Earnings Management

1. Provide a context for the concept of “earnings quality”

Earnings quality is a concept that covers multiple accounting concerns and consists of

two‭ ‬ ‭ ‬main‭ ‬ ‭ ‬elements.‭ ‬ ‭ ‬First,‭ ‬ ‭ ‬it‭ ‬ ‭ ‬touches‭ ‬ ‭ ‬on‭ ‬ ‭ ‬the‭ ‬ ‭ ‬idea‭ ‬ ‭ ‬that‭ ‬ ‭ ‬the‭ ‬ ‭ ‬accounting‭ ‬ ‭ ‬is‭ ‬ ‭ ‬a‭ ‬ ‭ ‬fair representation of the firm’s performance.

For this first element, the idea of accounting being a fair representation of the firm’s

performance entails the removal of bias, especially management bias, from the firm’s

financials. Bias can occur via a manager’s optimism or a manager’s incentive to report

numbers pessimistically.

Whether or not a firm’s financials is a fair representation of its performance is also

difficult given the fact that there can be subjectivity in choosing among accounting

principles, not to mention the additional uncertainly that arises because estimates are

often used when applying these principles.

Second, earnings quality entails the idea that the information that’s provided is relevant

for forecasting the firm’s expected earnings and future financial position.

2. Why is Harry Malone concerned about relying on Nuware’s reported

performance? If‭ ‬ Nuware follows‭ ‬ GAAP‭ ‬ shouldn’t‭ ‬ the‭ ‬ financial ‭ ‬statements ‭ ‬be

reliable?

In this instance, Harry Malone is particularly concerned about relying on Nuware’s

reported performance given the in depth research done on R.P. Stuart, his personal

relationships ‭ ‬with ‭ ‬R.P. ‭ ‬Stuart‭ ‬ ‭ ‬management, ‭ ‬his‭ ‬ ‭ ‬belief‭ ‬ ‭ ‬in‭ ‬ the‭ ‬ ‭ ‬transparency‭ ‬ ‭ ‬of‭ ‬ their reporting and ‭ ‬the ‭ ‬fact‭ ‬ ‭ ‬that though Nuware and R.P. Stuart‭ ‬ ‭ ‬have ‭ ‬virtually identical business models, R.P. Stuart struggled to match last year’s profitability and Nuware increased its earnings by almost 20%.

Theoretically‭ ‬ ‭ ‬firms‭ ‬ ‭ ‬that‭ ‬ ‭ ‬follow‭ ‬ ‭ ‬GAAP‭ ‬ ‭ ‬should‭ ‬ ‭ ‬release‭ ‬ ‭ ‬reliable‭ ‬ ‭ ‬financial‭ ‬ ‭ ‬statements....