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Chapter 4 Case 4-13: Earnings Quality
Julia Szabo
School of Business, Liberty University
ACCT 301: Intermediate Financial Accounting I
Professor William Sullivan
September 4, 2025
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Chapter 4 Case 4-13: Earnings Quality
Requirement 1
There are several aspects of earnings quality. The textbook defines it as “the ability of
reported earnings…to predict a company’s future earnings” (Spiceland et al., 2018/2025, p.
167). Other descriptions complement this definition. In one survey of CFOs, the majority agreed
that high-quality earnings were “sustainable and repeatable” (Dichev, 2013, p. 2). Moreover, the
survey reported that reliable reporting, correspondence to cash flows, and avoidance of long-
term estimates contributed to earnings quality.
Requirement 2
One aspect of assessing earnings quality is distinguishing permanent earnings from
temporary earnings (Spiceland et al., 2018/2025). Permanent earnings are those that are likely
to recur, producing future profits (Spiceland et al., 2018/2025). Temporary earnings are the
opposite. They are either unlikely to recur or, if they do, are unlikely to affect earnings the same
way (Spiceland et al., 2018/2025). When investors assess a company's earnings quality, they
focus on permanent earnings because these suggest more about a company’s future income
than temporary earnings do.
Requirement 3
One activity that affects earnings quality is earnings management, defined as “a clear
discretionary choice” (Dichev, 2013, p. 24). These choices usually involve the assumptions and
estimates used in financial reporting (Spiceland et al., 2018/2025, p. 168). For example, the
practice of income smoothing changes estimates across reporting periods to make income
appear more consistent (Spiceland et al., 2018/2025).
While earnings management is consistent with GAAP (Spiceland et al., 2018/2025), it
raises ethical concerns and may negatively affect earnings quality. With a practice like income
smoothing, earnings quality appears higher. Since reported income seems consistent and
therefore more likely to predict future income, investors will place more trust in the company.
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However, because income is actually less consistent than reported, the quality of earnings is
lower than they realize. In fact, earnings quality is made even lower by earnings management,
which degrades the quality of consistent reporting.
One must also consider biblical ethics. According to Scripture, “Better is a poor man who
walks in his integrity than a rich man who is crooked in his ways” (English Standard Bible,
2001/2016, Pvs. 28:6). Clearly, the Bible values integrity over wealth. Therefore, it is better for a
manager to lose a bonus than to mislead investors about his company’s earnings quality.
Requirement 4
In Case 4-13 (Spiceland et al., 2018/2025, p. 226), a manufacturing company reports a
considerable gain from selling investment securities in its annual income statement. As the
textbook asks, how does one decide whether or not to include this gain in permanent earnings?
First, one must consider whether this gain is likely to recur. Because the entity in question is a
manufacturing company, any gains from investment securities are not included in operating
income. However, some non-operating income may be permanent if it happens frequently
(Spiceland et al., 2018/2025). So, if there is evidence that this gain is likely to recur, one may
consider including it in permanent earnings.
Assuming this gain does recur, one should also consider if it will recur in similar amounts.
Because it is large, and because market prices on investment securities could change, it is less
likely that these gains will remain the same size over time. So, this gain should probably not be
included among permanent earnings, even if doing so would increase the company’s apparent
earnings quality.
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References
Dichev, I. D., Graham, J. R., Harvey, C. R., & Rajgopal, S. (2013). Earnings quality: Evidence from
the field. Journal of Accounting and Economics, 56(2-3), 2, 24.
https://doi.org/10.1016/j.jacceco.2013.05.004
English Standard Bible. (2016). Crossway Bibles. (Original work published 2001)
Spiceland, J. D., Nelson, M. W., Thomas, W., & Winchel, J. (2025). Intermediate Accounting.
McGraw Hill LLC.
https://prod.reader-ui.prod.mheducation.com/epub/sn_fc2dc/datauuid-
72c9b3d52b934c6d80a05e679c8663e2 (Original work published 2018)
