The Emerald Research Register for this journal is available at www.emeraldinsight.

com/researchregister

The current issue and full text archive of this journal is available at www.emeraldinsight.com/0268-6902.htm

Measuring the quality of earnings

Khaled ElMoatasem Abdelghany
Accounting Department, College of Business and Economics, Qatar University, Doha, Qatar

Measuring the quality of earnings 1001

Abstract
Purpose Although the academic research on the quality of earnings has been improved by presenting different approaches of measurement, there is no agreed-upon generally accepted approach to measure the earning quality. Aims to present results of an empirical study measuring the quality of earnings on companies listed in NYSE. Design/methodology/approach Uses a sample of 90 companies listed in the NYSE. The analysis is directed to reach a general assessment of the quality of earnings if there is a complete consistency among the three approaches, and if not, the quality of earnings is questionable and needs further analysis and investigations. Findings The results show that different approaches of measuring the quality of earning lead to different assessment, and one industry or one company can not be labeled as having low or high quality of earning based on the result of one approach only. The results also suggest that the stakeholders before making any nancing, investing decision or taking any corrective action, have to use more than one approach to assess the quality of earnings. Originality/value Indicates that nancial analysts and governmental agencies dealing with companies should apply more than one measure for the quality of earning in order to have strong evidence about the level of quality before taking any corrective action or making any decision related to those companies. Keywords Earnings, Financial analysis, Measurement Paper type Research paper

1. Introduction Generally accepted accounting principles (GAAP) offer some exibility in preparing the nancial statements and give the nancial managers some freedom to select among accounting policies and alternatives. Earning management uses the exibility in nancial reporting to alter the nancial results of the rm (Ortega and Grant, 2003). In other words, earnings management is manipulating the earning to achieve a predetermined target set by the management. It is a purposeful intervention in the external reporting process with the intent of obtaining some private gain (Schipper, 1989). Levit (1998) denes earning management as a gray area where the accounting is being perverted; where managers are cutting corners; and, where earnings reports reect the desires of management rather than the underlying nancial performance of the company. The popular press lists several instances of companies engaging in earnings management. Sensormatic Electronics, which stamped shipping dates and times on sold merchandise, stopped its clocks on the last day of a quarter until customer shipments reached its sales goal. Certain business units of Cendant Corporation inated revenues nearly $500 million just prior to a merger; subsequently, Cendant restated revenues and agreed with the SEC to change revenue recognition practices. AOL restated earnings for $385 million in improperly deferred marketing expenses.

Managerial Auditing Journal Vol. 20 No. 9, 2005 pp. 1001-1015 q Emerald Group Publishing Limited 0268-6902 DOI 10.1108/02686900510625334

MAJ 20,9

1002

In 1994, the Wall Street Journal detailed the many ways in which General Electric smoothed earnings, including the careful timing of capital gains and the use of restructuring chares and reserves, in response to the article, General Electric reportedly received calls from other corporations questioning why such common practices were front-page news. Earning management occurs when managers use judgment in nancial reporting and in structuring transactions to alter nancial reports to either mislead some stakeholders about the underlying economic performance of the company or to inuence contractual outcomes that depend on reported accounting numbers (Healy and Whalen, 1999). Magrath and Weld (2002) indicate that abusive earnings management and fraudulent practices begins by engaging in earnings management schemes designed primarily to smooth earnings to meet internally or externally imposed earnings forecasts and analysts expectations. Even if earnings management does not explicitly violate accounting rules, it is an ethically questionable practice. An organization that manages its earnings sends a message to its employees that bending the truth is an acceptable practice. Executives who partake of this practice risk creating an ethical climate in which other questionable activities may occur. A manager who asks the sales staff to help accelerate sales one day forfeits the moral authority to criticize questionable sales tactics another day. Earnings management can also become a very slippery slope, which relatively minor accounting gimmicks becoming more and more aggressive until they create material misstatements in the nancial statements (Clikeman, 2003) The Securities and Exchange Commission (SEC) issued three staff accounting bulletins (SAB) to provide guidance on some accounting issues in order to prevent the inappropriate earnings management activities by public companies: SAB No. 99 Materiality, SAB No. 100 Restructuring and Impairment Charges and SAB No. 101 Revenue Recognition. Earnings management behavior may affect the quality of accounting earnings, which is dened by Schipper and Vincent (2003) as the extent to which the reported earnings faithfully represent Hichsian economic income, which is the amount that can be consumed (i.e. paid out as dividends) during a period, while leaving the rm equally well off at the beginning and the end of the period. Assessment of earning quality requires sometimes the separations of earnings into cash from operation and accruals, the more the earnings is closed to cash from operation, the higher earnings quality. As Penman (2001) states that the purpose of accounting quality analysis is to distinguish between the hard numbers resulting from cash ows and the soft numbers resulting from accrual accounting. The quality of earnings can be assessed by focusing on the earning persistence; high quality earnings are more persistent and useful in the process of decision making. Beneish and Vargus (2002) investigate whether insider trading is informative about earnings quality using earning persistence as a measure for the quality of earnings, they nd that income-increasing accruals are signicantly more persistent for rms with abnormal insider buying and signicantly less persistent for rms with abnormal insider selling, relative to rms which there is no abnormal insider trading.

Balsam et al. (2003) uses the level of discretionary accruals as a direct measure for earning quality. The discretionary accruals model is based on a regression relationship between the change in total accruals as dependent variable and change in sales and change in the level of property, plant and equipment, change in cash ow from operations and change in rm size (total assets) as independent variables. If the regression coefcients in this model are signicant that means that there is earning management in that rm and the earnings quality is low. This research presents an empirical study on using three different approaches of measuring the quality of earnings on different industry. The notion is; if there is a complete consistency among the three measures, a general assessment for the quality of earnings (high or low) can be reached and, if not, the quality of earnings is questionable and needs different other approaches for measurement and more investigations and analysis. The rest of the paper is divided into following sections: Earnings management incentives, Earnings management techniques, Model development, Sample and statistical results, and Conclusion. 2. Earnings management incentives 2.1 Meeting analysts expectations In general, analysts expectations and company predictions tend to address two high-prole components of nancial performance: revenue and earnings from operations. The pressure to meet revenue expectations is particularly intense and may be the primary catalyst in leading managers to engage in earning management practices that result in questionable or fraudulent revenue recognition practices. Magrath and Weld (2002) indicate that improper revenue recognition practices were the cause of one-third of all voluntary or forced restatements of income led with the SEC from 1977 to 2000. Ironically, it is often the companies themselves that create this pressure to meet the markets earnings expectations. It is common practice for companies to provide earnings estimates to analysts and investors. Management is often faced with the task of ensuring their targeted estimates are met. Several companies, including Coca-Cola Co., Intel Corp., and Gillette Co., have taken a contrary stance and no longer provide quarterly and annual earnings estimates to analysts. In doing so, these companies claim they have shifted their focus from meeting short-term earnings estimates to achieving their long-term strategies (Mckay and Brown, 2002) 2.2 To avoid debt-covenant violations and minimize political costs Some rms have the incentive to avoid violating earnings-based debt covenants. If violated, the lender may be able to raise the interest rate on the debt or demand immediate repayment. Consequently, some rms may use earnings-management techniques to increase earnings to avoid such covenant violations. On the other hand, some other rms have the incentive to lower earnings in order to minimize political costs associated with being seen as too protable. For example, if gasoline prices have been increasing signicantly and oil companies are achieving record prot level, then there may be incentive for the government to intervene and enact an excess-prot tax or attempt to introduce price controls.

Measuring the quality of earnings 1003

MAJ 20,9

1004

2.3 To smooth earnings toward a long-term sustainable trend For many years it has been believed that a rm should attempt to reduce the volatility in its earnings stream in order to maximize share price. Because a highly violate earning pattern indicates risk, therefore the stock will lose value compared to others with more stable earnings patterns. Consequently, rms have incentives to manage earnings to help achieve a smooth and growing earnings stream (Ortega and Grant, 2003). 2.4 Meeting the bonus plan requirements Healy (1985) provides the evidence that earnings are managed in the direction that is consistent with maximizing executives earnings-based bonus. When earnings will be below the minimum level required to earn a bonus, then earning are managed upward so that the minimum is achieved and a bonus is earned. Conversely, when earning will be above the maximum level at which no additional bonus is paid, then earnings are managed downward. The extra earnings that will not generate extra bonus this current period are saved to be used to earn a bonus in a future period. When earnings are between the minimum and the maximum levels, then earnings are managed upward in order to increase the bonus earned in the current period. 2.5 Changing management Earnings management usually occurs around the time of changing management, the CEO of a company with poor performance indicators will try to increase the reported earnings in order to prevent or postpone being red. On the other hand, the new CEO will try shift part of the income to future years around the time when his/her performance will be evaluated and measured, and blame the low earning at the beginning of his contract on the acts of the previous CEO. 3. Earnings management techniques One of the most common earnings management tools is reporting revenue before the seller has performed under the terms of a sales contract (SEC, SAB No. 101, 1999). Another area of concern is where a company fails to comply with GAAP and inappropriately records restructuring charges and general reserves for future losses, reversing or relieving reserves in inappropriate periods, and recognizing or not recognizing an asset impairment charge in the appropriate period (SEC, SAB No. 100, 1999). Managers can inuence reported expenses through assumptions and estimates such as the assumed rate of return on pension plan asset and the estimated useful lives of xed assets, also they can inuence reported earnings by controlling the timing of purchasing, deliveries, discretionary expenditures, and sale of assets. 3.1 Big bath Big Bath charges are one-time restructuring charge. Current earnings will be decreased by overstating these one-time charges. By reversing the excessive reserve, future earnings will increase. Big bath charges are not always related to restructuring. In April 2001, Cisco Systems Inc. announced charges against earnings of almost $4 billion. The bulk of

the charge, $2.5 billion, consisted of an inventory write down. Writing off more than a billion dollars from inventory now means more than a billion dollars of less cost in the future period. This an example of what ultra-conservative accounting in one period makes possible in future periods. 3.2 Abuse of materiality Another area that might be used by accountants to manipulate the earning is the application of materiality principle in preparing the nancial statements, this principle is very wide, exible and has no specic range to determine where the item is material or not. SEC uses the interpretation ruled by the supreme court in identifying what is material; the supreme court has held that a fact is material if there is a substantial likelihood that the fact would have been viewed by reasonable investor as having signicantly altered the total mix of information made available (SEC, SAB No. 99, 1999). The SEC has also introduced some considerations for a quantitatively small misstatement of a nancial statement item to be material: . whether the misstatement arises from an item capable of precise measurement or whether it arises from an estimate and, if so, the degree of imprecision inherent in the estimate; . whether the misstatement masks a change in earnings or other trends; . whether the misstatement hides a failure to meet analysts consensus expectations for the enterprise; . whether the misstatement changes a loss into income or vice versa; . whether the misstatement concerns a segment or other portion of the registrants business that has been identied as playing a signicant role in the registrants operations or protability; and . whether the misstatement involves concealment of an unlawful transaction. 3.3 Cookie jar Cookie jar reserve sometimes labeled rainy day reserve or contingency reserves, in periods of strong nancial performance, cookie jar reserve enable to reduce earnings by overstating reserves, overstating expenses, and using one-time write-offs. In periods of weak nancial performance, cookie jar reserves can be used to increase earnings by reversing accruals and reserves to reduce current period expenses (Kokoszka, 2003). The most famous example of use of cookie jar reserves is WorldCom Inc. In August 2002, an internal review revealed that the company had $2.5 billion reserves related to litigation, uncollectible and taxes. The company used most of them in a series of so-called reserve reversals in order to have higher earnings. 3.4 Round-tripping, back-to-back and swaps The practice of selling an unused asset to another company while at the same time agreeing to buy back the same or similar assets at about the same price is known as round-tripping. Back-to-Back is the same process but with a short time lag the two transactions are not scheduled to occur at precisely the same time. Swaps occur when two companies sell each other virtually identical assets to recognize revenue.

Measuring the quality of earnings 1005

MAJ 20,9

1006

These techniques articially inate the revenue of both the buyer and the seller (Kokoszka, 2003). Qwest Communication International allegedly was one of the most aggressive users of swap transactions selling long-term capacity on its ber network to another carrier, buying the same amount of ber on another carriers net work, and then booking the contract as revenue. Qwest is also alleged to have boosted sales by selling equipment to another companies and then leasing services back from those same concerns. 3.5 Timing of adoption of mandatory accounting standards Since its formation in 1973 the Financial Accounting Standards Board (FASB) has issued 151 accounting standards an average of ve new standards per year. Typically, the FASB standards are enacted with a two-to-three-year transition period prior to mandatory adoption but with early adoption encouraged. While not all rms are affected by each standard issued, the relative frequency of new standards combined with long adoption windows provides an opportunity for managers to select an adoption year most favorable to the rms nancial picture (Ayres, 1994). Ayres (1986) provides the empirical evidence that the rms who adopted the Statement of Financial Accounting Standard (SFAS) #52 Accounting for Foreign Currency Translation early had the opportunity to increase earnings with an average of $0.38 per share. In comparison to rms that adopted the standard later, the early-adopting rms were smaller, closer to debt and dividend constrains, and less protable than later-adopting rms. Early adoption of accounting standard that increase income may convey an impression that a company needs to nd income from wherever possible. Early adoption can lower investors perception of earning quality. 3.6 Voluntary accounting changes Another method of managing earnings is to switch from one generally accepted accounting method to another. While a rm cannot make the same type of accounting changes too frequently, it is possible to make several different types of accounting changes either together or individually over several periods. 3.7 Conservative accounting Conservative accounting means choosing the accounting method that keeps the carrying values of the assets relatively low. Therefore, LIFO accounting for inventories is conservative relative to FIFO (if inventory prices are increasing); expensing research and development expenditures rather than capitalizing and amortizing them is conservative; and policies that consistently overestimate allowances for doubtful accounts, sales returns or warranty liabilities are conservative. Conservative accounting affects not only the quality of numbers reported on the balance sheet, but also the quality of earnings reported on the income statement. When the rm increase investment, conservative accounting leads to reported earnings that are lower than would have been had management made more liberal accounting choices. These lower earnings, however, create unrecorded reserves that provide managers more exibility to report more income in the future. Management can increase these reserves, and so reduce earnings, by increasing investment.

Management can also release the reserves and create additional earnings, by subsequently reducing investment (Penman and Zhang, 2002). 3.8 Using the derivatives According to the SFAS #133 Accounting for Derivative Instruments and Hedging Activities, if the company has fair value hedge on the available for sale securities, the unrealized holding gain or loss on the available for sale securities will not be reported in the comprehensive income statement and will be reported in the income statement to offset the gain or loss on the change of the fair value of the hedging instrument. So the manager can manipulate the income by buying a hedging instrument (for example, put option) for a specic period of time in order to switch the unrealized gain or loss from the comprehensive income statement to the income statement. Thus, the manager will realize a controlled amount of gain or loss when selling the available for sale securities at a certain point of time. 4. Model development Although the phrase earnings quality is widely used, there is neither an agreed-upon meaning assigned to the phrase nor a generally accepted approach to measuring earnings quality. There are three basic approaches to measure the quality of earnings which control three different dimensions of earning management. The rst approach is focusing on the variability of earnings based on the idea that managers tend to smooth income because they believe that the investors prefer smoothly increased income. The notion of this approach is the relative absence of variability is sometimes associated with higher-quality earnings. Leuz et al. (2003) measures the variability of earnings by calculating the ratio of the standard deviation of operating earnings to the standard deviation of cash from operations (smaller ratios imply more income smoothing). The second approach is suggested by Barton and Simko (2002), which is focusing on the idea of earnings surprise as reected in the beginning balance of net operating assets relative to sales. They provide empirical evidence that rms with large beginning balance of net operating assets relative to sales are less likely to report a predetermined earnings surprise. The third approach is focusing on the ratio of cash from operation to income, this measuring of earnings quality is based on the notion that the closeness to cash means higher quality earnings, as mentioned by Penman (2001), this is the simplest technique to measure the earnings quality. The model will use these three approaches to measure the quality of earnings, the notion is; the result of each measure will be different based on the type of industry, market capitalization, number of employees, and many other factors. If one industry (company) is showing low quality of earnings according to the three approaches, that will conrm the existence of earnings management in that industry (company). On the other hand if there is no consistency among the three measures for one industry or company, the quality of earning will be questionable and needs further investigations and analysis. Finally, if there is consistency among the three measures for one industry (company) that will conrm that the accounting information represents the real economic performance of the industry without any interference from the management. Table I presents the three-dimension model.

Measuring the quality of earnings 1007

MAJ 20,9

Leuz et al. (2003) approach Quality of earnings is measured by variability of earnings which is equal to the standard deviation of operating income divided by the standard deviation of cash ow from operation The smaller the ratio the lower the quality of earnings

Barton and Simko (2002) approach Quality of earnings is measured by the earning surprise indicator which is the ratio of the beginning balance of net operating assets relative to sales The smaller the ratio the higher the quality of earnings

Penman (2001) approach Quality of earnings is measured by the ratio of cash ow from operation divided by the net income The smaller the ratio the higher the quality of earnings

1008
Table I. The three-dimension model

5. Sample and statistical results One hundred companies listed in NYSE were selected randomly using the data base of the Wall Street Journal for the period 1999-2003, the available complete data was for only 90 companies. Table II presents classication of the companies according to their activities and the mean and the standard deviation for the variables used in the model. The research design is structured primarily on the basis of calculating three different measures of the quality of earnings on the industry level and on the company level. The analysis is directed at testing whether there is consistency among the three measures for one industry or one company in order to have strong evidence about whether the quality of earnings is low or high. The quality of earnings will be marked as questionable if there is no consistency among the three measures. In this case, the quality of earnings measure needs more analysis and investigations and may be in some cases different techniques to conrm whether it is high or low. Table III presents the results of the empirical study for the industry level. As shown in Table III, there is consistency among the three measures of the quality of earning for the full sample, the banks, insurance, and investment industry and for the technology industry. For the manufacturing companies and the mining, oil and gas companies the quality of earnings is questionable and cannot be assessed based on these three measures. Table IV presents the empirical study results for the company level. As shown in Table IV, the manufacturing industry has 13 companies (42 percent) with high quality of earnings, one company with low quality of earnings, and 17 companies (55 percent) their quality of earnings measure is questionable and cannot be assessed based on this model and needs further investigation and analysis.

Industry Table II. Industrial classication and variables description (n 90) Manufacturing Mining, oil, and gas Service Banks, insurance, and investment Technology

No. of companies Variable name 31 9 28 15 7 Sales Operating income Net income Total assets Operating cash ow

Mean 1771269.13 248786.55 128049.99 3904900.73 3390458.2

Std. dev. 365,557 554186.4 423,625 12341846.5 695952.7

Industry classication 90 31 9 28 15 7 0.09 1.107 Low High 11.40 0.958 Low High 13.952 Low 2.288 High 0.163 1.042 1.014 0.385 Low High High Low 2.281 2.031 1.462 0.584 Low Low High High 5.435 1.236 4.042 5.641 Low High Low Low

Leuz et al. approach Earnings Measure quality

Barton and Simko approach Earnings Measure quality Penman approach Earnings Measure quality

General earnings quality assessment Low Questionable Questionable Questionable Low High

Full sample Manufacturing Mining, oil, and gas Service Banks, insurance, and investment Technology

1009

Measuring the quality of earnings

Table III. The empirical study results: industry level

MAJ 20,9

1010

No.

Panel A: manufacturing companies (n 31) 1 RPM 1.635 2 CSS 1.719 3 CAE 14.344 4 SSD 1.686 5 HAN 0.122 6 AEP 0.471 7 MAG 1.133 8 PPL 1.047 9 DPL 1.090 10 MSC 0.947 11 MNC 52.92 12 ACV 1.687 13 COH 1.722 14 AQA 1.140 15 COA 1.362 16 AZZ 1.629 17 CCE 1.011 18 INTC 0.967 19 SAM 1.728 20 CCH 1.588 21 DDR 0.303 22 DRS 1.949 23 AED 0.963 24 MON 0.159 25 AAA 1.591 26 ARA 2.44 27 MOT 1.270 28 EON 2.726 29 BDR 0.901 High High High High Low Low High High High Low High High High High High High High Low High High Low High Low Low High High High High Low 0.836 0.897 0.991 0.805 2.045 1.995 1.553 2.716 3.506 1.130 0.409 0.639 0.571 2.602 0.041 0.812 1.532 1.552 0.524 2.345 8.184 1.268 1.353 2.169 09367 4.224 1.156 2.405 1.115 High High High High Low High Low Low Low High High High High Low High High High High High Low Low High High Low High Low High Low High 1.928 21.890 2.859 1.139 16.561 5.515 1.930 2.256 5.351 3.289 0.199 1.364 1.803 0.522 2.289 1.998 6.248 1.949 1.702 3.509 1.521 2.010 1.764 2.169 1.262 1.985 2.127 1.044 5.579 High Low High High Low Low High High Low Low High High High High High High Low High High Low High High High High High High High High Low

Table IV. The empirical study results: company level Leuz et al. approach Measure Earnings quality Barton and Simko approach Measure Earnings quality Penman approach Measure Earnings quality General assessment High Questionable High High Low Questionable Questionable Questionable Questionable Questionable High High High Questionable High High Questionable Questionable High Questionable Questionable High Questionable Questionable High Questionable High Questionable Questionable (continued)

Company symbol

No. 0.537 Low 1.683 High companies 1.079 0.402 1.378 1.346 1.544 1.016 1.840 0.497 1.608 1.485 0.498 1.177 0.894 0.860 1.478 0.445 1.587 0.232 1.513 1.782 0.197 0.980 0.545 0.817 1.441 High Low High Low Low High Low High Low High High Low High Low Low High 0.494 1.185 1.567 11.005 1.190 0.317 1.688 0.755 5.754 0673 0.774 0.437 1.381 0.648 0.479 3.364 High High High Low High High High High Low High High High High High High Low 1.694 0.067 1.071 1.219 7.575 1.069 17.550 1.237 0.128 2.968 1.144 1.5627 2.045 6.810 0.860 30.589 High High High High Low High Low High High High High Low High Low High Low High Low High High High High High Low High 1.572 2.370 1.48 1.974 1.378 1.291 2.683 4.041 1.385 High Low High High High High Low Low High 2.776 0.114 2.583 1.845 2.351 1.218 4.443 3.183 2.627 High High High High High High Low Low High High Questionable High High High High Questionable Low High High High High Questionable Questionable High Questionable High Questionable High High High High Questionable Questionable Questionable (continued) 11.189 1.073 Low High 0.077 0.761 High High Questionable High

Company symbol

Leuz et al. approach Measure Earnings quality General assessment

Barton and Simko approach Measure Earnings quality

Penman approach Measure Earnings quality

30 SSI 31 TTG Panel B: mining, oil, and gas (n 9) 1 MEF 2 MMR 3 RES 4 EEP 5 GAS 6 GGY 7 GSS 8 CCJ 9 OGE Panel C: service companies (n 28) 1 TOO 2 ESC 3 AMR 4 NNN 5 CCC 6 MAN 7 TCN 8 URS 9 CSK 10 RRD 11 DDE 12 LEE 13 ATR 14 AGL 15 BOO 16 LIC

Measuring the quality of earnings 1011

Table IV.

MAJ 20,9

1012

No. 0.593 0.556 4.789 2.385 1.283 0.572 3.233 0.438 1.302 0.990 0.768 1.200 0.016 16.153 5.590 12.990 0.894 16.839 3.670 18.050 7.603 28.425 25.102 3.859 38.220 6.314 3.309 High Low Low Low High Low Low Low Low Low Low Low Low Low Low 1.905 0.741 7.031 0.803 1.776 2.709 3.014 0.924 1.641 1.003 0.529 1.790 0.087 2.473 3.440 High High Low High High High Low High High High High High High High Low High High Low Low High High Low High High High High High 1.918 1.850 3.881 3.692 1.430 32.853 2.457 3.768 4.020 2.604 1.907 1.051 High High Low Low High Low High Low Low High High High

17 WLP 1.715 High 18 UNH 1.577 High 19 AES 0.775 Low 20 EE 2.646 High 21 ABT 1.252 High 22 GGI 0.512 Low 23 DQE 0.901 Low 24 SAL 1.045 High 25 BAY 1.381 High 26 HCA 1.532 High 27 ATH 1.712 High 28 LLL 1.937 High Panel D: banks, insurance, and investment companies (n 15) 1 KEY 0.9411 Low 2 BBT 1.293 High 3 XL 1.173 High 4 BCH 1.211 High 5 JLG 0.524 Low 6 CHC 0.964 Low 7 MAA 0.507 Low 8 BAC 0.726 Low 9 BRE 0.388 Low 10 UBS 1.743 High 11 ASA 0.122 Low 12 NEN 0.902 Low 13 FF 0.002 Low 14 CBL 3.224 High 15 FFH 1.132 High

Table IV. Leuz et al. approach Measure Earnings quality Barton and Simko approach Measure Earnings quality Penman approach Measure Earnings quality General assessment High High Low Questionable High Questionable Questionable Questionable Questionable High High High High Questionable Questionable Questionable Questionable Questionable Low Questionable Questionable Questionable Questionable Questionable Questionable Questionable Questionable (continued)

Company symbol

No.

Company symbol

Leuz et al. approach Measure Earnings quality

Barton and Simko approach Measure Earnings quality

Penman approach Measure Earnings quality

General assessment

Panel E: technology companies (n 7) 1 SAP 2 IMCO 3 BMC 4 MMM 5 DRS 6 ASE 7 ABB 1.935 0.496 1.308 1.433 1.949 1.055 1.310 High Low High High High High High 1.065 1.315 2.015 0.914 0.253 0.671 1.564 High High Low High High High High 1.608 3.851 21.468 1.630 2.010 0.541 3.130 High Low Low High High High Low

High Questionable Questionable High High High Questionable

Measuring the quality of earnings 1013

Table IV.

MAJ 20,9

1014

For the mining, oil, and gas industry, there are six companies (67 percent) with high quality of earnings, one company with low quality of earnings, and two companies with questionable measure for the quality of earnings. For the services industry, there are 15 companies (54 percent) with high quality of earnings, one company with low quality of earnings, and 12 companies (43 percent) their quality of earnings is questionable. For banks, insurance, and investment industry, there is one company with high quality of earnings, one company with low quality of earnings, and 13 companies (87 percent) with questionable quality of earnings. For the technology industry, there are four companies (57 percent) with high quality of earnings, and three companies (43 percent) with questionable quality of earnings. These results suggest that the nancial analysts and the government before reaching any conclusion about the quality of earnings for one company, they should have a complete consistency among different measures from different prospective, other wise the quality of earnings needs more investigations and research. 6. Conclusion This research presents an empirical study about the use of different measure of quality of earnings on different industries. The notion is; since there is no agreed-upon denition or technique to measure the quality of earnings, one company or one industry cannot be labeled as having low quality of earnings based on one technique of measurement. In another words, the company or the industry can be judged as having low or high quality or earnings only if there is consistency among the results of more than one approach or technique for measurement. This research concludes that the nancial analysts and any governmental agency dealing with the company should apply more than one measure for the quality of earning in order to have strong evidence about the level of quality before taking any corrective action or making any decision related to that company. If one company is having low quality of earning according to one technique and high quality of earnings according to another, the stakeholders cannot have a nal conclusion about that company and they need more investigations and analysis to assess the quality of earnings.
References Ayres, F.L. (1986), Characteristics of rms electing early adoption of SFAS 52, Journal of Accounting and Economics, Vol. 8, pp. 143-58. Ayres, F.L. (1994), Perception of earnings quality: what managers need to know, Management Accounting, March, pp. 27-30. Balsam, S., Krishnan, J. and Yang, J.S. (2003), Auditor industry specialization and earnings quality, Auditing: A Journal of Practice & Theory, September, pp. 71-98. Barton, J. and Simko, P.J. (2002), The balance sheet as an earnings management constraint, The Accounting Review, December, pp. 1-27. Beneish, M.D. and Vargus, M.E. (2002), Insider trading, earnings quality, and accrual mispricing, The Accounting Review, October, pp. 755-92.

Clikeman, P.M. (2003), Where auditors fear to tread: internal auditors should be proactive in educating companies on the perils of earnings management and in searching for signs of its use, Internal Auditor, August, pp. 75-80. Healy, P. (1985), The effect of bonus schemes on accounting decisions, Journal of Accounting and Economics, April, pp. 85-107. Healy, P. and Whalen, J. (1999), A review of the earning management literature and its implications for standard setting, Accounting Horizons, December, pp. 365-83. Kokoszka, R.J. (2003), Recognizing the signs: internal auditors can help organizations avoid the risks associated with inappropriate earning management by understanding the symptoms and sharing their knowledge, Internal Auditor, Vol. 60, pp. 64-7. Leuz, C., Nanda, D. and Wysocki, P. (2003), Earnings management and investor protection: an international comparison, Journal of nancial Economics, Vol. 69, pp. 505-27. Levit, A. (1998), The numbers game, NYU Center for Law and Business, New York, NY, available at: www.sec.gov/news/speech/speacharchive/1998/spch220.txt (accessed 28 September 1998). McKay, B. and Brown, K. (2002), Coke to abandon forecasts to focus on long-term goals, The Wall Street Journal, 16 December. Magrath, L. and Weld, L.G. (2002), Abusive earnings management and early warnings signs, The CPA Journal, August, pp. 50-5. Ortega, W.R. and Grant, G.H. (2003), Maynard manufacturing: an analysis of GAAP-based and operational earning management techniques, Strategic Finance, July, pp. 50-6. Penman, S. (2001), Financial Statement Analysis and Security Valuation, McGraw-Hill/Irwin, New York, NY. Penman, S.H. and Zhang, X-J. (2002), Accounting conservatism, the quality of earnings, and stock returns, The Accounting Review, April, pp. 237-65. Schipper, K. (1989), Commentary on earnings management, Accounting Horizons, Vol. 3, pp. 91-102. Schipper, K. and Vincent, L. (2003), Earnings quality, Accounting Horizons, Annual, pp. 97-111. Securities and Exchange Commission SEC, Staff Accounting Bulletin SAB No. 99 (1999), Materiality, available at: www.sec.gov/interps/accout/sab99.htm (accessed August 1999). Securities and Exchange Commission SEC, Staff Accounting Bulletin SAB No. 100 (1999), Restructuring and impairment charges, available at: www.sec.gov/interps/accout/ sab100.htm (accessed November 1999). Securities and Exchange Commission SEC, Staff Accounting Bulletin SAB No. 101 (1999), Revenue recognition, available at: www.sec.gov/interps/accout/sab101.htm (accessed December 1999). Further reading DeAngelo, L. (1986), Accounting numbers as market valuation substitutes: a stud of management buyouts of public stockholders, The Accounting Review, Vol. 40 No. 1, pp. 400-20. Lipe, R. (1990), The relation between stock returns and accounting earnings given alternative information, The Accounting Review, Vol. 65 No. 1, pp. 49-71.

Measuring the quality of earnings 1015