The Behavior of Earnings - Literature review Example

Name : xxxxxx Tutor : xxxxxxx Title : The Behavior of Earnings Institution : xxxxxxx @2010 Earnings as a general term refer to what a firm, an industry or a business organization gets out of its investment inclusive of offering of goods and services to the target customers or market. There are several properties of earnings that are used in its analysis. These include persistence of earnings and quality of earnings, among other properties. Persistence earning is the measure of how stable the current earnings are in the prediction of future earnings (Bernard and Thomas 1990). Quality earnings on the other hand refer to the total earnings which are attributable to increased sales or decreased costs instead of artificial profits which are brought into existence by anomalous accounting in such areas as inventory and inflation (Knechel et al., 2007). Considering the persistence of earnings, there are two main factors that affect its outcome. These are the magnitude and the sign of the accruals. Accruals could be looked at as ‘the difference between accrual earnings and cash earnings’ (Sloan 1996 pp. 289-315). Firms that experience high accruals tend to realize an improvement it its earning persistence. This is relative to the cash flow realized or recorded by the firm at the end of the financial accounting term or year. On the other hand, those firms that experience low levels of accruals normally realize a reduction in the earnings persistence relative to the flow of cash in the firm at the end of every financial year or term. This can be demonstrated as the realization of low or reduction in earning’s persistence especially in the firms with low accruals (Card 1996). This has been proved by researchers such as Fairfield, Whisenant and Yohn (2003) to be primarily initiated by the adjustments made to the balance sheet specifically those relating to items that are considered special. It is also evident that firms that have got special items tend to have high possibility of earning much higher stock returns in future even if they are experiencing low levels of accruals compared to firms with low accruals and have got no special items. This analysis of earnings persistence is sometimes a challenge especially to investors who wish to invest their money or other forms of resources in various firms. Most of them misunderstand the transitory nature of accruals and that of special items in relation to the firm’s earnings persistence (Ananth 2002). Special items are those items which are outside the normal operations of a business, and which a company may choose to report on after the ‘income tax expense on their income statements’ (Helfert 2001 pp. 40). These special items may include discontinued operations, or a variation in the principle of accounting. It is argued that high levels of firm’s accruals are most likely to be the result of rules with a descriptive perspective statement of income while realization of low accruals is a result of the rules with a perspective statement of a balance sheet and these two have a high implication on the outcome of the earnings properties. Further analysis shows that low accrual firms with special items have been facing financial distress apart from their poor performance and this has left them with no investors without understanding that the special items are likely to control the future returns of the firms and there is a likelihood of turning around the performance of the firm in future. Failure to understand this leads to investors not investing in low accrual special item firms without any clue that there is a chance for everything to successfully turn around in future with requisition of high performance (Anderson 1982). Therefore, stable firms need to show some considerable level of persistence in its earnings and with that in place, the investors both from inside and outside the firm are most likely to commit their resources in the firm even if the earnings are not high enough to the level expected. Firms that realize non-persistence in earnings should take a step of coming up with special items that are likely to reflect as an outcome on the balance sheet statement so that such firms might revive their abilities of performing well again in future. The dreams of such firms to regain persistence in their earnings only lie in the special items as described above. There are several possible motivations that make the firm examine its persistence in earnings. One of them is the need to measure the performance of the firm. Examining the persistence of earnings helps the firm to come up with a clear illustration on how it is performing financially. A firm with a persistent earnings record tends to be well performing compared to firms with non-persistent earnings. Therefore the need to know whether the firm is performing well or not is one of the possible motivations that spearhead the examining of the firm’s earnings persistence (Ralph 2003). The need to estimate profits or losses is also one of the factors that motivate examining of earnings persistence of a firm. There is a great need for each and every profit oriented firm to carry out an evaluation of its earnings and the expenditure to determine whether it is making profit or loss. During this process, the earnings of a firm are evaluated consistently from one year to the next and from the analysis, one is able to draw conclusions whether the firm has been persistent in its earnings over the years or not. Another possible motivation for examining persistence of earnings is the need to know the quality of the earnings. Quality of the earnings and the persistence of earnings are both properties of earnings and are much related. High quality earnings are evident in firms that have got persistent earnings and the opposite is true for firms with no persistence in earnings. Therefore, the need for firms to achieve high quality earnings motivates them to examine whether the firm is recording persistent earnings. The other one is attracting investors. Investors are important resource to any firm since they give in capital for investment by the firm. Before they decide to invest in a firm, they need to know the performance of the firm as well as the persistence of the firm’s earnings. Thus they motivate the firm to carry out an examination of he earning’s persistence of the firm so that they can present the outcomes to the investors. By doing so, the investors act as a possible motivation for examining the earnings persistence of a firm (Sherwin 1999). Customers are also one of the stakeholders that motivate examination of the earnings persistence of a firm. Customers are vital to the firm and are the main source off earnings for the firm. In order to create loyalty among customers, the firms are encouraged to examine their persistence in performance and publish the records to the customers so that they can establish customer loyalty. Each organization that is profit driven would like create a good image of itself in the eyes of its customers. By doing so, customers act as a motivation for examination of earnings persistence of the firm which is one of the factors that are evaluated when measuring the performance of a firm. Motivations for examining the persistence of earnings also come from employees including the senior management who have several targets to meet in terms of performance. By evaluation of the persistence of earnings, the employees’ performance is also in evaluation and this is the main source of obtaining corrections that are needed to improve performance depending on the outcome of the evaluation. Achieving persistence in earnings is in itself a motivation to the employees. Legal requirement for firms to publish their performance records after the end of every financial year is also a possible motivation for examining the persistence of earnings of a firm. Since every firm is required by law to produce a statement of income and a balance sheet statement after the end of every financial year, this acts as a motivation to all the firms to examine their performance including their earning’s persistence. Lastly, competition from rivals venturing in the same business activity is a source of motivation to the competing firms to examine their earnings performance. When the earnings are persistent compared to those of the competitors then the firm is stable and is likely to out compete its rivals but when the earnings are evaluated as non persistent over a period of time, then the firm is likely to be out competed by its fellow competitors (Sherwin 1999). There are several factors that impact on the persistence of a firm’s earnings. One of them is the level of accruals. Fairfield, Whisenant and Yohn (2003) in a research they carried out report that firms with high levels of accruals tend to exhibit high persistence in their earnings as compared to firms with reduced or low levels of accruals. The other factor is the size of the firm. Talking about the size of the firm does not mean the size in terms of physical appearance but rather the size in terms of production capacity and product lines. A larger firm is described as the firm with a multiplicity of product lines. The advantage of larger firms is that incase of failure in performance or expected outcome in one product line, the other product lines are available for compensation or replacement, unlike firms with few product lines. This means that firms with diversified product lines are likely to realize persistence in earnings compared to firms with limited product lines (Heckman 2002). Availability of special items especially for firms with low level of accruals is also a factor that affects the firm’s persistence of earnings. Low accrual firms with special items are likely to realize persistent earnings especially in the long run compared to firms’ with low accruals but have no special items thus are likely not to be persistent in their earnings. There is also the issue of competition. When a firm faces stiff competition from competitors venturing in the same business, the firm is likely to realize inconsistence in its earnings and this affects persistence of its earnings. The shift of customers from one firm to the other affects the expected performance of the firm especially in terms of the earnings expected and thus the persistence of earnings is also affected. Firms that enjoy monopoly faces inconsistence in terms of earnings on very rare occasions therefore, they are likely to achieve a high level of persistence in terms of earnings as compared to firms that face stiff competition. Labor turnover as one of the factors of production is likely to have a huge impact on the persistence of the earnings of a firm. Firms that experience frequent labor turn over record low persistency in their earnings compared to those firms with very low labor turn over. this is because a lot of resources are used to replace the employees exiting the organization as well as a possible reduction in client base due to a poor reputation. Quality of production is also another factor. Consistency in the production quality or continual improvement of the quality of production establishes customer loyalty and thus fluctuation in terms of the firm’s earnings is very minimal thus the firm is likely to maintain a persistent earnings record. However firms that are inconsistent in terms of quality of the products they produce are likely to lose customers to competitors due to poor quality products and this directly affects the expected earnings of the firms and thus the persistence of the earnings is also likely to be very low or generally reduce. Investors also have an impact on the firm’s persistency of earnings. If the firm receives low investment opportunities from investors then it is likely to fail to meet the expected level of earnings and this affects the persistency of the earnings. However firms that attract investors receive more investment capability from the resources brought about by the investors thus can venture in several product lines to ensure persistence in the earnings of the firm. Lastly, the risk factor also plays an important role. Risks are uncertainties that may be expected or not expected by the firm and all depends on how well the firm management has planned for various risks. A risk can be a tragedy to the firm and once this is the case, the performance of the firm in terms of expected earnings may be adversely affected thus it is recommended that firms need to diversify their possible risks so that in case of risk occurrence, the firm does not suffer a total loss in terms of earnings. One way of diversification of risks is by planning for alternative product lines in products that are highly susceptible to the risk. Incase the risk occurs, a replacement is available and the firm only suffers an insignificant loss. Firms that poorly plan for risks that are likely to be involved suffer substantial loss incase the risk occurs, therefore firms that diversify risks are likely to achieve higher persistence in terms of their earnings as compared to those firms that does not diversity their risks (Tatyana 2007). Determining the persistence of earnings is a very vital activity to researchers and analysts. There are several empirical methods employed by researchers to determine the persistence of earnings. The most commonly used method is the “threshold autoregressive panel unit root approach” (Behrman 1989, p.28). In this method, there is a proposal of reassessment of the hypothesis which states that the current earnings persistence performance is expected to decrease in the direction of accrual earnings magnitude and increase in the component of cash flow earnings magnitude. With this in mind, a fisher type is then used by these researchers of the autoregressive unit root panel to determine the persistence of earnings. In this method or approach, there is application of conditioned and unconditioned measures of persistence. First, the researchers distinguish between these measures of persistence and this allows them to infer whether the component conditions of earnings are persistence. One of the main examples where this approach was applied is in Brazil. Here, samples of about one hundred and twenty six firms were put under study to determine their earnings persistence within the period of ten years starting from 1997 to the year 2007. The results were that the persistence of the earnings of the firms that were under investigation showed a heterogeneity among the sample firms and generally there was a relatively low measure of unconditioned earnings persistence across the sample firms. A partial rejection of the initial hypothesis as mentioned above proved fruitful especially considering the impacts or consequences of components of accruals over the persistence of earnings of the firms that were sampled for the research study (Greenwood 2001). By application of this method of determining earnings persistence, researchers such as Fairfield, Whisenant and Yohn (2003) found that firms that experienced high accruals indeed realized an improvement it its earning persistence. This is relative to the cash flow realized by the firm or recorded by the firm at the end of the financial year. Those firms that experienced low levels of accruals realized a reduction in the earnings’ persistence relative to the flow of cash in the firm at the end of the financial year. Thus the method simply involves determination of the accruals earned by the firm over a given period of time in relation to the cash flow of the firm and from this, they compare and contrast the outcomes from one year to the next. With thorough evaluation, the persistence of earnings is easily estimated from the variation of the accruals. Low variation in terms of cash flow shows persistence in earnings while high variation of cash flow over the duration means that the earnings of the firm are not persistent. However, high accruals levels show high persistence while low accrual levels show slow persistence levels. The other approach of determining earnings persistence is by use of earnings response co-efficient. In this method, analysts use capital markets by relating the firm’s accounting earnings and the firm’s security earnings. In this model, the variable for the returns realized by the firm which is also termed as the earnings of the firm are primarily determined by the level of earnings, the change in earnings and the combination of both the level and the change in earnings. In this method, there is a determination of the persistence of earnings with an assumption that earnings of a given firm are either entirely transitory or completely permanent. But in cases where there is a mixture of transitory and permanent earnings components, the earnings response co-efficient is determined and it is from this determination of earnings response co-efficient that the earnings persistence is determined (Krueger 1999). When combining both the permanent and transitory earnings to get the persistence of earnings of a firm by employing the level and the changes in earnings, the result is termed as the waited average of the firms earnings. There is also estimation of those earnings that are unexpected and when these are combined, the results become more consistent as well as the latter. Kruger says argues that at this level, it is important to simply compare and contrast these waited average results of firms under the study from period to period and they can now easily determine the earnings persistence by verification of the difference in waited average of earnings from year to year. Considering this context, the empirical studies that were carried out previously by other researchers such as Foster, Olsen and Shevlin (1984) tend to show that the levels variable are very important additions to the changes variable especially when there is transitory components in the firm’s earnings. Considering this approach, evidence was gathered that the level earnings and the change of earnings as scaled by the price are the major fundamental explanatory measures of the earnings persistence of a firm. When the two are analyzed properly, then there is an assurance of correct estimation or determination of the firm’s earnings persistence over the decided period or duration of evaluation (Behrman 1989). An Association between earnings persistence and earnings quality has been established by Kormendi and Lipe (1987). Earnings quality is a very vital aspect that is used in determination or evaluation of the financial health of a firm entity. Although many financial statement users including investors and creditors overlook this aspect, this is the main basis of a reflection of the true earnings of a firm. The earnings quality can be described as the ability of prediction of future earnings of a firm from the reported earnings. It also refers to persistence, stability as well low variability or no variability in the reported earnings. Considering the description of quality earnings, there is a great empirical association evident between the earnings quality and the persistence of earnings. One of the associations is that both of them can be used to draw conclusion about the expected future earnings of a firm entity. If the earnings of the firm are persistent over a period of time, then it is easy to project the expected earnings in the coming period compared to a situation when the earnings are not persistence or are variable. The same case applies to a situation where the firm is experiencing quality earnings. When the earnings quality of a firm is persistent, then it is easy to draw future conclusions or prediction on the expected performance. In order to evaluate or determine the earnings quality, the earnings quality assessment model is used. In this model, there is determination of the reported earnings as well as the changes in the earnings over the period to which the evaluation has been done. From this, the earnings quality is determined by comparing and contrasting the outcomes of both the level and the changes of reported earnings over the duration of assessment. If the reported earnings show considerable or substantial variations over the years, then the earnings quality of the firm is low but if there is consistence in the reported outcome of the reported earnings even if the earnings are low, then the earnings are described to be of high quality. This mode of determination of earnings quality seems to be same in principle as the models discussed above for determination of the earnings persistence of a firm (Gottschalk 1994). From the foregoing, it can be established that the persistence of earnings plays an important role in determining the profitability of an organization. The organization’s earnings and the return of abnormal profits are greatly influenced by the level of the persistence earning of that organization. If the organization posts a higher persistence of earning, it will have a positive association and it organization’s activities after such a posting will be positive. when the persistence of earnings are low on the other hand, it will the organization will have a negative association and this will consequently lead to a negative perception of the organization by stakeholders, which will negatively affect its post-posting activities. Organizations can take advantage of this by using accounting and economic fundamentals which help achieve a positive persistence of earnings. a good example is in the stock market where stock prices rise or fall depending on the organization’s ability to sustain a positive persistence of earnings, or its failure and consequent positing of negative persistence of earnings. This is an indication that the value of the persistence of earning in organizations cannot be overemphasized. Bibliography Anderson, D., 1982. 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