RCMA 4: QUALITY OF EARNINGS

Quality of Earnings

Key Definitions

Earnings Quality - refers to the reliability, sustainability, and transparency of a company's reported earnings. It indicates the degree to which reported earnings accurately reflect the underlying economic performance of the business and can be trusted by investors and other stakeholders in making decisions.

Company executives can influence reported income by decisions regarding the assumptions and accounting principles applied. Opting for one assumption or principle over another can alter the reported income figures, making it a matter of significance for investors. Investors place considerable importance on the reliability of reported earnings, preferring high-quality earnings as they are perceived to offer comprehensive and transparent information.

Chosen Accounting Method

Management can be aggressive or conservation in choosing their accounting principles.
A conservative management approach is to choose the principles and methods that will not overstate earnings.
An aggressive accounting method is frowned upon. Excessive conservatism can also negatively impacts earnings quality.
Transparency and clarity of information results to higher quality of information therefore notes to financial statements should contain disclosures regarding accounting principles and methods used by management.

Asset Maintenance and Future Economic Earnings Power

Management has the authority to determine the expenditure allocated to specific expense categories. Management may choose to forgo certain expense to improve the bottom-line at the expense of not keeping certain parts of the business at its optimal state. Among the most prevalent is the allocation for repairs and maintenance of equipment and buildings. Temporarily reducing such spending can boost reported income in the short-term. However. Sustaining this reduction over an extended period poses risks, such as potential equipment breakdowns and building deterioration. In such instances, the expenses incurred for repairs may escalate, potentially leading to disruption in daily business operations and, consequently, a decline in sales. Therefore, a balance must be struck between immediate spending and potential future expenses.

Impact of Economic Forces

Businesses are not immune to cyclical and economic forces and these usually have certain effects on earnings. In order to minimize the adverse effect of these forces, managements could engage in activity to mitigate the impact to the company.

Earnings Stability

Earnings persistence refers to the notion that present earnings serve as a reliable indicator of future earnings. Analysts seek consistent earnings patterns across consecutive years as an indication of effective management within a company. When earnings demonstrate stability over time, they become a reliable predictor of future earnings trends. Conversely, earnings that fluctuate significantly from year-to-year present challenges in accurately forecasting future earnings.

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Practice Questions

Part 1: Theories (5)

1. Which of the following companies would an analysts conclude has relatively low earnings quality?

A. A and C

B. A, B, and C

C. C only

D. A and B

2. A manufacturing company operates in an environment of significant inflationary pressures. Which one of the following inventory methods should the company choose to produce financial statements considered to be of the highest earnings quality?

A. Specific Identification

B. First-in, first-out

C. Last-in, first-out

D. Average cost

3. Which (if any) of the following actions can an analysts take to assess the quality of a company’s earnings?

A. A, B, and C

B. C only

C. A and B

D. A and C

4. Which of the following has lower quality of earnings?

A. A and C

B. B only

C. B and C

D. A, B, and C

5. What is meant by “earnings quality”?

A. A measure of how closely expense accruals correspond to actual expenses without management bias.

B. A measure to determine management bias by comparing reported income to actual cash flows.

C. A measure to determine management bias by comparing actual reported profits with “true” earnings.

D. A measure of how closely earnings correspond to earnings reported without management bias.

Part 2: Problem Solving (5)

1. In Year 3, BINI Fam and BLOOM Fam Taps both closed down their kitchen fixtures divisions and sold the divisions' assets. Financial information for each firm is provided here.

If the income tax rate is 30%, then BINI’s yearly income from continuing operations was:

A. $1,722,450

B. $1,554,150

C. $1,205,715

D. $1,585,590

2. In Year 32, Yanny Enterprises and Lovely Industries both closed down their computer divisions and sold the divisions' assets. Financial information for each firm is provided here.

If the income tax rate is 25% on all items, then Yanny’s net income for the year is:

A. $680,700

B. $456,900

C. $223,800

D. $298,400

3. Taylor Corporation has income before taxes of $598,500 and a loss on discontinued operations before income taxes of $204,000. Taengoo Industries has income before taxes of $611,600 and a loss on discontinued operations before taxes of $241,800. If both firms' income tax rate is 30% on all items, then which of the following statements is accurate?

A. Karina's loss on discontinued operations (net of taxes) is $37,800 less than Taengoo's.

B. Karina's loss on discontinued operations (net of taxes) is $11,340 less than Taengoo's.

C. Karina's loss on discontinued operations (net of taxes) is $26,460 less than Taengoo's.

D. Karina's loss on discontinued operations (net of taxes) is $24,700 greater thanTaengoos.

4. Ramz Industries has income before taxes of $884,600 and a loss on discontinued operations of $261,720. Wendy Manufacturing has income before taxes of $799,500 and a loss on discontinued operations of $142,400. If both firms' income tax rate is 30% on all items, then Irene's income from continuing operations is________ than Wendy’s.

A. $34,220 less

B. $59,570 greater

C. $23,954 less

D. $83,524 greater

5. Marie Industries has income before taxes of $880,000 and a loss on discontinued operations of $261,720. Wendy Manufacturing has income before taxes of $798,500 and a loss on discontinued operations of $142,400. If both firms' income tax rate is 30% on all items, then Irene's income from continuing operations is________ than Wendy’s.

A. $65,740 less

B. $85,870 greater

C. $14,398 less

D. $57,050 greater

Answer Key

Theories

1. Answer: Letter A. A and C

Explanation: As for letter A, Reducing spending on R&D can signal a short-term focus over long-term innovation and growth. R&D is crucial for pharmaceutical companies to develop new drugs, improve existing ones, and stay competitive in the market. Also, with letter C when reducing spending on equipment maintenance may result in short-term cost savings but could lead to several long-term issues. Insufficient maintenance can increase the risk of equipment breakdowns, production delays, quality issues, and safety hazards.

In both cases (Option A and Option C), the increase in net income is achieved through short-term cost-cutting measures that compromise the companies' long-term growth prospects and operational effectiveness. As a result, analysts would likely conclude that these companies have relatively low earnings quality.

2. Answer: Letter C. Last-in, first-out

Explanation: LIFO assumes that the most recently acquired inventory is sold first. In a period of inflation, this method matches the higher current costs of inventory with revenue, resulting in a higher cost of goods sold (COGS) and lower taxable income compared to other inventory valuation methods like First-in, first-out (FIFO) or Average cost.

3. Answer: Letter D. A and C

Explanation: As for letter A, analyzing the consistency of earnings over a period of time, such as 5 years, is a fundamental method for assessing earnings quality. Consistency in earnings indicates stability and reliability in the company's performance. As for letter C, footnotes in financial statements provide valuable information about the accounting policies, estimates, and assumptions utilized by the company. Analyzing these footnotes allows analysts to gain insights into the quality and reliability of the reported earnings.

In summary, assessing the consistency of earnings over time (option A) and analyzing footnotes to understand the estimates used in financial reporting (option C) are both essential techniques for evaluating the quality of a company's earnings. These actions provide valuable insights into the stability, reliability, and transparency of reported earnings, allowing analysts to make more informed investment decisions.

4. Answer: Letter C. B and C

Explanation: As for letter B, A company that increases its net income by reducing spending on advertising: Reducing spending on advertising may lead to short-term increases in net income by lowering expenses. As for letter C, A company that increases its net income by reducing spending on equipment maintenance: Reducing spending on equipment maintenance may temporarily boost net income by lowering expenses.

In summary, both options B and C suggest potential short-term tactics that may compromise the long-term sustainability and quality of earnings. Option B reflects a reduction in vital marketing efforts that could impact future revenue streams, while option C indicates a neglect of essential operational maintenance that could lead to efficiency losses and potential risks to the business.

5. Answer: Letter D. A measure of how closely earnings correspond to earnings reported without management bias.

Explanation: Earnings quality refers to the accuracy, transparency, and reliability of a company's reported earnings. Option D captures this essence by highlighting the importance of earnings that are reported without management bias or manipulation. High-quality earnings accurately reflect the economic reality of a company's performance, without being distorted by managerial discretion or accounting irregularities.

Problem-Solving

1. Answer: Letter B. $1,554,150

Explanation: BINI’s yearly income from continuing operations was $1,554,150. This answer is derived from the formula:

Income from continuing xxx

Add/Less: Loss/Gain from disposal xxx

Add/Less: Loss/Gain from division on operations xxx

Net income $xxx

From that formula, we add first the Disposal of BINI amounting to $310,800 and the Division on operation amounting to $250,200 (310,800 + 250,200 = 561,000). Then, we multiply it by the tax rate of 70% ($561,000 x 70% = 392,700). We then add the Gain from operations of BINI amounting to $1,161,450 and 392,700 and that will result in $1,554,150.

2. Answer: Letter C. $223,800

Explanation: Yanny’s net income for the year is $223,800. This answer is derived from the formula:

Income from continuing xxx

Add/Less: Loss/Gain from disposal xxx

Add/Less: Loss/Gain from division on operations xxx

Net income $xxx

From that formula, we deduct the amounts of Yanny’s disposal of $414,000 and operations of $195,200 to her yearly income of $907,600 ($907,600 - 414,000 - 195,200 = 298,400). We then multiply it by the tax rate of 75%, which is 298,400 x 75%, and will result in a net income of $223,800.

3. Answer: Letter C. Taylor's loss on discontinued operations (net of taxes) is $26,460 less than Taengoo's.

Explanation: Taylor’s loss on discontinued operations (net of tax) is $26,460 less than Taengoo’s. This answer is derived from the formula:

Income from continuing xxx

Add/Less: Loss/Gain from disposal xxx

Add/Less: Loss/Gain from division on operations xxx

Net income $xxx

From that formula, we deduct the discontinued operations amounting to $241,800 from discontinued operations before income taxes of $204,000, and that will result to $37,800. Then, we will multiply is by the tax rate of 70%, which is 37,800 x 70%, and will result in a loss of discontinued operations of $26,460 which is less than Taengoo’s.

4. Answer: Letter B. $59,570 greater

Explanation: Ramz’s income from continuing operations is $59,570 greater. This answer is derived from the formula:

Income from continuing xxx

Add/Less: Loss/Gain from disposal xxx

Add/Less: Loss/Gain from division on operations xxx

Net income $xxx

From that formula, the income before taxes $884,600 is deducted from the income before taxes of $799,500 which results to $85,100. Then, we multiply it by the tax rate of 70% and that is 85,100 x 70% and will result in $59,570 greater.

5. Answer: Letter D. $57,050 greater

Explanation: Marie’s income from continuing operations is $59,570 greater. This answer is derived from the formula:

Income from continuing xxx

Add/Less: Loss/Gain from disposal xxx

Add/Less: Loss/Gain from division on operations xxx

Net income $xxx

From that formula, the income before taxes $880,000 is deducted from the income before taxes of $798,500 which result to $85,500. Then, we multiply it by the tax rate of 70% and that is 85,100 x 70% and will result in $57,050 greater.

References

Wiley. (2023). Wiley CMA Exam Review 2023 Study Guide Part 2: Strategic Financial Management Set (1-year access). Wiley.