Quality of Earning
Overview of Quality of Earnings - Some Guiding Principles/Framework
The issue of earnings quality arises because of the cost/benefit trade off between cash accounting and accrual accounting.
For our purposes, we want reported earnings to do two things:
1) to accurately represent current operating performance
2) to aid in accurately forecasting future operating performance
These requirements for high-quality earnings mean that the reported earnings amounts for a particular period should:
Represent the underlying economics of the business
Be both persistent and predictable (the metric should be stable over time)
Methods for Measuring Earnings Quality
To measure earnings that meets the criteria for high quality, we need a metric that honors the fundamental qualities of GAAP. These features are reliability and relevance.
Reliability - The metric is verifiable, free from error or bias and accurately represents the transaction.
Relevance - The metric is timely and has predictive power; it can confirm or reject prior predictions and has value when making new predictions.
There are two basic ways to present a company's operating performance and measure earnings during a given period - cash accounting and accrual accounting. Each has tradeoffs in terms of relevance and reliability. Cash Accounting: Cash accounting involves recording transactions whenever cash enters or leaves the firm. This accounting method records transactions that have been completed and the amounts involved are certain.
Does this make the financial statements relevant or reliable, stable etc.?
Accrual Accounting: Accrual accounting introduces the idea of periodicity. Periodicity states that each transaction should be assigned to a given period and split accordingly if it covers several periods. This is an attempt to recognize revenues in the period in which they were actually earned (revenue recognition principle) as well as to match
The issue of earnings quality arises because of the cost/benefit trade off between cash accounting and accrual accounting.
For our purposes, we want reported earnings to do two things:
1) to accurately represent current operating performance
2) to aid in accurately forecasting future operating performance
These requirements for high-quality earnings mean that the reported earnings amounts for a particular period should:
Represent the underlying economics of the business
Be both persistent and predictable (the metric should be stable over time)
Methods for Measuring Earnings Quality
To measure earnings that meets the criteria for high quality, we need a metric that honors the fundamental qualities of GAAP. These features are reliability and relevance.
Reliability - The metric is verifiable, free from error or bias and accurately represents the transaction.
Relevance - The metric is timely and has predictive power; it can confirm or reject prior predictions and has value when making new predictions.
There are two basic ways to present a company's operating performance and measure earnings during a given period - cash accounting and accrual accounting. Each has tradeoffs in terms of relevance and reliability. Cash Accounting: Cash accounting involves recording transactions whenever cash enters or leaves the firm. This accounting method records transactions that have been completed and the amounts involved are certain.
Does this make the financial statements relevant or reliable, stable etc.?
Accrual Accounting: Accrual accounting introduces the idea of periodicity. Periodicity states that each transaction should be assigned to a given period and split accordingly if it covers several periods. This is an attempt to recognize revenues in the period in which they were actually earned (revenue recognition principle) as well as to match