We utilize two basic approaches to measure the quality of earnings which control two different dimensions of earnings management.
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The research design is structured primary on the basis of calculating two different measures of the quality of earnings on the industry level and on the company level. This research concludes that various stakeholders should apply more than one measure for the quality of earning in order to have strong evidence about the level of quality before taking any corrective action or making any decision related to that company.
Reasons to Perform a Quality of Earnings (QofE) Check | Investment Bank
If one company is having low quality of earning according to one technique and high quality of earnings according to another, the stakeholders cannot have a final conclusion about that company and they need more investigations and analysis to assess the quality of earnings. How to cite this paper: Houqe, M.
In general, earnings that are calculated conservatively are considered more reliable than those calculated by aggressive accounting policies. Quality of earnings can be eroded by accounting practices that hide poor sales or increased business risk. Fortunately, there are generally accepted accounting principles GAAP. The more closely a company sticks to those standards, the higher its quality of earnings is likely to be. Several major financial scandals, including Enron and Worldcom, have been extreme examples of poor earnings quality that misled investors. It provides a point of reference for how well the company is doing from an earnings perspective.
If net income is higher than it was the previous quarter or year, and if it beats analyst estimates, it's a win for the company. But how reliable are these earnings numbers? Some companies manipulate earnings downward to reduce the taxes they owe.
Others find ways to artificially inflate earnings to make them look better to analysts and investors. Companies that manipulate their earnings are said to have poor or low earnings quality. Companies that do not manipulate their earnings have a high quality of earnings. As noted above, companies with a high quality of earnings stick with the GAAP standards.
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The fundamental qualities of those standards are reliability and relevance. That is:. Analysts usually start at the top of the income statement and work their way down. For instance, companies that report high sales growth may also show high growth in credit sales. Analysts are wary of sales that are due only to loose credit terms.
Changes in credit sales, or accounts receivable, can be found on the balance sheet and cash flow statement.
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Working down the income statement, analysts then might look for variations between operating cash flow and net income. A company that has a high net income but negative cash flows from operations is achieving those apparent earnings somewhere other than sales.
One-time adjustments to net income, also known as nonrecurring income or expenses, are another red flag. For example, a company may decrease expenses in the current year by refinancing all of its debt into a future balloon payment. This would lower debt expense and increase net income for the current year while pushing the repayment problem down the road. Naturally, long-term investors don't care for that move. A company can manipulate popular earnings measures such as earnings per share and price-to-earnings ratio by buying back shares of its own stock, which reduces the number of shares outstanding.
In this way, a company with declining net income may be able to post earnings-per-share growth.
When earnings-per-share goes up, the price-to-earnings ratio goes down. That should signal that the stock is undervalued. It doesn't, though, if the company changed the number by simply repurchasing shares. It is particularly worrisome when a company takes on additional debt to finance stock repurchases. Financial Ratios.