Qtm_study Material

• Defined in terms of…

• Providing information about the features of firm’s financial performance
• Relevance to specific decision…  
• … to be made by a specific decision maker

• Earnings management:

• “Purposeful intervention in the external financial reporting process, with the intent of obtaining some private gain”

• Properties of higher quality earnings:

• Consistent and conservative in accounting policy
• Derived from recurring transactions related to basic business
• Stable, predictable and indicative of future earnings levels
• Accruals that are quickly convertible into cash
• Reasonable earnings projections → Ex: Exchange rate forecast

Indicators of earnings mis-statement

• Volatility

• High quality earnings are associated with highly predictable earnings
• Presence of one-time incomes in the income statement
• Decline in gross margin, while net margin increases

• The net income vs. cash flow differences

• Changes in accounting policies towards more liberal
• Sharp changes in accruals
• An ‘out-of-line’ increase in receivables (vice versa for payables)
• Reductions of managed costs, such as advertising
• An unusual increase in tangible assets
• Reduction of reserves by direct charges / reversals
• Reliance on non-core businesses / one-time event

• Recurring vs. non-recurring economic activities

• One large order producing wind-fall in a year

• Business combination accounting and timing
• An unusually long audit report
• Under-reserving for future losses

Incentives for earnings mis-statements

• Firm characteristics

• Firm performance
• Debt
• Growth and investment

• Capital market incentives

• Raising capital
• Target beating

• External factors

• Political processes
• Tax and non-tax regulations

• Governance and controls

• The principal-agent relationship
• Characteristics of BoD and internal control procedures… constraints managers’ ability to manage earnings
• Managerial share ownership and compensation… provides incentives for earnings management

• Auditor quality

• … negatively associated with discretionary accruals

Uses of earnings quality analysis

• Stock analysis

• Identify the role of accounting in any changes in earnings
• Measure the proportion of distributable cash
• Identify mis-pricing

• Managerial

• Compensation decisions

• Policy making

• Framing appropriate regulations to discourage earnings management
• Punitive actions against large-scale earnings mis-management

What is wrong in showing poor quality earnings

• Litigation propensity
• Audit opinions
• Market valuations
• Real activities
• Executive-level compensation

• Special items being taken out of pay-for-performance structure

• Executive-level labor market outcomes

• Reduced future opportunities, if identified with mis-statements

• Cost of equity capital
• Cost of debt capital

Earnings surprises – the puzzle

• Earnings have the potential to be manipulated
• Also… low quality earnings produce negative stock returns
• But… earnings have predictive power of stock prices