »

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