Definition of Earnings Quality
According to Chaney, Jeter and Lewis (2007) earnings quality refers to the amount or value of earnings that are attributed to the higher level of sales or the ones attributed to lower costs instead of the artificial gains or profits brought by accounting activities and anomalies that include inflation in the inventory of an organization. Also, it is the ability of the firm’s income to determine and predict the future earnings of the company (Lord, 2006). It is a criterion for assessing how the earnings of the organization are controllable, bankable and repeatable amongst other concerns and factors and have been described as the level at which the earnings reflect the economic impacts.
The distinction between Permanent and Transitory Income
Any organization has both permanent and transitory earnings and their relationship have been determining financial performance of the firm. Ali, Klein, and Rosenfeld (2008) state that transitory income is a form of earning that is short lived. It is calculated or obtained from the difference between current and permanent incomes. In most cases, the expectations are that the transitory incomes should not occur again or in the future. On the other hand, permanent earnings are the ones are the one expected to be repeated or to reoccur in future. The characteristic of the income determines whether it should be under permanent or transitory earnings. Therefore, transitory earnings can be classified among the short-term earnings while the permanent is considered as a long-term earning because it is expected to keep occurring.
How Earning Management Practice affect the Quality of Earnings
Quality of earnings has been dependent on different factors among them being the management practices in relation to earnings. It is important for any organization to control its management practices to ensure smooth operations, including the improving or maintaining the quality of earnings. According to Francis, Olsson, and Schipper (2010), earning management is the planned or organized timing of expenses, revenues, losses, and gains to improve the earnings of an organization. Mostly, earning management is applied with an aim of increasing the income and earnings in the current time or situation at the benefits or expenses of the income in the future years. Furthermore, the earnings management can help in decreasing the current income with an aim of improving the income gained in the future. Nevertheless, the earning practices are the ones through which the earning reports show the aims and the desire of the management team as opposed to the underlying well-being of the company’s financial effectiveness or performance. The management can allow a way of manipulating the performance and the integrity of the organization can lose out to various illusions. The earnings management practices can encourage fraud, therefore affecting the ability of the organization to achieve the future goals. Francis, Olsson, and Schipper (2008) put it clear that the earning management practices are the ones that determine how effective the organization’s financial performance is and its future operations. The integrity of the earnings management practices guides the operation of the organization and the crookedness of the earnings management practices would destroy the effectiveness of the firm.
Company’s Permanent Earnings
In determining whether to include the gains of the company in the firm’s permanent earnings, it is essential to evaluate the amount of the loss or gain in comparison to the net gains or income. Gains and losses have been determining the profits earned by an organization and therefore comparing the losses or gains and the net income would help in determining whether to include them in the permanent earnings or not. In addition, it is important to evaluate the investment portfolio of the company. Investment portfolio plays a significant role in evaluating the stability of the company. Furthermore, it is important to review the performance of the previous year to evaluate how frequently the gains and the losses are flowing and to make a prediction of the future years. When considering all the above-mentioned factors, an individual are able to evaluate the probability of recurrence of the earnings in the future (Ali ; Zarowin, 2012). Therefore, if gains and losses are likely to occur again in the coming years, it is recommended that they should be included in the permanent earnings section or account.
The concept and components of transitory and permanent earnings have been of help to different organizations. Analysts have been using information about permanent and transitory earnings in making forecasts about annual and future earnings. The relationship between the earnings has been helping in determining the effectiveness of the organization. Earnings management practices have been playing a critical role in determining the and forecasting the importance of the earnings.
Definition of Earnings Quality