CASE 52 Earnings Quality

Economic income is considered to be a better predictor of future cash flows than accounting income is. A technique used by securities analysts to determine the degree of correlation between a firm's accounting earnings and its true economic income is quality of earnings assessment.

Obtain an annual report for a large corporation and perform a quality of earnings assessment using the format below.

1.Compare the accounting principles employed by the company with those generally used in the industry and by competitions.Do the principles used by the company inflate earnings?

2.Review recent changes in accounting principles and changes in estimates to determine if they inflate earnings.

3.Determine if discretionary expenditures, such as advertising, have been postponed by comparing them to previous periods.

4.Attempt to assess whether some expenses, such as warranty expense, are not reflected on the income statement.

5.Determine the replacement cost of inventories and other assets.Is the company generating sufficient cash flow to replace their assets?

6.Review the notes to financial statements to determine if loss contingencies exist that might reduce future earnings and cash flows.

7.Review the relationship between sales and receivables to determine if receivables are increasing more rapidly than sales.

8.Review the management discussion and analysis section of the annual report and the auditor's opinion to determine management's opinion of the company's future and to identify any major accounting issues.