Assessing the Quality of Earnings: A Survey of Financial Statement Users's Perceptions towards the Reporting Importance of Selected Categories of Information

By Azad, Ali N. | Journal of International Business Research, July 2004 | Go to article overview

Assessing the Quality of Earnings: A Survey of Financial Statement Users's Perceptions towards the Reporting Importance of Selected Categories of Information


Azad, Ali N., Journal of International Business Research


ABSTRACT

The earnings of an enterprise provide indications of both future cash flows and future earnings. To the extent the current rules of accounting measurement contaminates the quality of earnings, it would hinder such indications. The objective of this research is twofold: to investigate the reporting importance of selected categories of information vis-a-vis assessment of the quality of earnings; and, to compare the perceptions of different user groups concerning the said reporting importance. To achieve the research objectives, two hypotheses were formulated and a mailed survey was used to collect the data. Appropriate statistical methods were used to test the research hypotheses. The findings, with one exception, did not reveal any significant differences among the perceived reporting importance of different categories of information. The findings, however, did demonstrate the existence of significant differences among the perceptions of various user groups concerning the reporting importance of the information. The results of this study may assist standard setters to promulgate "localized" financial reporting standards. Such environmentally specific standards would enhance financial statements users' ability to assess both future cash flows and future earnings.

INTRODUCTION

Financial statements user groups have a variety of specific information needs and only "specific purpose" financial statements may have the ability to address those needs. For a host of reasons, it is accepted on a priori, that satisfying specific information needs of different users through public financial reporting is both impractical and infeasible. Therefore, out of mere necessity if not for any other reason, the bodies responsible for establishing financial reporting standards throughout the world, have opted for the current framework of "general purpose" external financial reporting.

One of the objectives of public financial reporting, according to the Statements of Financial Accounting Concepts (SFAC) No. 1, is to provide information about the economic performance and earnings (income) of an enterprise. The other objective is to provide information useful in assessing future cash flows. To achieve these objectives, the reported earning should enjoy the necessary quality that would allow the prediction of future cash flows as well as prediction of future performance and earnings (Delaney et. al., 1997).

Measurement of income, as defined by accountants, is based on the current rules of revenue recognition and expense realization. As there are some theoretical as well as practical problems with the current rules, the quality of reported earnings resulting from their application is compromised. Income measured under the existing rules does not have the ability to capture the "true" economic substance of the transactions and cannot realize fully SFAC's stated objectives of financial reporting. Examples of the problems that are entrenched in the process of earnings' measurement include the syntactic nature of the earnings definition, the arbitrary nature of estimates involved in the earnings measurement, and the "finite uniformity" in application of accounting methods (Wolk & Tearney, 1997). These problems allow for the "management of earnings" (earnings management) via manipulation of accruals, deferrals, and discretionary items (Easton, 1985; Lipe, 1986; O'Glove, 1987; Hayes, 1995; Haim, 1998).

Earnings management that is made possible by the above-mentioned problems diminishes the "quality of earnings" reported by the firms. The concept of "quality of earnings" refers to the ability of earnings (current or past) to reflects the operational performance of an entity and correspond to the concept of "real income." In another word, the "quality of earnings" is defined as the information content of income components and other related information which would allow for an "exact" prediction of future earnings. …

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