Perceptions of earnings quality: what managers need to know.  Frances L. Ayres.

Full Text: COPYRIGHT Institute of Management Accountants 1994 Making the bottom line look better may have a negative result.

Certificate of Merit, 1992-93

Two firms, Topnotch and Lowdown, have developed new products through internal research. They both experience significant increases in earnings from sales of the products, which are expected to continue indefinitely into the future. The products are assumed to be manufacturable and salable using each company's existing capacity, and the products are of equal value for Topnotch and Lowdown. Will the earnings increases be perceived as equally valuable for the two companies?

The answer is probably not if Lowdown's earnings are perceived to be of lower quality because of certain patterns and behaviors that are thought to reduce the quality of earnings and hence the value of the signal associated with a change in earnings.

A firm that wants to provide a strong signal about future earnings performance should avoid giving the negative impression that earnings are low in quality. The capital market's perception of the quality of earnings may be as important as the underlying earnings number.

The term "earnings quality" has been defined in various ways. One view of earnings quality relates to the overall permanence of earnings. That is, high-quality earnings reflect earnings that can be sustained for a long period. Another view relates earnings and stock market performance. Under this view the stronger the relation between earnings and market returns the higher the earnings quality.

THE EARNINGS QUALITY CONCEPT

The concept of earnings quality is not new. It evolved from the fundamental analysis notion of searching for undervalued and overvalued securities, which developed in the 1930s. An under- or overvalued security was one priced at less or more than its "true" or intrinsic value. This true value could be ascertained by carefully analyzing a company's financial statements for information that would suggest a company should be trading for more or less than the present market value. Implicit in this concept is the idea that the market is not efficient and that a firm's stock price moves only gradually toward its true value.

 The concept of earnings quality became better known in the late 1960s and early 1970s. One of the best known advocates of the earnings quality approach to financial analysis, Thornton L. O'Glove, published Quality of Earnings, an investor advisory report. O'Glove's approach involves detailed analysis of the components of earnings in order to assess the degree of permanence in reported earnings.(1)

PERCEPTIONS OF EARNINGS QUALITY

Being aware of a number of factors related to perceived earnings quality can be important to a manager faced with choices that affect the bottom line. These factors may affect investors' and creditors' perception of the quality of earnings. Managers need to consider the trade-off between improvement in reported earnings and a possible negative perception of earnings quality if the improvement in earnings is perceived to result in lower-quality earnings.

To illustrate this point, consider evidence provided by Beaver and Dukes that price/earnings (P/E) ratios differ systematically among firms as a function of the method of depreciation used. Firms using straight-line depreciation, which tends to result in higher earnings, will have lower P/E ratios than firms using accelerated depreciation methods, other factors being equal.(2)

In our example at the beginning, the two firms, Topnotch and Lowdown, are the same except that Topnotch uses accelerated depreciation and has a P/E multiple of 15, while Lowdown uses straight-line depreciation and has a P/E multiple of 10. If Lowdown's use of straight-line depreciation is viewed as a signal to the market that the company is seeking to report higher earnings by slow asset writeoffs, its earnings will be perceived to be of lower quality than Topnotch's earnings. The market then may discount the future value of Lowdown's innovation. This perception can affect market participants' valuation of earnings increases even if the increase in earnings has no impact on reported depreciation. Essentially, Lowdown's use of straight-line depreciation can be viewed as a signal that the company can't afford to take the faster writeoffs associated with accelerated depreciation. In contrast, Topnotch, by using accelerated depreciation, signals its strong financial position.

Note that the P/E ratio example discussed above appears contrary to the popular wisdom that low P/E stocks are good buys while high P/E stocks may be overvalued. That is, the empirical results of Beaver and Dukes indicate that the market "sees through" the accounting method choice and capitalizes earnings at a rate unaffected by the method of accounting.

This reaction may be appropriate so long as earnings innovations result in proportionate increases in depreciation. However, if, as in the above example, the innovation results in increased earnings but no change in fixed charges, then capitalization of the earnings stream based on the pre-innovation P/E ratio would result in Topnotch's innovation being overvalued relative to Lowdown's. Lowdown's use of straight-line depreciation suggests to the market that Lowdown's earnings are lower quality because straight-line depreciation increases earnings relative to accelerated. As a result, the value of even permanent earnings increases not requiring additional depreciation charges may be reduced. The firm may convey the impression that earnings are lower quality than they really are by using accounting methods that tend to increase earnings.

FACTORS RELATED TO PERCEIVED EARNINGS QUALITY

Several factors can influence investors' perceptions of earnings quality. Managers should be aware of these factors and of the trade-offs in making accounting policy choices and in managing accruals.

One such factor is impression management, which suggests that perceptions can be as real as facts. Impression management refers to the conscious management of the image conveyed to others as a result of an individual's or organization's behavior. The area of impression management has been studied extensively by researchers in management. An excellent review of concepts and research in this area is provided in Giacalone and Rosenfeld.(3) The literature in the area of impression management suggests that the way a person is perceived can be as important to that person's success as his or her underlying qualifications. Similarly, perceived earnings quality may be as important as actual earnings quality in determining a firm's future market performance.

Two firms with the same basic financial situation can be perceived as being of different quality. This perception may be a self-fulfilling prophecy, but its potential costs can be avoided easily if managers and accountants consider care fully the implications of making choices that may solve short-run profitability problems but lead to longer-run difficulties. They must avoid choices that lead users of financial statements to conclude that one firm's earnings are of lower quality than other firms' earnings.

Income smoothing, a second factor, refers to an attempt to report a steady stream of earnings and/or growth in earnings. Various reasons have been suggested as to why managers might attempt to smooth earnings. They may believe that:

 * Smooth earnings are more highly valued,

* Smooth earnings minimize the risk of possible debt and dividend covenant violations, and

* Income smoothing can maximize management bonuses.

Earnings management refers to an intentional structuring of reporting or production/investment decisions around the bottom line impact. It encompasses income smoothing behavior but also includes any attempt to alter reported income that would not occur unless management were concerned with the financial reporting implications.

Schipper defines earnings management as "... purposeful intervention in the external reporting process with the intent of obtaining some private gain".(4)

For example, if management chooses not to undertake an advertising campaign because it thinks the campaign will not be cost effective given the revenue projections, this decision would not be considered earningsmanagement but sound decision making. In contrast, if a company has sufficient funds to undertake an advertising campaign and believes it is cost effective but decides not to conduct the campaign because of the "hit" to earnings, the decision is an example of earningsmanagement.

In general, earnings that are smoothed or otherwise managed are thought to be less informative to investors, creditors, and other users and thus are lower quality. Although some forms of earningsmanagement may not be visible to the reader of the financial statement (as in the advertising example), other forms are more visible. Certain factors have come to be associated with firms that appear to be trying to report earnings more favorable than the underlying cash flows would suggest. These factors are discussed next and are summarized in Table 1.

TABLE 1/PERCEIVED EARNINGS QUALITY
 
                               HIGH                   LOW
 
Accruals                 Consistent from          Altered frequently as
                          year to year             preacrrual income
                                                   fluctuates
 
Accounting methods:
 
Depreciation method      Accelerated              Straight-line
 
Inventory method         Last-in, first-out       First-in, first-out
 
Accounting changes       Decrease income          Increase income
                         Occur seldom             Occur frequently
 
Income pattern           Reflects underlying      Appears "managed"
                          cash flows
 
Disclosure level         High                     Low or misleading

Accrual management. Accrual management refers to changing estimates such as useful lives, collectability of receivables, and other year-end accruals to try to alter reported earnings in the direction of a desired target. While accrual management often is difficult to observe directly, analysis of patterns in accruals may reveal that the cash flow changes are moving in a different direction from accruals. Investors do not necessarily view increasing sales by a more generous collection period as good news. In so doing, a company may create the impression that it is in some degree of financial distress because financially distressed companies commonly act this way.

Adoption of mandatory accounting policies. A second form of earningsmanagement involves the timing of adoption of mandatory accounting policies. Since its formation in 1973 the Financial Accounting Standards Board (FASB) has issued 117 accounting standards--an average of more than six 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 firms 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 firm's financial picture. For example, in previously published research the author examined characteristics of firms adopting Statement of Financial Accounting Standards 52 (SFAS 52), "Accounting for Foreign Currency Translation."(5) Adoption of SFAS 52 gave the early-adopting firms (in 1981) the opportunity to increase earnings an average of $.38 per share or about 11% of pre-change earnings.

In comparison to firms that adopted the standard later, the early-adopting firms were smaller, closer to debt and dividend constraints, and less profitable than later-adopting firms. Not including the increase in earnings provided by early adoption, the early-adopting firms had an average decrease in earnings of 10%, while firms deferring adoption for one or two years (until 1982 or 1983) had earnings increases of 11%. Early adoption of accounting standards that increase income may convey an impression that a company needs to find income from wherever possible. Early adoption can lower investors' perceptions of earnings quality.

Voluntary accounting changes. Another method of managing earnings is to switch from one generally accepted accounting method to another. While a firm cannot make the same type of accounting method changes too frequently, it is possible to make several different types of accounting changes either together or individually over several periods. Furthermore, some types of accounting changes do not preclude a later change. For example, firms often expand or reduce the use of one inventory method. The use of voluntary accounting changes to manage earnings results in a signal similar to that associated with early adoption of mandatory standards--the company is viewed as managing earnings.

WHY NOT SMOOTH?

At first glance, the favorable bottom-line earnings effect may appear to be a good reason to smooth or manage earnings. If judicious use of year-end accruals can even-out temporary fluctuations, then why not do it? The answer is that by acting to smooth earnings the manager may create a new problem--investors' impressions that earnings have been manipulated can lower their perception of the quality of earnings, leading to lower market values and potential future problems in capital markets.

In contrast, what happens if a firm seeks to use accounting methods that, in the view of managers, most closely reflect underlying cash flows? If investors perceive that managers are seeking to report earnings fairly, then underlying values of the firm should reflect this perception. Temporary fluctuations in earnings will be viewed by the market as temporary, and new products and innovations will be valued at a level reflecting the underlying cash flows related to the innovation. This effect may be enhanced if the company conscientiously follows a pattern of full disclosure regarding good news and bad news. A company with a known pattern of reliable disclosure about bad news items is likely to be more credible when a good-news event occurs.

In summary, impressions do matter, and the conscientious financial manager and management accountant will take heed of some pitfalls, pointed out here, to avoid in financial reporting. A decision that provides a boost to short-run earnings can have some very real long-term costs.

1 Thornton L. O'Glove, Quality of Earnings, Macmillan, Inc., New York, N.Y., 1987.

2 W. Beaver and R. Dukes, "Interperiod Tax Allocation, Earnings Expectations and the Behavior of Security Prices," Accounting Review, April 1972, pp. 320-332.

3 R.A. Giacalone and P. Rosenfeld, editors, Impression Management in the Organization, Lawrence Erlbaum Associates, Hillsdale, N.J., 1989.

4 K. Schipper, "Commentary on EarningsManagement," Accounting Horizons, 3, 1989, pp. 91-102.

5 Frances L. Ayres, "Characteristics of Firms Electing Early Adoption of SFAS 52," Journal of Accounting and Economics, 8, 1986, pp. 143-158.

Frances L. Ayres, CPA, is an associate professor in the College of Business Administration of the University of Oklahoma. She received her Ph.D. at the University of Iowa. She is a member of the Oklahoma City Chapter, through which this article was submitted. She can be reached at (405) 325-5768.