Accounting: The Language of Business - Vol. 2 (Intermediate: Part 45)

The religious hypothesis, therefore, must be considered only as a particular method of accounting for the visible phenomena of the universe: but no just reasoner will ever presume to infer from it any single fact, and alter or add to the phenomena, in any single particular.

David Hume

Statements of Net Income and Comprehensive Income (Part C)

by

Charles Lamson

Earnings Quality

All the information included in the financial statements is important and useful for assessing a firm's financial position and performance---yet earnings is the single most important measure for financial statement users. Thus, preparers, auditors, regulators, and academics devote a considerable amount of time to focusing on earnings quality. Earnings quality captures the degree to which reported income provides financial statement users with useful information for producing future firm performance.

We focus our discussion on two factors impacting earnings quality:

1. Earnings quality is dependent upon whether the components of earnings presented are permanent or transitory in nature.

2. Management will sometimes engage in earnings management by using the discretion afforded under the accounting standards to manipulate earnings to meet desired goals.

Permanent and Transitory Earnings

In assessing earnings quality, financial statement users gauge the portion of reported earnings that is permanent versus those that are transitory. Permanent components of earnings are likely to continue into the future. For example, earnings from sales revenue from regular customers are likely to continue into the future. Transitory components of earnings are unlikely to continue in the future. For example, gains or losses from the sale of equipment are usually transitory. Permanent earnings result in higher earnings quality whereas transitory earnings result in lower earnings quality.

The order of the income elements on the statement of net income guides financial statement users in distinguishing the permanent and transitory elements. Elements presented earlier in the statement of comprehensive income are typically more permanent than those included later in the statement. Exhibit 5.1 lists income statement line items commonly viewed as permanent and transitory.

EXHIBIT 5.1 Common Permanent and Transitory Items

Elements in OCI are often transitory in nature, such as unrealized gains and losses on investments that are held by the entity. Also, income that is included in special sections of the statement of net income such as income from discontinued items is typically transitory. Generally, they occur in one year and then do not reoccur in the foreseeable future.

Most elements presented in operating income are permanent in nature. For example, the salary expense related to an entity's salesforce is likely to occur in every period for the foreseeable future. However, not all elements included in operating income are considered permanent. For example, discretionary expenses such as R&D expenses and training expenses are generally more transitory.

Given the issues and concerns with the usefulness of the income statement and earning quality, a future post will introduce financial statement analysis as a technique for understanding and interpreting a company's performance. The post after that will extend the discussion of financial statement analysis to profitability analysis.

JUDGMENTS IN ACCOUNTING: 

Earnings Management

In addition to assessing the nature of the reported earnings, financial statement users should be aware of the possibility of earnings management, which lowers a firm's earnings quality.

Accounting standards allow managers to make judgments that affect the reported earnings so that they can report the firm's financial position and performance in the most accurate and informative manner possible. A company's management understands the company's financial position and performance best. Thus, managers who are honest and have a desire to communicate accurate information to their stakeholders can do so.

However, some managers may use the areas of judgment inherent in financial reporting to manage earnings in an opportunistic and sometimes fraudulent fashion. For example, managers must determine which expenditures for equipment are material enough to record as an asset as opposed to an expense. They will likely expense a stapler but record a tractor as an asset. there is a gray area in this type of decision that provides an opportunity for earnings management. For example, should we expense a chair or record it as an asset? Of course, recording an asset for a material expenditure that the authoritative literature clearly designates as an expense constitutes fraud. Extreme forms of earnings management are fraudulent and thus illegal. 

*GORDON, RAEDY, SANNELLA, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 174-175*

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