Financial Accounting: In an Economic Context

ASSESSING EARNINGS QUALITY

Earnings quality refers to the extent to which the reported financial statements deviate from the true financial condition and performance of the company. One aspect of assessing earnings quality involves determining the extent to which management's biases have influenced the financial statements. Four strategies used by managers to “manage” reported accounting numbers are well known. Each is discussed below.

Overstating Operating Performance

In certain situations, managers simply attempt to devise a more favorable picture by overstating the performance of the company. This is often achieved by accelerating the recognition of revenues or deferring the recognition of expenses. Young, fast-growing, aggressive companies sometimes use this reporting strategy to help them attract much-needed capital, and it is also common in situations where companies face financial difficulties.

In a well-known article entitled “Earnings Hocus-Pocus,” Business Week reported that when the economy slows and Wall Street gets jittery, concerns grow that companies desperate to keep up earnings and stock prices practice even more aggressive accounting. Explain what this means and provide several examples of “aggressive accounting.”

Taking a Bath

When a company experiences an extremely poor year, it sometimes chooses very conservative accounting methods, estimates, or judgments ...