Electronic Case - Earnings Quality

Earnings Quality

Financial analysts are concerned with more than just the bottom line of the income statement—net income. The presentation of the components of net income, and the related supplemental disclosures, provide clues to the user of the statement in an assessment of earnings quality.  The term earnings quality refers to the ability of reported earnings (income) to predict a company’s future earnings. After all, an income statement simply reports on events that have already occurred. The relevance of any historical-based financial statement hinges on its predictive value. To enhance predictive value, analysts try to separate a company’s “transitory earnings” effects from its “permanent earnings.” Transitory earnings effects result from transactions or events that are not likely to occur again in the foreseeable future, or that are likely to have a different impact on earnings in the future.  

Three items - extraordinary items, changes in accounting principle, and discontinued operations - because of their transitory nature, are required to be reported separately in the bottom of the income statement.  

Income before these three items is commonly referred to as income from continuing operations. Analysts begin their assessment of permanent earnings with income from continuing operations.

It would be a mistake, though, to assume income from continuing operations reflects permanent earnings entirely. In other words, there may be transitory earnings effects included in income from continuing operations.  In a sense, the phrase “continuing” may be misleading.  

Manipulating Income and Income Smoothing

An often-debated contention is that, within GAAP, managers have the power, to a limited degree, to manipulate reported company income. And the manipulation is not always in the direction of higher income. For instance, Kroger in 2001 announced it was restating profits for three prior years due to intentional and inappropriate earnings management that occurred within a company it had purchased, prior to the acquisition.  SEC chairman Arthur Levitt recently began a crusade against earnings management activities.  One author states that “Most executives prefer to report earnings that follow a smooth, regular, upward path. They hate to report declines, but they also want to avoid increases that vary wildly from year to year; it’s better to have two years of 15% earnings increases than a 30% gain one year and none the next. As a result, some companies ‘bank’ earnings by understating them in particularly good years and use the banked profits to polish results in bad years.”[1]  

Many believe that manipulating income reduces earnings quality because it can mask permanent earnings. A recent Business Week issue was devoted entirely to the topic of earnings management. The issue, entitled “Corporate Earnings: Who Can You Trust,” contains articles that are highly critical of corporate America’s earnings manipulation practices.  Arthur Levitt, Jr., Chairman of the Securities and Exchange Commission, has been outspoken in his criticism of corporate earnings management practices and their effect on earnings quality.  In a recent
"article appearing in the CPA Journal, he states that "While the problem of earnings management is not new, it has swelled in a market that is unforgiving of companies that miss their estimates.  I recently read of one major U.S. company that failed to meet its so-called “numbers” by one penny and lost more than six percent of its stock value in one day"  and that "[i]ncreasingly, I have become concerned that the motivation to meet Wall Street earnings expectations may be overriding common-sense business practices.  Too many corporate managers, auditors, and analysts are participants in a game of nods and winks.  In the zeal to satisfy consensus earnings estimates and project a smooth earnings path, wishful thinking may be winning the day over faithful representation.  As a result, I fear that we are witnessing an erosion in the quality of earnings, and therefore, the quality of financial reporting.  Managing may be giving way to manipulation; integrity may be losing out to illusion."

One practice frequently mentioned as a technique for earnings management is "restructuring." 

• How do managers manipulate (smooth) income?  

• Is earnings management always intended to produce higher income?  Explain.

• SEC Chairman Levitt would like to see various rule changes by standard setters to improve the transparency of financial statements.  Does this involve eliminating flexibility in financial reporting?

• Using a fictitious example and numbers you make up, describe in your own words how restructuring charges could be used to "manage earnings."  How might that benefit the company?

• Read the Business Week article, "Earnings Hocus Pocus."  In your opinion, should financial statement users consider restructuring costs to be part of a company’s permanent earnings stream, or are they transitory in nature?  Why?  [You might want to investigate DuPont, Alcoa, and Eastman Kodak over the last decade.] 

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