suggest current earnings quality should be defined for shareholders who rely on financial reports to buy future earnings. [2] All definitions seem to extend the idea that higher quality earnings are those that enable higher quality decisions about the future prospects for an entity. [3] Market based definitions of earnings quality relate higher quality to the ability of a firm to generate cash [4] or to be useful in predicting the future, as summarized in the following quote published in the CPA Journal in 2005:
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 variability in reported earnings. [5]
High-quality earnings can be characterized as ‘repeatable, controllable and bankable.’ [6] In general, ‘taken as a whole, the quality of earnings can generally be summarized as the degree to which earnings are cash or non-cash, recurring or nonrecurring, and based on precise measurement or estimates that are subject to change.’ [7] Alternately, diminished earnings quality has been described as, ‘the extent to which net income reported on the income statement differs from true earnings.’ [8]
Note that some definitions seemingly conflict with others. Predictable earnings may be useful in predicting future earnings streams, but may not reflect the underlying volatility of an entity’s transactions. For example, entities with seasonal earnings patterns may be more difficult to predict, but the quality of earnings may be quite high. Persistent or recurring earnings as a determinant of earnings quality seems to be straightforward, but upon deeper examination, persistence implies the potential for smoothing, which is in conflict with the idea of having current earnings reflect an entity’s true earnings.
Under US GAAP, the underlying objective of financial reporting is to provide information that is useful to decision makers, primarily investors, in predicting the future earnings and cash flows of an entity. For financial statements to be useful to decision makers they must be transparent and of high quality – in other words, they must be representationally faithful. [9] Higher quality financial reports exhibit a high degree of correspondence between what they measure and what they purport to measure. [10] The AICPA notes that true earnings quality underlies the relation between the economic substance of a transaction, and our ability to reflect the transaction using accounting rules that require substantive judgment in a world of increasingly complex rules and transactions. [11] Transparency represents the next layer of the financial reporting model. Transparent financial reports are clear, accurate reports that reflect the economic substance of transactions in a straightforward manner, even in times of great uncertainty.
1 Scott Richardson, “Earnings Quality and Short Sellers”, Accounting Horizons 17, Supplement (2003), pp. 49-61. [return to text]
2 Stephen H. Penman, “The Quality of Financial Statements: Perspectives from the Recent Stock Market Bubble”, Accounting Horizons 17, Supplement (2003), pp. 77-96. [return to text]
3 Katherine Schipper and Linda Vincent, “Earnings Quality”, Accounting Horizons 17, Supplement (2003), pp. 97-110. [return to text]
4 www.ratefinancials.com [return to text]
5 Jodi L. Bellovary, Don E. Giacomino, and Michael D. Akers, “Earnings Quality: It’s Time to Measure and Report”, www.nysscpa.org/cpajournal/2005/1105/essentials/p32.htm. [return to text]
6 www.investopedia.com/articles/02/103002.asp [return to text]
7 Deloitte & Touche, Quality of Earnings, 2002. [return to text]
8 Frank Hodge, “Investors’ Perceptions of Earnings Quality, Auditor Independence, and the Usefulness of Audited Financial Information”, Accounting Horizons 17, Supplement (2003), pp. 37-48. [return to text]
9 See Schipper and Vincent, “Earnings Quality”, Supplement, Accounting Horizons (2003), pp. 97-110 for a discussion of Earnings Quality. [return to text]
10 CON 2, ¶ 63. [return to text]
11 http://fmcenter.aicpa.org/Resources/Traditional/Quality+of+Earnings+Case+Study+Collection.htm [return to text]
2. Transparency of the Balance Sheet: Fair Valuation
A. Fair valuation under alternative market assumptions
Much of the current controversy regarding full adoption of IFRS for US GAAP entities rests on the relation between fair valuation and financial reporting transparency. International Accounting Standard No. 18 (IAS 18) defines fair value as, ‘the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction.’ [12] FASB’s Codification [13] Master Glossary provides two similar definitions, stating that fair value represents, ‘the amount at which an asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale,’ and ‘the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.’ The first FASB definition was introduced as part of CON 7 and the second was provided in FAS 157. Note that these definitions imply active participants with available market prices.
But how are assets and liabilities valued if market prices are not available? FAS 107 identifies alternatives:
Quoted market prices, if available, are the best evidence of the fair value of financial instruments. If quoted market prices are not available, management’s best estimate of fair value may be based on the quoted market price of a financial instrument with similar characteristics or on valuation techniques (for example, the present value of estimated future cash flows using a discount rate commensurate with the risks involved, option pricing models or matrix pricing models).
FAS 157 identifies three valuation techniques that are to be consistently applied in estimating fair value:
1 The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities;
2 The income approach uses valuation techniques (including present value techniques, option-pricing models such as the Black-Scholes-Merton formula, and the multi-period excess earnings method which reflects a discounted cash flow method used to estimate the fair value of certain intangible assets) to convert future amounts, for example, cash flows or earnings, to a single present discounted amount;
3 The cost approach which is based on the amount that currently would be required to replace the service capacity of an asset (often referred to as current replacement cost).
B. Hierarchy of inputs
In addition, FAS 157 establishes a revised hierarchy of inputs to be used in determining fair value estimates. Comparable to FAS 107, the hierarchy gives the highest priority to observable market inputs and the lowest priority to unobservable market inputs as follows:
• Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date;
• Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly;
• Level 3 inputs are unobservable inputs for the asset or liability, (e.g. inputs derived through extrapolation or interpolation that cannot be corroborated by observable market data).
Level 1 inputs transparently reflect fair value. Fair valuation of either financial or non-financial assets based on recent sales for identical assets in functioning markets conveys the underlying true value of the assets and reflects the substance of fair valuation as promulgated by IFRS. The same can be said for non-financial or financial liabilities using Level 1 inputs: such comparisons