Earnings Quality

In the Financial Statement Analysis Module the sub branch above, “Analyzing Earnings Quality” is organized around two sub-sections:

Quality of Earnings (Balance Sheet)
Quality of Earnings (Cash Flow)

Financial Reporting Quality is an area that has attracted both academic and practitioner attention.  The quality of financial reports affects both the accuracy of the financial statements as well as how relevant they are for predicting future cash flows.  This has led to a large body of research that attempts to understand accrual accounting and its impact upon financial reporting quality. 

Accrual versus Cash Income

Accrual income differs from cash income by carefully accounting for expenses incurred but not yet paid for and expenses paid for but not yet realized.  For example, an expense paid for but not yet realized is prepaid insurance.  This covers a future accounting period and similarly future depreciation expense represents the cost of future services from plant property and equipment that has already been acquired.  Examples of expenses incurred but not yet paid for arise from invoices that come into the business after the accounting period has ended.  This is a common event in practice.  On the revenue recognition side accrual income will deviate from cash income on the basis of whether or not the revenue is recognized in the current period.  These cases arise when the goods or services provided have been paid for but not yet provided.  Under accrual accounting this creates liability items (i.e., credits) on the balance sheet referred to as unearned revenue that can be both current and non-current.

Accounting resolves these differences between accrual and cash income by applying the matching principle.  That is, accrual income attempts to match expenses to revenue per period irrespective of the timing of cash inflows and outflows.  Cash accounting on the other hand matches cash inflows and outflows to the period.  Accounting for these real economic differences in practice require managerial judgment and the accounting standards provide flexibility to allow for managerial judgment.  As a result, both income measures are subject to being managed over time but accrual accounting provides management with greater flexibility for managing earnings.  Financial Reporting Quality attempts to assess the degree to which management is relying upon accruals to meet earnings target.  Earnings’ are judged to be of higher quality the lower the dependence upon accruals.   It is important to note that the use of accruals does not imply that earnings are being manipulated or that earnings management is bad, instead what is important is that the impact upon income from the use of accruals, tend to reverse over time whereas cash income tends to persist over time.   As a result, earnings are judged to be more persistent the higher the quality of earnings is judged to be. 

The reversal of accruals results from the matching principle and historical cost accounting.  For example, if a firm chooses straight line over accelerated depreciation for their plant, property and equipment then current income is higher than later income under straight line depreciation compared to an accelerated depreciation method.  The hypothesized difference between cash flows and accruals, in terms of a sustainable earnings impact, is supported empirically.  For example, a higher proportion of accruals relative to cash earnings is associated with lower earnings performance in the subsequent period (Sloan 1996).   As a result, the question facing outside analysts is:

To what degree is the flexibility provided by accrual accounting being applied?

In the Earnings’ Quality branch there are two calculators.  These ratios are designed to provide an analyst with insight into earnings quality. 

Quality of Earnings (Balance Sheet)

The scaling variable under the balance sheet measure is referred to as Net Operating Assets.  This term is the difference between operating assets and liabilities and it is constructed to meet several needs.  First, operating assets subtracts out cash and near cash in a consistent manner with the subtraction of cash earnings from Aggregate Accruals.  Second, in the liabilities part financing decision effects are subtracted.  Thus Net Operating Assets sharpens the measurement of the impact of accounting accruals upon the numbers resulting from the investment decision.

Operationally these defined relative to two successive Consolidated Balance Sheets as follows:

NOA(t)  = Net Operating Assets (t) = (Total Assets(t) – Cash & Near Cash(t)) – (Total Liabilities(t) – Total Debt(t))

Average Net Operating Assets = (NOA(t) + NOA(t-1))/2

Net Operating Assets at time t is the difference between operating assets and operating liabilities after eliminating accounts that are not subject to accounting accrual measurements.

The quality of earnings using the balance sheet approach is now defined as:

Balance Sheet Accruals Ratio (t) = (Net Operating Assets (t) - Net Operating Assets (t-1) / Average Net Operating Assets (t, t-1)

That is, both the numerator and the denominator of the measure of accruals come entirely from the balance sheet.

Quality of Earnings (Cash Flow)

The Aggregate Accruals (AA) can be defined from the Consolidated Statement of Cash Flows as follows:

Aggregate Accruals(t) = Net Income(t) – (Cash Flows from Operating Activities(t) + Cash Flows from Investing Activities(t))

Cash Flow Accruals Ratio (t) = Aggregate Accruals (t) / Average Net Operating Assets (t, t-1)

The above measure differs from the balance sheet measure in terms of the numerator which measures aggregate accruals from the cash flow statement.  This measure raises the question – why include Cash Flow from Investing Activities in the numerator?

The answer to this question depends upon whether or not future operations are included in the measure.  That is, by including cash flow from investing activities includes cash capital expenditures that support future operating activities with current cash operating activities but excludes investments that are financed via a stock or debt issue.  As noted earlier cash income is predicted to persist and accruals are predicted to reverse, the inclusion of investing activities and its relation to future operating activities is designed to reinforce this property.

A variation for assessing earnings quality that drops cash flows from investing activities is also provided in the calculator.  In this variation the focus is purely on cash flow from operations and the scaling variable is changed to Net Income in an attempt to increase the sensitivity of the measure of the impact from accruals upon Income.

Quality of Earnings (Cash Flow) Scaled by Net Income

This refinement is analyzed empirically by Hafzalla, Lundholm and Winkel (2010) and is defined as:

Percent Operating Accruals = (Net Income – Cash from Operations)/Net Income

This relates the non-cash earnings to earnings to provide what is argued to be a more sensitive measure of the relative importance of earnings management.