Measurement of Accounting Quality: Various Methods Pros and Cons Essay

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Before proceeding to the research, it is imperative to start by providing the meaning for accounting quality. The purpose of a financial coverage and reporting is to make the information about financial position, procedures, and changes in financial state of a body more available, as this is essential for economic decisions making. These users could be represented by the government, the investors, employees, lenders, suppliers, customers, lenders and, the public in general. But in recent times, the quality of financial reporting has being given enormous attention specifically after current accounting modifications. Although these recent interests are very high, they tend not to procreate a clear and standard definition for the term accounting quality. It is still yet not clear to understand and tough to define. Therefore, the main objective of IASB is to attract the public, and develop a single and positive definition for the term. However, despite there attempts, they have failed to present a high quality definition. In this regard, Dechow (2003, p 356) states that a just assessment of those interests application of accounting quality should be used in terms of shareholders’ interest. The researcher’s idea about accounting quality is closely associated with the relevance of data for stakeholders and the use of bespoke shareholder strategies. Under the practice of this indecisive approach, accounting quality should tend to consider the public interest in the process of upholding shareholders.

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Despite the fact a clear definition for accounting quality has failed to be mentioned correctly in the provision, most researches apply methods referred as to measures of accounting quality. Apart from others, these measures involve the earnings quality, prompt loss recognition, and the value relevance (Moralis and Curto, 2008, p. 104). They are not without advantages and disadvantages; therefore, it is necessary to discuss the advantages and disadvantages of the measures of accounting quality lucidly. Let us start by using the earnings quality.

Earnings quality

Dechow et al. (2009) believe that earnings quality is considered to be an important feature of financial reporting due to the fact that investors purchase future revenues. Earnings quality can be also defined as “the extent to which reported earnings faithfully represent Hicksian income,” which includes “the change in net economic assets other than from transactions with owners” (Demski, et al., 2006, p. 39).

It is obvious that this is a great drawback, as an approach without a clearly defined meaning is very confusing to adopt. In this regard, a plethora of definitions exists regarding different economists perceptions. In comparison with accounting quality, the earnings quality is also ambiguous and has various interpretations. Most authors relay earnings quality to the precise representation of fundamental economic transactions and proceedings. A different elucidation covers aggressiveness of earnings where earnings of higher quality are sustainable and push into the future. A more wide-ranging elucidation of the resolution idea is recommended by tying earnings quality with predictability. Maintaining those earnings of higher quality is a good display of future earnings. Therefore, it is evident that there are no clearly defined methods to follow. It is reasonable to regard earnings quality as the extent to which reported income reflects working fundamentals; some authors relate it to accounting conservation.

Despite the disadvantages pending from the definition, an advantage is from the importance of earnings for stakeholders. Preceding studies involving earnings quality have used diverse measures to attempt earnings quality. Exemplifying, Bissessur (2008, p. 40) classifies the earnings quality according to some condition: variability, persistence and predictability, dealings with cash, accruals, and income; qualitative concepts in the FASB’s conceptual framework and implementation decisions (incentives and expertise of preparers and auditors). In particular, persistent incomes are connected with larger investors responses to reported earnings, which also implies a larger variation attributed to persistent earnings (Bissessur, 2008, p. 40)

It should be stressed that practical investigations show that separate typical of earnings quality is advantageous for the predetermined by unchangeable nature of innate determinants (Fransis et al, 2008, p. 20). Another advantage of earnings quality is that it relates to and, consequently, deals with cash, accruals, and income; these variables: persistence, variability, predictability, and qualitative concepts in the conceptual framework and implementation decisions from incentives and expertise of the preparers and auditors (Bowen et al., 2002, p. 525). First, in the net profit evaluated by total assets, it is necessary to use the variability of the change. For, our explanation we are going to be using some variables, therefore from our discussion above these variables will be illustrated with mathematical explanation for a better understanding uses. Considering or where NI net income at the end of the year combined with total assets (TA), from our mathematical explanation about the variables, a higher discrepancy is associated with a lesser level of earnings smoothing. Second, in net profit to the fluctuation of the change in managing cash flows, it is necessary to use its ratio where NI corresponds to the net income and OCF identifies cash flows from operations. Firms apply increases for controlling earnings and, therefore, the change fluctuation in net income is lower than that of current cash flows. Third, we apply Spearman’s interdependence between rises of cash flows from operations and the expectations that rises and cash flows from operations are mutually depended. The Fourth mathematical explanation is the test to determine as to whether firms manage earnings towards small positive earnings (Moralis and Curto, 2008, p. 104). The main point in this test is the coefficient on small positive net income in the decline mentioned below: this is a mathematical equality where post assumes the value 1 in case the firm decides to accept IASB standards. It is also necessary to explain some of the definitions used in this mathematical formula: percentage range in sales is considered to be the growth; the percentage range in common stock is issue. The point known as the Lev that is defined as the relation between the total responsibility at the end of the year and the book value of equity. When sales are evaluated by total assets at the end of year, it can be called as Turn. Despite the accurate classification of these approaches, the shortcoming derives from the emerging difficulty of adoption. Evidently, this depicts the earnings quality working more effectively when applied with IAS standards. Another shortcoming is that the evaluation of earnings provides numerous difficulties, because many companies emphasize a variety of earnings conditions: revenues, operating earnings, incomes, and pro forma earnings (Beatty et al., 2009). In addition, companies often analyze these conditions separately. This is why the income calculations alone are useless in predicting future earnings.

Timely loss recognition

Finally, following Lara et al. (2008) and Moraliz and Curto (2008) to test prompt loss recognition, we measure it as the coefficient on the ratio of negative net income in the succeeding recession and explain it mathematically. Hence, post equals to 1 in case the company adopts IASB standards and to 0 in another case; the natural logarithm of the market value in the end of the year is the Size; the change variation in sales is referred to the growth; the change variation in common stock is the ensue; the relation between the total responsibilities and the book equity value. The disadvantage lies in sales measured by total assets in the end of the year, which is Turn; the cash flows from operations and indicator variable are assessed as 1 in case the net income is less than -0.20 (Luez et al., 2005, p. 123). Another drawback of the timely loss recognition is connected with effective works in case the IASB standards are introduced.

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Barth et al. in their research on the connection of International Accounting Standards and accounting quality have found out that these standards are more effective for developing financial reporting standards than non-US domestic standards (2005, 468). According to the results of the study, the principles-based standards issued by the International Accounting Standards Board reflect a more accurate economic position and performance of a company. In addition, the researchers have discovered that IAS display “less earnings smoothing, less managing of earnings toward a target, more timely recognition of losses and a higher association of accounting amount with share prices and returns” (Barth et al., 2005, p. 496). This investigation proves that the above-mentioned standards is one of the best methods for defining the extreme transparency of companies’ financial reports due to the fact that IAS also provide managers with more general requirements and accurate information.

Value relevance

Hitchner (2003, p. 192) were the first to report that stock prices react to the information disclosed in financial statements. He believes that stock prices differ from those indicated for financial statement data, which is explained by the idea that the investors and shareholder generally rely on the stock prices to guide and to control the company (Hitchner, 2003, p. 192). However, Alford et al. (1993) apply the term value relevance in the context of efficient accounting data disclosing information used by just investors. Since then, quite a lot of studies have examined the price-earnings relation with the use of diverse variables. Unlike the earnings, quality of earnings that emerge with the acceptance of IASB Standards, recent research has discovered that there is a decrease in value relevance of accounting information with the assumption of IASB standards (Dechow et al., 1996, p 4).

There have been arising questions patterning the use of these measures. Even though there has been an absence of a decision context, the earning quality remains the appropriate measure for accounting quality. This is explained by the fact that earnings quality is the key point for evaluating the financial stability; it is an instrument that should not be underestimated by investors, and creditors. Earnings quality covers the ability of reported incomes to outline the company’s true revenues and predict future earnings (Beneish, 1997, p. 274).

In conclusion, it should be also stressed that the measurements presented in this paper have both advantages and disadvantages. Therefore, it is hard to define which one is the most effective one so that it is better use them in combination with each other. Due to the fact that the income quality prevails, there is an urgent need for the identification of a clear definition and a effective model to measure income quality. It should be also stressed that recently obtained research does not coherently make a distinction in terms of the impact of a firm’s basic earnings process on the decision efficacy or quality of its earnings from the effect of the relevance of accounting measurement to that process. Existing research attention has centered on earnings management that moderates the dependability of earnings more willingly than on the ability of precise features of an accrual-centered accounting system to make a more decision-useful measure available for the firm’s fundamental earnings process which is conditional. Generally speaking, the quality of earnings is closely associated with the scope of incomes and their maintenance and competence in future to predict further accounting periods. The above shows that accounting evaluates the approaches used by the company to influence the quality of earnings. Managers have been constantly searching to incomes target, since management has options in terms of positioning these income constituent parts. Finally, the paper also reveals different standards for measuring earnings quality like domestic and international approaches. Anyways, the latter is more relevant as its presents a wider range of norms and requirements that make the financial data more accessible for the companies’ members and for the public.

Reference

Alford, A. et al. 1993. The relative informativeness of accounting disclosure in different countries. Journal of Accounting Research, v. 31, p. 183- 223.

Barth, M. E., Landsman, W. R., and Lang M. H. 2005. International Accounting Standards and Accounting Quality. Journal of Accounting Research. 46(3), pp. 467-498.

Beatty, A. L., Liao, S., 2009. Regulatory Capital Ratios, Loan Loss Provisioning and Pro-Cyclicality. Web.

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Beneish, M.D., 1997. Detecting GAAP violations: Implications for assessing earnings management among firms with extreme financial performance, Journal of Accounting and Public Policy, 16, pp. 271-309.

Bissessur, S. W., 2008. Earnings quality and earnings management: the role of accounting accruals. UK: Rozenberg Publishers.

Bowen, R.M., A.K. Davis and S. Rajgopal, 2002. Determinants of revenue reporting practices for internet firms, Contemporary Accounting Research 19, pp. 523-562.

Dechow, P. M., Ge, W., and Schrand, C. M., 2009. Understanding Earnings Quality: A Review of the Proxies, Their Determinants and Their Consequences.

Dechow, P., S. Richardson and Tuna, I. 2003. Why are earnings kinky? An examination of the earnings management explanation, Review of Accounting Studies 8, pp. 355-384.

Dechow, P., Sloan, R., and Sweeney, A., 1996. Causes and consequences of earnings manipulation: An analysis of firms subject to enforcement actions by the SEC, Contemporary Accounting Research, 13, pp. 1-36.

Demski, J. S., Antle, R., Gjesdal, F., and Liang, P. J., 2006. Essays in accounting theory in honour of Joel S. Domski. US: Springer.

Francis, J., Olsson, P., and Shipper, K., 2008. Earnings Quality. US: Now Publishers Inc.

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Hitchner, J. R. Financial valuation: applications and models, volume 2002. US: John Wiley and Sons.

Lara G., Osma M. J., Garcia B., and Neophytou, E., 2008. Earnings Quality in Ex-Post Failed Firms Accounting and Business Research, Forthcoming.

Lee, T.A., R.W. Ingram, and T.P.Howard, 1999. The difference between earnings and operating cash flow as an indicator of financial reporting fraud, Contemporary Accounting Research, 16, pp. 749-786.

Leuz, C., Ptaff, D., and Hopwood, A., 2005. The Economics of Accounting: International Perspectives on Research Trends, Policy and Practice. UK: Oxford University Press.

Moralis, A. I., and Curto, J. D., 2008. Accounting quality and the adoption of IASB standards – Portuguese evidence. Annual Congress of the European Accounting Association, 19(48), pp. 103-111.

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