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Earnings Quality: It's Time to Measure and Report Jodi L Marquette University e-Publications@Marquette Accounting Faculty Research and Publications Business Administration, College of 11-1-2005 Earnings Quality: It's Time to Measure and Report Jodi L. Gissel Marquette University, [email protected] Don Giacomino Marquette University, [email protected] Michael D. Akers Marquette University, [email protected] Published version. The CPA Journal, Vol. 75, No. 11 (November 2005). Permalink. Reprinted from The PC A Journal, November 2005, © 2005, with permission from the New York State Society of Certified Public Accountants. The uthora of this document, Jodi L. Gissel, published under the name Jodi L. Bellovary at the time of publication. Earnings Quality: It's Time to Measure and Report Jodi L Bellovary; Don E Giacomino; Michael D Akers The CPA Journal; Nov 2005; 75, 11; ABI/INFORM Global pg. 32 AC COUN TING & A U DITI NG accounting Earnings Quality: It's Time to Measure and Report By Jodi L. Bellovwy, Don E. and the extent to which it can predict and Information," Accoullting Horizons 17 Giacomino, and Michael D. Akers anticipate future eamings. (Supplement), 2003]. Penman ["The Quality of Financial Statements: arnings quality is an important Earnings Quality Defined Perspectives from the Recent Stock Market aspect of evaluating an entity' s A variety of earnings-quality definitions Bubble ," A ccounting Horizons 17 E tinancial health, yet in vestors, cred­ exist. Teets ["Quality of Earnings: An (S upplement), 2003] indicates that quality itors, and other financial statement users often overlook it. Earnings quality refers to the ability of reported earnings to reflect the company's true earnings, as well as the usefulness of reported earnings to predict future earnings. Earnings quality also refers to the stability, persistence, and lack of vwiability in reported eamings. The evaluation of earnings is often difficult, because companies highli ght a variety of eamings figures: revenues, operating earn­ ings, net income, and pro forma earnings. In addition, companies often calculate these figures differently. The income state­ ment alone is not useful in predicting futu re earnings. The SEC and the investing public are demanding greater assurance about the quality of earnings. Analysts need a more suitable basis for earnings estimates. Credit rating agencies are under increased sc ruti­ ny of their ratings by the SEC. Such comfort level and informati on are not provided in the audit report or the finan­ Introduction to the Issues in Accounting of earnings is based on the quality of for­ cial statements. Only 27% of finance exec­ Education," Issues in Accounting ward earnings as well as current reported utives recently surveyed by CFO "feel Education, 17 (4), 2002] states that earnings. Schipper and Vincent ["Earnings 'very confident' about the quality and com­ "some consider quality of earnings to Quality," Accounting Horizons 17 pleteness of information available about encompass the underlying economic per­ (Supplement), 2003] define earnings public companies" ["It's Better (and formance of a firm , as well as the account­ quality as "the extent to which reported Worse) Than You Think," by D. Durfee ing standards that report on that underly­ earnings faithfully represent Hicksian May 3, 2004]. ing phenomenon; others consider quality income," which includes "the change in net There are a variety of definitions and of earnings to refer o nl y to how well economic assets other than from transac­ models for assessing earnings quality. accounting earnings convey infonnation tions with owners." The authors have proposed a uniform, inde­ about the underlying phenomenon." Pratt Using various definitions of earnings pendent definition of quality of earnings defines earnings quality as "the extent to quality, researchers and analysts have devel­ that allows for the development of an which net income reported on the income oped several models. The Sidebar sum­ Earnings Quality Assessment (EQA) statement differs from true earnings" [in F. mw·izes eight models for measuring earn­ model. The proposed EQA model evalu­ Hodge, "Investors' Perceptions of EWllings ings quality. The models are used for very ates the degree to which a company 's Quality, Auditor Independence, and the naITOW, specific purposes. While the crite­ income statement repot1S its true eWllings Usefulness of Audited Financial ria used in these definitions and models 32 NOVEMBER 2005/ THE CPA JOURNAL Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. CFRA ERP FER L-T ML RJ s&P UBS Criteria Pension fund expenses x x (Continues on page 34) NOVEMBER 2005/ THE CPA JOURNAL 33 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. overlap, none provide a comprehensive Framework is to assist investors in mak­ revenue and expense items, as well as one­ view of earnings quality. For example, the ing investment decisions, which includes time items, accounting changes, acquisi­ primary purpose of the Center for Financial predicting future earnings. The Conceptual tions, and discontinued operations. The Research and Analysis (CRFA), s model is Framework refers not only to the reliabil­ model also assesses the stability, or lack to uncover methods of earnings man ipula­ ity (or truthfulness) of financial statements, thereof, of a company, which leads to a tion. Of the eight models discussed, on ly but also to the relevance and predictive more complete understanding of its future the Lev-Thiagarajan and Empirical ability of information presented in finan­ earnings potential. Research Partners models have been empir­ cial statements. The authors' detinition of The criteria were drawn from the eight ically tested for evidence of usefulness relat­ quality of earnings draws from Pratt's models discussed, including the 10 criteria ed to quality of earnings. Lev a nd and Penman' s definitions. The authors overlapping two or more models. The EQA Thiagarajan's findings confirm that their define earnings quality as the ability of evaluator assigns a point value ranging hom fundamental (earnings) quality score corre­ reported earnings to reflect the company's I to 5 for each of the 20 criteria, with a pos­ lates to earnings persistence and growth, true earnings and to help predict future sible total of 100 points. A score of 1 indi­ and that subsequent growth is higher in high earnings. They consider earnings stability, cates a negative effect on earnings quality, quality-scoring groups. Empirical Research persistence, and lack of vari ability to be and a score of 5 indicates a very positive Partners' model is ba~ed in part on method­ key. As Beaver indicates: "current earnings effect on earnings quality. EQA scores, then, ology developed and tested by Piotroski, are useful for predicting future earnings ... can range from 20 to 100. Similar to the whose findings indicate a positive rela­ [and] future earnings are an indicator of grading methods for bond ratings, grades tionship between scores ba~ed on the model future dividend-payi ng ability" (in M. are a<;signed based on the following scale: and future profitability. Bauman, " A Review of Fundamental 85-100 points = A, 69-84 points = AB, Exhihit 1 summarizes the criteria consid­ Analysis Research in Accounting," Journal 53-68 points = B, 35- 51 points = BC, and ered in each of the eight models for mea­ (~f Accounting Literature 15 , 1996). 20--34 points = C. While the EQA evalua­ suring earnings quality. Of the 51 crite­ tor needs to use professional judgment in riaJmeasurement~ used in the eight models, Earnings Quality Assessment (EGA) assigning scores to each of the criteria, the only eight (acquisitions; cash flow from oper­ The authors propose an Earnings Quality guidelines in Exhibit 2 are recommended. ations/net income; employee stock options; Assessment (EQA) that provides an inde­ operating earnings; pension fund expenses; pendent measure of the quality of a com­ Auditors Should Perform the Earnings R&D spending; share buyback/issuance; and pany's reported earnings. The EQA con­ Quality Assessment tax-rate percentage) are common to two sists of a model that uses 20 criteria that Responsibility for completion of the models, and only two (gross margin and one­ impact earnings quality (see Exhihit 2), EQA could fall to a variety of groups, time items) overlap in three models. applied as a "rolling evaluation" of all peri­ including financial analysts, corporate man­ The first step, then, is to develop a ods presented in the financial statements. agement, and auditors. Although Penman standard definition of earnings quality. One The EQA is more comprehensive than calls for a management-prepared quality­ of the objectives of FASB's Conceptual the eight models presented, considering of-earnings statement, the authors would EXHIBIT 1 (continued from page 33) Criteria in Models for Measuring Earnings Quality CFRA ERP FER l-T Ml RJ s&P UBS Tax benefits of a declining tax rate X Employee stock options ' X X Gains/losses from asset sales X Ongoing restructuring charges X Pension gains X Purchased R&D expenses X I Reversal of prior-year charges and provisions X Unrealized hedging gains/losses X Other post-employment liabilities X Pension asset assumed returns X CFRA: Center for Financial Research and Analysis; ERP: Empirical Research Partners; FER: Ford Equity Research; L-T: Lev-Thiagarajan; ML Merrill Lynch (David Hawkins); RJ: Raymond James & Associates (Michael Krensavage); S&P: S&P Core Earnings; UBS: UBS (David Bianco) * One-time items include goodwill impairment charges, litigation or insurance settlements, and write-downs of intangibles and tangibles. 34 NOVEMBER 2005/ THE CPA JOURNAL Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. not go that far. Management should be EXHIBIT 2 responsible for making an assertion about Criteria in Earnings Quality Assessment (EGA) the company's quality of earnings, similar to the financial statement assertions cur­ rently required. Given management's inher­ Criteria Score ent bias.
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