Question

Discuss the following topics on the quality of accounting earnings:

Define the quality of earnings information

How to measure the quality of earnings information

How to consider the earnings of information quality for investment decisions.

Answer 1

Step 1 : Definition of Quality of Earnings Information

The quality of earnings refers to the amount of earnings attributable to higher sale or lower costs rather than artificial profits created by accounting anomalies such as inflation of inventory. Quality of earnings is considered poor during times of high inflation. Also, earnings that are calculated conservatively are considered to have higher quality than those calculated by aggressive accounting policies.

Step 2 : Measurement of Quality of Earnings Information

Quality of earnings ratio can be calculated by dividing net cash from operating activities by net income for the same period. Net cash from operating activities is a line on balance sheet that shows available cash after adjusting for variables that don't appear on income statement or profit or loss statement. These adjustments include working capital, such as bank loans, that are not part of profit and loss statement, and depreciation allowances that appear on  profit and loss statement but does not represent expenses that actually paid for during the year.

A quality of earnings ratio of significantly less than 1 indicates that net cash from operating activities is significantly less than the net income reported for the same period. This situation suggest that a substantial amount of reported net income may have come from accounting adjustments rather than actual sale of goods or services.

Step 3 : Considering the earnings of information quality for investment decisions

High quality information is important in making good judgements and decisions. It is important for many participants in the financial reporting process such as investors, regulators, auditors, lenders etc. While making investment decision, earnings of information quality helps in determining where and how much to invest and what is the investment risk etc. Hence for making an investment decision, the earnings of information quality is considered.