Understanding Earnings Quality, Essay Example

There are many factors that have contributed to the deterioration of financial reporting quality. This includes the state of the economy, poor corporate governance, lack of scrutiny by financial analysts, and several other additional factors. It is important to determine why this financial reporting quality has decreased in addition to how it is described in the literature. Developing an understanding of this financial phenomenon is an important component that will help us predict how and why companies behave in certain manners.

According to Dechow et al., earnings quality can be measured in many different ways (2010). They describe that analysing “persistence, accruals, smoothness, timeliness, loss avoidance, investor responsiveness, and external indicators such as restatements and SEC enforcement releases” is an important part of this process (Dechow et al., 2010). Overall, this study concludes that it is challenging to provide a rigid definition to the concept of earnings quality because quality is dependent upon particular situations. Therefore, it is important for each organization to define the meaning of earnings quality within their own context. It is likely that quality for small and large organizations will differ significantly. It is also important to consider that the complexity of this very definition has the potential to contribute to the deterioration of financial reporting quality in recent years. If we cannot reasonable define earnings quality, then determining a method by which its deterioration could be prevented is an equally abstract concept.

The decline of financial reporting quality is evident based on the unreliability of earnings management figures that are produced. In some cases, income smoothing is common which leads to unreliable reports. A review of relevant literature determined that “income smoothing appears to reduce information quality and/or otherwise lacks credibility as a signal of reduced equity risk, it is associated with higher stock return volatility” (Walker, 2013). It is apparent that many firms are incentivized to fabricate their numbers to an extent in order to receive enhanced financial gain from these actions. However, this results in economists being less able to gain an understanding of what these numbers mean as they relate to the overall market. Therefore, this dishonesty prevents researchers from being able to gain a clear understanding of current economic trends. Since these activities have persisted for a prolonged period of time, the information that has been published pertaining to these trends in the last several years is not reliable due to a lack of unbiased information.

Other sources have indicated that the quality of financial reporting is diminishing because stock returns are predicted several months after the financial reporting date. This is often not enough information to be able to accurately determine the financial status of various organizations. According to Teoh et al., “The lack of readily available machine-accessible data precludes us from doing a large sample study using strictly pre-IPO data to measure earnings management” (1998). Generating a large sample study would have allowed these researchers to be more certain about the findings that they would produce. Therefore, it is unfortunate that the current system prohibits this best practice. To determine whether a trend reflect reality, it is beneficial to have a large sample size that is reflective of the topic being studied. Stock returns would therefore be predicted more accurately if more data was incorporated to the analysis. This holds true for most financial reporting mechanisms as a whole. Thus, to improve current financial practices it is important to promote predictions that are based off of larger quantities of data in addition to data that has been collected over a longer period of time.

According to the authors of a recent analysis of the accruals quality and disclosure quality problem, there is a “positive association between accruals quality and disclosure quality, suggesting that firms with higher disclosure quality engage less in earnings management and have higher accruals quality” (Mousellia et al., 2012). Therefore the disclosure quality has an impact on accruals quality. To establish a high level of financial reporting quality, it is therefore beneficial to strike a balance between these two characteristics. In essence, firms have an ability to control financial reporting quality, but this often counteracts the other goals that these organizations have in place.

Additional research has indicated the possibility that the reason for “deteriorating earnings quality is… idiosyncratic return volatility over 1962-2001” (Rajgopal et al., 2010). Ultimately, this trend has been building up over the past several decades. It can be assumed that this continued during the years following 2001. This is an important understanding because it takes into consideration the past willingness of organizations to disclose value-relevant information, the performance of stock returns and other aspects that include the defining characteristics of the organization, and the financial problems and growths that firms may encounter.

Overall, there are many different characteristics that contribute to the deterioration of financial reporting quality. Many of these features relate directly to the current state of the stock market. According to the author of a recent paper, “During the recent stock market bubble, the traditional financial reporting model was assailed as a backward looking system, out of date in the Information Age” (Penman, 2003). This raises the question as to whether the poor financial reporting quality that is currently experienced is an artefact of our failure to shift from primarily paper-based reporting to computer reports. Investing in the latest technology is therefore a reasonable way to prevent the diminishing quality of these reports with regards to the information gap. By publishing this information quickly and on the internet, it will be readily accessible for everyone that wishes to access it. In the age of information, this is necessary because it will ensure that analyses and predictions could be made in a timelier manner. Doing so will increase efficiency, hold reporting institutions accountable, and allow for the fast checking of information to ensure that the accuracy of reporting is maintained as well.

Whatever the reason for the deterioration effect, it is important to begin compiling the characteristics that contribute towards this effect and begin working towards improvement. In the age of information, we are constantly plagued with inaccurate information and this is a crisis we need to resolve. Independently of the financial situations of these firms, it is important for companies to report their financial standing so this information could be analysed by experts in the field. It is expected that this will contribute to enhanced knowledge for all stakeholders and will therefore improve business practices as a whole as a result. Rather than simply accepting the deterioration of financial reporting quality, it is necessary to strive for perfection.

References

Dechow P, Weili Ge, Schrand C. (2010). Understanding earnings quality: A review of the proxies, their determinants and their consequences. Journal of Accounting and Economics, 50: 344-401.

Mousellia S, Jaafarb A, Hussaineyc K. (2012). Accruals quality vis-à-vis disclosure quality: Substitutes or complements? The British Accounting Review, 44(1): 36–46.

Penman SH. (2003). The Quality of Financial Statements: Perspectives from the Recent Stock Market Bubble. Retrieved from https://www0.gsb.columbia.edu/mygsb/faculty/research/pubfiles/903/Penman_The_Quality_of_Financial_Statements.pdf

Rajgopal S, Venkatachalam M. (2010). Financial Reporting Quality and Idiosyncratic Return Volatility. Retrieved from https://faculty.fuqua.duke.edu/~vmohan/bio/files/rvFeb%202010.pdf

Teoh SH, Welch I, Wong TJ. (1998). Earnings Management and the Long-Run Market Performance of Initial Public Offerings. The Journal of Finance, 6: 1935-1974.

Walker M. (2013). How far can we trust earnings numbers? What research tells us about earnings management. Accounting and Business Research, 43(4): 445-481.