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  1. Earnings Quality: Introduction
  2. Earnings Quality: Understanding Accounting Standards
  3. Earnings Quality: Defining "Good Quality"
  4. Earnings Quality: Why Aren't All Earnings Equal?
  5. Earnings Quality: Reviewing Non-Accrual Items
  6. Earnings Quality: Measuring Accruals
  7. Earnings Quality: Adjusting Accruals For Proper Comparisons
  8. Earnings Quality: Analyzing Specific Accrual Accounts
  9. Earnings Quality: Investigating The Financing Of Accruals
  10. Earnings Quality: Measuring The Discretionary Portion Of Accruals
  11. Earnings Quality: Conclusion
By Tim Keefe,CFA (Contact Author | Biography)

One company's reported earnings are not of the same exact quality as another's because each management team uses its own judgment when recording business transactions. Because the firm's management has deep knowledge of the economics of its business, it is in a unique position to make judgments regarding expectations of future cash flow. Hopefully, management uses its judgment in a manner that reflects the stated principles and qualities of accrual accounting, but even with honest efforts to forecast the future, management will not always produce accurate accrual estimates, such as when business conditions change and what were thought to be very low-probability events occur more frequently than predicted. (To read about company management issues, see Evaluating A Company's Management and Get Tough On Management Puff.)

Unfortunately, management may not be so principled and can intentionally bias accrual estimates within GAAP in order to meet performance targets. They can do this by knowingly under- or overestimating accrual amounts in a variety of different areas at the start of the transaction. In addition, management can maintain accrual accounts based on old assumptions, even though they should adjust them to more accurately reflect new events and conditions. For example, a company that is aware that tooling machines aren't calibrated correctly, which increases defects and premature failure in the product, but doesn't increase the warranty allowance creates a bias in the earnings estimates.

Figure 6 describes the areas where management has accounting flexibility and Figure 7 discusses some areas in which manipulating business accounts might benefit management to the detriment of report users.

Accrual Item Management Flexibility Degree of Flexibility
Current Accruals
Inventory Influence the allocation of overhead between inventory and COGS and estimating the value of inventory High
Accounts Receivable Estimating product returns and the portion that is uncollectible High
Accounts Payable These are financial obligations that can be measured reliably Low
Other Current Liabilities These are financial obligations that can be measured reliably Low
Non-Current Accruals
PP&E and Goodwill Estimating the residual value of assets and choice of depreciation schedule High
Investments - Other Investments in marketable securities can be measured reliably, but the value of long-term receivables may not be Middle
Pension Liabilities Estimating returns on plan assets, discount rate on liabilities and growth in wages and healthcare costs High
Long-Term Debt These are financial obligations that can be measured reliably Low

Figure 6: Degree of management discretion when applying accounting rules

Debt Covenants
Firms that are close to violating contractual agreements have incentive to reduce the probability of covenant violation, specifically where they are required to maintain prespecified interest coverage and liquidity ratios.

Financial Market Reasons
Management may want to present data to influence stock or bond prices in the near term for a merger/acquisition or options that it wants to exercise.
Management Compensation Bonus compensation may be tied to performance targets.
Tax Reasons Some accounting policies must be used in shareholder reporting if the company wants to use it for tax reporting. For example, U.S. firms are required to use LIFO inventory accounting for this purpose.

Regulatory Reasons
Management may want to present favorable data for antitrust review, tariff considerations or due to concerns regarding an "excess-profit tax."

Competitive Reasons
Management may want to present data to influence labor negations or to discourage new business competitors.

Figure 7: Possible reasons for accounting manipulation

In order to limit management's ability to abuse its authority over accounting judgments, the accounting rules regulate how certain business transactions are recorded. Typically, the more uncertainty surrounding the future economic benefits or costs of a transaction, the more likely accruals will not be allowed. This is because the transfer of value described by the amounts involved in the transaction is difficult to measure accurately and/or may be highly unlikely to occur.

Evaluating Managerial Accounting Discretion
As was indicated previously, accrual accounting involves a tradeoff between relevance and reliability. Accrual accounting enables management to use its unique understanding of the business to convey important information about the economic welfare of the firm (relevance). It also allows management some discretion to manipulate important information about the economic welfare of the firm (reliability). Evaluating management's judgment regarding its use of accruals is what accounting analysis is all about.

Thus, a key to more-effective accounting analysis will be the ability to figure out how much accounting discretion management has in the areas that impact the economics of the business and how they implement this discretion. The analyst needs to be knowledgeable about management's general flexibility under the accounting rules and about how management handles specific accounting issues that are critical to the economics of the business. Having insight into these two subjects will provide context for the analysis as well as provide direction as to where to focus due care.

For example, with a firm in the equipment-leasing business, the ability to accurately forecast the value of the asset when the lease is over and the client returns it will be key to its economic success. Understanding that management has high flexibility when making this forecast means it will be important to find out the firm's policies regarding the recording of residual values.

Figure 6 in the prior section generally describes management flexibility under the GAAP. By noting the flexibility in GAAP and relating this to the business of the firm you can get an idea of the potential magnitude that management's judgment has on the reported financial statements. Note that this potential should not be read with the negative connotations of manipulation; it can also be read as potential to relay more accurate information. It just depends on how management exercises its flexibility.

Critical Accounting Policies
Management typically discusses its critical accounting policies in the Management Discussion and Analysis (MD&A) section of the Form 10-K filed with the Securities and Exchange Commission (SEC) annually. This discussion will provide insight into the accounting choices and estimates embedded in the company's key policies. By noting the firm's current policies and comparing them to the firm's own policy history and to its industry peers, you can begin to get an idea of how appropriate the current policies may be when producing management's accounting estimates. Further, look at how often and how large restatements, write-offs and the like have been in order to determine whether management's policies have been realistic in the past.

In the next sections, we discuss ways to scrutinize information in order to determine how well management has used its flexibility to represent the true economic condition of the firm. The methods rely on qualitative analysis of management's public statements and quantitative analysis of its financial statements.

Earnings Quality: Reviewing Non-Accrual Items
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