LOS d: Discuss earnings quality, explain simple measures of earnings quality, and compare and contrast the earnings quality of peer companies.

Q1. In measuring earnings quality, which of the following statements is most appropriate?

A)   Accruals can be measured as the change in net operating assets (NOA) over a period of time.

B)   The higher the accruals ratio, the higher the earnings quality.

C)   Accruals can be measured as net income less cash flows from operations (CFO) less cash flows from financing (CFF).

Q2. Jeremy Jennings is explaining the concept of earnings quality to his new colleagues. Which of the following measures is most

    indicative of a higher quality of earnings when attempting to forecast future earnings?

A)   Higher degree of conservatism of earnings.

B)   Higher degree of persistence of earnings.

C)   Higher level of earnings.

Q3. The following information pertains to Morley Inc. (Morley) and Crowell Inc. (Crowell) for 2007 and 2008:

Based on the information provided, which of the following conclusions about the two companies is most appropriate?

A)   Morley’s earnings quality is higher than Crowell’s.

B)   Crowell’s earnings quality is higher than Morley’s.

C)   Crowell’s earnings quality is deteriorating compared to Morley’s.

Q4. Costiuk Inc. (Costiuk) saw a large increase in its net operating assets (NOA) over the year. During the year, it also reported a

number of nonoperating revenues and deferred revenues. Which of the following statements regarding Costiuk’s increase in

NOA and the most likely item to self-correct is most accurate?

                 Increase in NOA                          Most likely item to self-correct

A) suggests lower earning quality        deferred revenues

B) suggests lower earning quality        nonoperating revenues

C) suggests higher earning quality       nonoperating revenues

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Q1. In measuring earnings quality, which of the following statements is most appropriate?

A)   Accruals can be measured as the change in net operating assets (NOA) over a period of time.

B)   The higher the accruals ratio, the higher the earnings quality.

C)   Accruals can be measured as net income less cash flows from operations (CFO) less cash flows from financing (CFF).

Correct answer is A)

Using the balance sheet, we can measure accruals as the change in net operating assets (NOA) over a period of time. NOA is the difference in operating assets and operating liabilities. Operating assets are equal to total assets minus cash, equivalents to cash, and marketable securities. Operating liabilities are equal to total liabilities minus total debt (both short-term and long-term). In summary, the formula for balance sheet based aggregate accruals is:

Accruals^BS = NOA_END ? NOA_BEG

We can also derive the aggregate accruals by subtracting cash flow from operating activities (CFO) and cash flow from investing activities (CFI) from reported earnings as follows:

Accruals^CF = NI ? CFO ? CFI

The lower the accruals ratio, the higher the earnings quality.

Q2. Jeremy Jennings is explaining the concept of earnings quality to his new colleagues. Which of the following measures is most

    indicative of a higher quality of earnings when attempting to forecast future earnings?

A)   Higher degree of conservatism of earnings.

B)   Higher degree of persistence of earnings.

C)   Higher level of earnings.

Correct answer is B)

The term earnings quality usually refers to the persistence and sustainability of a firm’s earnings; that is, more persistent and sustainable earnings are considered higher quality.

Measuring earnings quality based on conservative earnings is an inferior measure when attempting to forecast future earnings because most accruals will self-correct over time. For example, the lower earnings that result from accelerated depreciation will increase in the later years of the asset’s life. Focusing on accruals and deferrals is a more effective way of measuring earnings quality.

A higher level of earnings has no impact on increasing the quality of earnings since the former may be derived largely from earnings manipulation on the part of management.

Q3. The following information pertains to Morley Inc. (Morley) and Crowell Inc. (Crowell) for 2007 and 2008:

Accrual Ratio	2008	2007
Morley	16.1%	14.7%
Crowell	6.9%	8.5%

Based on the information provided, which of the following conclusions about the two companies is most appropriate?

A)   Morley’s earnings quality is higher than Crowell’s.

B)   Crowell’s earnings quality is higher than Morley’s.

C)   Crowell’s earnings quality is deteriorating compared to Morley’s.

Correct answer is B)

Crowell’s earnings quality is higher because its accrual ratio is lower in both years. Furthermore, Crowell’s earnings quality is also improving (due to the decrease in its accrual ratio) while Morley’s is deteriorating (due to the increase in its accrual ratio).

Q4. Costiuk Inc. (Costiuk) saw a large increase in its net operating assets (NOA) over the year. During the year, it also reported a

number of nonoperating revenues and deferred revenues. Which of the following statements regarding Costiuk’s increase in

NOA and the most likely item to self-correct is most accurate?

                 Increase in NOA                          Most likely item to self-correct

A) suggests lower earning quality        deferred revenues

B) suggests lower earning quality        nonoperating revenues

C) suggests higher earning quality       nonoperating revenues

Correct answer is A)

Deferrals and accruals are most likely to self-correct.

The large increase in net operating assets is indicative of a high accruals ratio as demonstrated by the following equation:

Accruals^BS = NOA_END ? NOA_BEG

In interpreting the ratio, the higher the ratio, the lower the earnings quality.

Nonrecurring and nonoperating revenues do not typically self-correct like deferrals and accruals, thereby providing a greater manipulation benefit to the firm.

thx