Academic journal article Academy of Accounting and Financial Studies Journal

A Model for Determination of the Quality of Earnings

Academic journal article Academy of Accounting and Financial Studies Journal

A Model for Determination of the Quality of Earnings

Article excerpt

ABSTRACT

This article is grounded on the premise that corporate earnings drive corporate value which subsequently drives stock prices. For example, if a corporation generates better than expected earnings, then corporate value increases and is followed by related stock price increases. Historically, literature suggests that good equity investments are those of companies that show better than average earnings. This close correlation of earnings and stock price movement often exerts an unrealistic demand on top company officials to maintain better than expected earnings figures. Such expectations led to the 'earnings management' phenomenon the United States began experiencing in 2001 that later reached epidemic portions during 2002. This state of affairs prompted a call for the accounting and finance community to do something to detect earnings management practices early so that investors did not continue to lose their life savings when investing in capital markets.

The authors propose a model identified as the Q Test that provides a mathematical approach to quality earnings determination. The model is designed along the same lines as Altman's Z Score, which is a widely acclaimed model used to assess companies in various stages of financial distress. The model is tested using financial statements of publicly held companies in which the Q Test is compared to stock price movements of selected companies. Results of the study indicate that the Q Test is a reliable measure of quality of earnings reported by publicly held companies.

INTRODUCTION

The marketing profession uses a measurement known as the Q Score in a way to measure the familiarity and appeal of a brand, company, or television show. There is evidence that the Q Score is more valuable to marketers than other popularity measurements such as the Nielsen Ratings because Q Scores indicate not only how many people are aware of or watch a product, but also how those people feel about the product. The music industry uses the Q factor to measure the "quality" of a resonant system. Resonant systems respond to frequencies close to the natural frequency much more strongly than they respond to other frequencies. The authors assert that there is a need for a measure in accounting that can be used to accurately assess the quality of earnings reported by public companies on financial statements. A mathematical model we identify as the Q Test is proposed in this article.

EARNINGS MANAGEMENT

Earnings management usually consists of one or a combination of the following: 1) over-statement of revenue, (2) understatement of expenses, and (3) misrepresentation of accruals. Such earnings management practices typically cause long-term disastrous results. Often affected companies' stock prices deteriorate to practically nothing in short periods of time (for example, Enron, WorldCom, and Lucent). The earnings management fiasco led to a call for the accounting and finance community to do something to detect the earnings management process early, thereby protecting investors from losing life savings when investing in capital markets. Many accounting and finance journals have included articles that identified ways of distinguishing quality earnings from managed earnings (Brown, 1999, Branner; 2001, Morgenson; 1999; and Krantz, 2002).

THE DETERMINANTS OF QUALITY EARNINGS

"High quality" EPS (Wayman, 2003) means that the number is a relatively true representation of what the company actually earned (i.e. cash generated). Amernic and Robb (2003) observed that quality earnings converge with reported profits of publicly held companies. It has been suggested (Kamp, 2002) that three elements encompass aspects of quality earnings; clear indication of ongoing costs and revenues, clear indication of performance of the company's core business, and a direct correlation of cash flow with earnings.

McClure (2004) purports the three characteristics of 'quality earnings' as those earnings that are repeatable, are controllable, and are efficient cash generators. …

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