Financial reporting quality is an issue that has been under research for some time. As a result there has been identified several parameters which can be used to indicate the quality of earnings such as smoothness, persistence, accruals, loss avoidance, timeliness and investor responsiveness among others. Although researchers have come to an agreement that these indicators can be used to show the quality of earnings, they have not come to a conclusion on the best method as quality is defined by the context of the required decision and performance objectives. From its definition, earnings quality is described as with the level of quality, i.e. earnings that are of higher quality tells more in regard to the features of the performance of the firm as required for making a specific decision by a specific decision makers.
The ambiguity from the definition of earnings quality makes it plausible to organize the earnings quality into three major categories according to their characteristics. The first category describes the earnings quality in terms of properties of earnings. The second proxy describe it in terms of the responsiveness if the a specific investor to earnings while the third category describes earnings quality in respect to the external indicators of misstatements in earnings (Dechow, Weili and Schrand 344). Earning persistence and accruals as a property of earnings is based on the assumptions that if the earnings are persistent for a considerable length of time, then they are of higher quality than the less persistent ones. For example such persistent earnings can be used in valuation of equity using the direct cash flow method. Extreme accruals on the other hand are assumed to be of low quality since they form part of less persistent component of earnings (Dechow, Weili and Schrand 351). Income smoothing improves the earnings persistence and level of information hence a high quality of earnings. It is also advisable to encourage timely recognition of losses as it represents a high quality of earnings.
Investor responsiveness to earnings is a study that aims at examining the earnings response coefficient (ERC) using the earnings return model. It is based on the theory that investors whose implications are of value (Dechow, Weili and Schrand 367). The investor calculates the level of correlation between the information and value and a higher correlation is a reflection better performance hence a higher quality of earnings. This method of determining the quality of earnings is contextualized to equity valuation decisions and links directly the earnings to decision usefulness.
External indicators of earnings misstatements are another measurement of the quality of earnings. These indicators include accounting and Auditing Enforcement releases (AAERs) by the SEC, restatements and the internal control procedures deficiency as reported under the Sarbanes Oxley Act (SOX) (Dechow, Weili and Schrand 361). These indicators are useful in that they identify misstatements in earnings and their reports can directly indicate the level of quality of earnings. However, restatement which is done by the management team may not be appropriate measure of quality since the management can put misstatements in the books both intentionally and unintentionally. Rationally, the intentional misstatements are made to increase the quality of the earnings where as in the real situation it is otherwise. It is, therefore, important to confirm the nature of restatement through audits and the internal control deficiencies procedure report before concluding on the quality of earnings (Dechow, Weili and Schrand 361). Measurement of earnings quality is, therefore, a dynamic and integrated issue and one may need to use more than one parameter for a valid conclusion.
References
Dechow Patriciah, Weili G, and Schrand C. “Understanding earnings quality: A review of the proxies, their determinants and their consequences.” Journal of Accounting and Economics 50 (2010): 344-401. Print
