Financial Accounting: Quality of Earnings

The terms “quality of earnings” is used by accountants to describe how well a reported earnings number communicates a firm’s true performance. It is further distinguished using high-quality earnings and low-quality earnings. Management in any firm can influence earnings causing the earnings to either, increase or decrease. Among most firms there can be several income manipulators; three of the most common ways are big bath charge, a cookie jar reserve, and revenue recognition. We will show where you can identify such manipulations when analyzing a company’s financial statements.

Indicators of Earnings: High and Low

High

• Persistence in Earnings
• A Strong and consistent relationship between the income and operating cash flow
• Reasonable, conservative, and consistent use of accounting methods and estimates
• Fewer internal and external risks, similar to the health care industry.

Low

• Unexplainable, steep fluctuations in net income
• Frequent changes in accounting principles – FIFO to LIFO, amortization tables for fixed assets, and so on.
• Use of aggressive accounting methods instead of conservative accounting methods.

Big Bath Charge – this type of method is used when a company is not performing. It reduces the quality of earnings, and management will swap future expenses in the non-performing year with the current profits to the future term. This type of method violates the matching principle of GAAP. To notice if this method is being used it can be seen over several years, not just in one single year. Unusual expenses and write-offs in the previous years, read the management reports and analysis on the company’s overall performance for those years to determine if such a method is being used.

A Cookie Jar Reserve – this method reminds me of the expression and/or situation “got your hand stuck in the cookie jar” which is similar to this method. This method more describes an account more of which is a liability but is used when recognizing an estimated expense inaccurately. When the accurate amount and/or expenditures actually occur it is charged against the reserve rather than the income. This method is also a violation of the matching principle. To identify this manipulation in a financial report and/or statement we have to read and review the notes and look at the different trends in such reserves, for example, the allowances for bad debt account.

Revenue Recognition – this method is used to record earnings that haven’t been collected as revenue. For example, I walk into a Joe Depot Store and charge a new refrigerator as credit. The company takes the credit as earned and/or collected revenue when it is on a credit account and not received from the creditors yet. To identify such a manipulation when reviewing financial records pay close attention to the policy and analyze the relationship between accounts receivable and sales. If accounts receivable as a percentage of sales rises, a red flag would be raised and an investigation would need to be conducted.