Audit and Accounting

QUALITY OF EARNINGS and

earnings management

A Primer for Audit Committee Members

BY Roman L. Weil

» FEBRUARY 09

As an audit committee member, you are familiar with the terms

“quality of earnings” and “earnings management.” This primer

defines these terms and explains your role in performing oversight

of a company’s financial statements.

What is Quality of Earnings?1

The terms “quality of earnings” and

“earnings quality” have no single,

agreed-upon meaning. Both terms are

used when making accounting choices;

considering the business cycle, including

timing of transactions; and discussing

earnings management [see page 2].

Accounting Choices

•  ome use “quality of earnings” to mean

S

the degree to which management’s

choices of accounting estimates can

affect reported income (these choices

occur every period). For example:

those who use the term in this manner

judge an insurance company’s earnings

to be of low quality. The company’s

management must re-estimate its future

payments to the insured, by period —

and the estimates are made about long-

term imponderables, such as how long

a person will live or future earnings on

investments. Such estimates are difficult

to quantify, or fuzzy, which gives the

company the opportunity to report a

wide range of periodic earnings. The

result: even if management does not

use fuzzy estimates to manipulate its

earnings, the opportunity is there —

which causes users to think earnings

numbers are of low quality.

•  thers use the phrase to mean

O

the degree to which management

takes advantage of its flexibility. For

them, an insurance company that does

not vary its methods and estimating

techniques, despite the opportunity

to do so, has high-quality earnings.

• Some have in mind the proximity in time



between revenue recognition and cash

collection on the one hand, and expense

recognition and cash expenditure on

the other. For them, the shorter the

delay, the higher the...