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Unformatted text preview: fect wealth in the same manner Analysts must judge the relative worth of the various income disclosures EARNINGS QUALITY EARNINGS QUALITY (CONT.) Earnings sustainability An enterprise’s capacity to produce earnings on a recurring basis Permanent in nature (i.e., they occur every reporting period) Fundamental wealth increases Produced by central business operations Highly valued by analysts EARNINGS QUALITY EARNINGS QUALITY (CONT.) Transitory earnings are not permanent Marginal wealth increases Result from nonrecurring or intermittently recurring items Not highly valued by analysts EARNINGS QUALITY EARNINGS QUALITY (CONT.) Nonoperating income items Can have a recurring affect on wealth (e.g., interest income)
Can affect wealth sporadically (e.g., corporate restructurings)
Corporate restructurings complicate assessment of earnings sustainability
Multiple restructurings reduce earning quality to an even greater degree than those resulting from a single restructuring EARNINGS QUALITY EARNINGS QUALITY (CONT.) The policies and procedures used to determine income define earnings measurement, examples include Costing inventory on a FIFO or LIFO basis Depreciating fixed assets on a straightline or accelerated basis EARNINGS QUALITY EARNINGS QUALITY (CONT.) The continual selection of accounting choices that increase income is known as earnings management, examples include a
Reluctance to reduce inventory costs to their lower market value Overestimation of the life of fixed assets EARNINGS QUALITY EARNINGS QUALITY (CONT.) Benchmarking Evaluation of one entity’s accounting principles and policies against the those of its competition and against itself over time Incompatibility with other firms or inconsistency over time may indicate earnings management EARNINGS QUALITY EARNINGS QUALITY (CONT.) Earnings sufficiency
An assessment if an entity generates enough profits to remain viable Analysts evaluate various profit margins to gain insight
Gross profit: revenues minus cost of good sold
Operating profit: gross profit minus operating expenses
Net profit: operating expenses minus other revenues and expenses EARNINGS QUALITY EARNINGS QUALITY (CONT.) Sufficiency indicators High gross and operating profit margins indicate sufficient earnings
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This document was uploaded on 03/24/2014.
- Spring '14