The concept of earnings quality has roots in the judgmental nature of accounting, which can be seen in the fact the different parties may interpret the economics underlying a transaction differently, and different firms may have different business characteristics.
Interpretation of underlying economics The interpretation of the economics underlying a transaction and even the wording of the accounting standards can vary between firms. This, along with the fact that a firm's
financial statements are the responsibility of the firm's management, allows management to structure transactions to achieve desired accounting results, by choosing an interpretation of the economics underlying the transactions that may be different from another party's. This use of judgment by management thus increases the chances that the earnings presented in a firm's financial statements may have been
manipulated.
Differing business characteristics Furthermore, the fact that firms have different fundamental business characteristics increases the possibility of error in or manipulation of presented earnings. For example, companies that operate in different industries may use a given machine for entirely different purposes or wear out a given machine at dramatically different rates, which makes it appropriate to allow management to choose between alternative
depreciation methods and
useful lives to be applied to the use of the machine. This discretion, however, increases the possibility for firms to make both honest mistakes, such as the accidental use of a wrong useful life, or to
manipulate earnings.
Earnings quality and ways to lower it The above factors lead to investors needing to assess the extent to which a firm's reported earnings are free from mistake or manipulation, i.e. the quality of the firm's earnings. Other ways
accounting choices can lower a firm's earnings quality include • Recording
revenue too soon or of questionable quality, • Recording fictitious revenue, • Boosting income with one-time gains, • Shifting current expense to a different period, • Failing to record or improperly reducing
liabilities, • Shifting current revenue to a later period, and • Shifting future expenses to the current period as a special charge ==Assessing earnings quality==