REPLY - DB

            Simply defining earnings quality is not an easy task. Earnings quality takes on many dimensions depending on the intended meaning of its use. The most simplistic definition references income and the source of that income. “The quality of earnings refers to the proportion of income attributable to the core operating activities of a business” (Bragg, 2020). While this definition is helpful, earnings quality has other components that extend past income. I relate the earnings quality concept to tracing the source of the earnings.

Where was this major boost in income generated from? Quality of earnings is a foretelling measurement of the future income of profits that originate from operating activities. An example would be a company that generates a large steady profit from selling a product, as this is more favorable than making money on selling a one-time asset. Steadiness and continuity in generating income is preferred rather than one large profit that cannot be reproduced easily.  

Explain the distinction between permanent and temporary earnings as it relates to the concept of earnings quality:

             “Temporary earnings arise from transactions or events that are not likely to occur again in the foreseeable future or that are likely to have a different impact on earnings in the future” (Spiceland et al., 2019, p. 173). Temporary earnings are somewhat self-explanatory, they should not be thought of as a steady source of income because they simply are not. In a true juxtaposition, permanent earnings are firm and somewhat continuous. “…Permanent earnings arise from operations that are expected to generate similar profits in the future” (Spiceland et al., 2019, p. 173).  Permanent earnings from operations provide measurement for future confidence. Investors, creditors, and other providers of capital can base solid conclusions on truthful permanent earnings.

How do earnings management practices affect the quality of earnings?

            Quality of earnings can be manipulated by management. The perception of this manipulation depends on who you ask. “…U.S. Generally Accepted Accounting Principles (GAAP) allow for managerial discretion in reporting decisions, and many people believe that using that discretion to achieve earnings objectives is an integral part of doing business and protecting the interest of shareholders” (Hamilton et al., 2018). While I believe quality of earnings can be manipulated greatly, this is still an observable measure. The numbers for a poor performing company can only be switched around and manipulated so many times. If there are not enough funds flowing in from core operations, cracks will appear.

Long-term observation of the numbers will affect earnings quality based upon what is classified under permanent versus temporary earnings. Fraud and manipulation can cause distrust from investors. Perceptions are an important aspect of determination of earnings quality. Damage could occur if a company makes attempts at pure deception with financial reporting. “Income smoothing” is a fairly common attempt at altering appearances of performance (Spiceland et al., 2019, p. 173). The highs and lows are evened out to make performance seem more solid than it actually is. While small attempts at this type of reporting can inspire confidence, it should be applied with caution. Earnings quality should be based on performance that is achieved ethically.

Assume that a manufacturing company’s annual income statement included a large gain from the sale of investment securities. What factors would you consider in determining whether or not this gain should be included in an assessment of the company’s permanent earnings?

             When considering whether a large gain should be included on the company’s permanent earnings, there are several questions to be asked. Will this event occur again next year? How about the year after? If this event is a one-time occurrence it should not be considered a part of the company’s permanent earnings. Is the event related directly to the companies core operations? If the company manufacturers products; this sale of investment securities is not operational in nature. While the gain is a positive thing to the company, it is not guaranteed to be recurring. Overstating permanent earnings may look and feel good in the present, but it could damage performance perceptions in the future.

            Biblically, this decision is an easy one. “You shall not steal; you shall not deal falsely; you shall not lie to one another” (Leviticus 19:11, English Standard Version). Stretching the truth and concealing the true facts are examples of dealing falsely and lying. GAAP does allow for managerial decision making; but we must remember the ultimate law we answer to. God always watches the decisions we make. There is still a place in business for honesty, integrity, and Christian influence.

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