Persistence and Quality of Earnings - Literature review Example

CRITICAL ANALYSIS: LITERATURE REGARDING PERSISTENCE AND QUALITY OF EARNINGS. Critical analysis: literature regarding persistence and quality of earnings. Abstract The research focuses on critically analysing the past literature concerned with ‘persistence of earnings’, classifies and explicates the diverse existent probable motivations for investigating the persistence of earnings, the research further explores on the factors that impact on the persistence of a firm’s earnings, while considering the impacts of quality of earning on firms where earnings have persisted over time. Several researches suggests a perception that earnings volatility is inversely related with earnings, the paper articulates and analyse critically the empirical methods utilised by researches in deriving the empirical evidence of an association between earnings persistence and earnings quality suggesting that precariousness is an outcome of economic and accounting factors, which significantly and predictably reduce earnings. The research uses several secondary sources of information to critically examine the effect of persistence of earnings on the quality of the earnings, while appreciating that there are several influences other that the persistence of earnings over time and considering Beaver’s theory on the relationship between earnings quality and the value of common stock. The paper is based on empirical papers on persistence and quality of earnings as well as past performance and persistence of organizational earning, which seeks to proposition the existence of negative and positive correlation between the quality of earnings and the persistence over time of the earnings. Considered are the aspects diversity of the influences on the earnings persistence and quality, which may not be within organizational control. The research shall be theoretically founded on the time series behaviour of earnings as proposed by Beaver, (1970) which shall provide the motivation for examining the persistence of earnings, the motivations to be considered are relative forecast ability of alternative income measurements, income smoothing and interim reporting, (Beaver, 1970) where issues such as the distribution of long-term growth rates, whether good performers can be identified ex ante and the opinions regarding persistence in operating performance of a firm. The study shall utilize qualitative researchers which aspires to congregate an in-depth understanding of earnings quality and the raison d'être that govern such qualities, this shall be combined with inductive and deductive reasoning. The research shall be secondary research which involves summary, collation and/or synthesis of existing research in terms of systematic reviews. The knowledge base in terms of collected data shall be analyzed and suggestive conclusions derived, which is envisioned to assist stakeholders, investors and organizations objectively perceive and manage the quality of earnings, without only concentrating on the quantity of the earnings. Introduction Quality, persistence and predictability in earnings have been touted by several past researches as a contentious issue. Schipper and Vincen (2003), defined earnings quality as the degree to which accounted earnings authentically symbolize Hicksian Income, where representational faithfulness means correspondence or agreement between a measure or description and the phenomenon that it purports to represent. This is related to the research by Ball and Brown (1968) and Beaver, (1970) which recognized and founded the convention of an anomalous returns variable to an unexpected earnings variable. Earlier researches on earnings viz-a-viz projections, such as Beaver,(1968) were instrumental in establishing a relationship between earnings and predictability, this was fostered by other authors such as Brown et al. (1987) who focussed on basing historical earnings data to compare the accuracy of analysts to time-series models, agreeing with several other researches that analysts' earnings conjectures are relatively precise than forecasts from past time-series of earnings. According to Beaver, (1968), the information content of earnings is of prevalent importance and is an important consideration of metrics in accounting where is has been a source of controversy. Beaver, (1968) further suggests that valuation theory determines the relationship between earnings and the value of common stock, in essence Beaver, (1968), concentrates on the extent of Information offered in earnings in consideration of the quality of earnings Literature review Numerous researches exist on the persistence of earnings; most of the researches conform to the theorem proposed by Beaver, (1968) which is supported by the findings of Luttman and Silhan, (1995) who argues that the extent to which reported earnings most accurately reflect underlying conditions and events could be used to describe the quality of the earnings. However, (Kormendi and Lipe 1987) argues that the notion of the quality of earnings is founded on the condemnatory temperament and 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. Studies have engaged several empirical methods to determine the persistence of earnings Most of the literature on earnings persistence literature has engaged time-series model, including the Moving Average Auto-regressive, Integrated, model often referred as the (ARIMA), to calculate approximately the measure of earnings persistence, Dichev, (2003). The empirical method used by the researches which are based on time series has several advantages as argued by Ball and Brown, (1968), the principle merit is that the models such as ARIMA have optimality and are highly comprehensive. Critically analyzing the empirical methods however point out several shortcomings, such as having a lower aggregate base in comparison to other models such as smoothing. Furthermore, the empirical models which are based on time series have difficult identification, with limited structural interpretation and are immensely time consuming. Furthermore, the empirical models utilized by researches may not be easily explainable to others and corresponding models on chronological statistics may offer dissimilar forecasts. In addition, models based on are time consuming with limited Identification and estimation accuracy which can be imperfectly distorted by outlier effects and are dependent on automatic identification stratagem that surpass connoisseurs and alternative approaches such as exponential smoothing. Some researches have employed exponential smoothing to determine the persistence of earnings. In this regard, the technique in utilized on time series data and information to generate smoothed data for forecasting or presentation purposes. In determining the persistence for forecast purposes, the studies implement a weighted moving mean of the previous data as the foundation for a forecast and that the exponential smoothing methods output relatively less weight to observations that have existed for a longer duration of time, when compared to the more weight awarded to observations of more recent information. On the persistence of earnings, the occurrences of information of relatively more recent past may be more critical and important than related observations of financial information of relatively more distant past. On critical examination of the method, it is effective and valuable in circumstances of random demand where seasonal fluctuations in the data do not exist. The time series models which have been utilised and implemented in several researches in determination of the persistence of earnings however require a long time span of financial reports in order to be effective. Several researches on the earnings persistence have focused on the extensive duration of earnings, this is essential to investors for appraisal principles, where earnings persistence is in most cases especially tied with quick en masse investor reactions to reported earnings, and is a commonly used representation of earnings quality, Schipper and Vincent (2003) and other researches have portrayed discrepancy persistence as regards earnings, accruals and cash flows. There are diverse factors which influence the persistence of firms’ earnings. According to Yeo, (2003) there have been several researches of factors influencing the volatility and magnitude of the earnings response coefficient, which is defined as the coefficient on measures of unanticipated accounting earnings in degeneration of anomalous share market returns on the specified and diverse variables. Erratic behaviour portrayed by the earnings response coefficient is some circumstances has been attributed to risk which has been a significant factor in determining the behaviour of persistence of earnings. In addition, the persistence of earnings in organizations has been supported by researches such as Dhaliwal and Reynolds, (1994) which presents empirical evidence suggesting that the persistence of earnings is influenced by the default risk measured by bond ratings. The default risk is portrayed to be inversely related to the magnitude of the Earnings Response Coefficient (ERC), hence being concomitant with the concept that high intensity of default risk is expected to be related with market perceptions of lower persistence in the least unexpected constituent of reported earnings, as a result the influence of whichever extend of unexpected earnings on uncharacteristic market returns would be respectively reduced, this suggests that the persistence of earnings in influenced by the default risks as well as systematic risks. Ahmed, (1994) argues that persistence of earnings is not per se an outcome of the quality but also influenced by investor disagreement over information interpretation which leads to increased trading activities, the researches point out from the results of the analysis and implications that speculations such as rumours is positively linked with trading activity. According to the research a greater coefficient of variation of analysts forecasts of EPS means higher trading volume, this is in agreement with the other studies which point out that that the persistence of earnings, is usually gauged from the trading volume perspective (quantity) rather than the quality of the earnings. Other researches have argued that Contracting Motivation also referred to as Debt Covenants impact on the persistence of a firm’s earnings. Since debt covenants influence a firm’s capability to have access to funds such as loans. In most cases creditors investigate net income as pointer of potential prospected net cash inflows, where the percentage between total debts to total capital is a pointer to economic stability. Firms tend to manipulate the earnings to reflect strong potential to generate future net cash inflow hence enhancing the possibility of accessing capital. Other researches have concurred that the persistence of earnings is influenced by the efficiency of the governing boards where executives of a firm can substantially alter the earnings reports to reflect strong financial positions. The governance systems and the government supervisory and regulation procedures influence the persistence of earnings since the regulatory environment may change over time, hence altering the persistence of earnings in an organization. In weak regulatory environments, the supervisors may also be interested parties in the firms, hence resulting to conflicts of interests, where firms can substantially alter earning reports, hence influencing the persistence of earnings over time. The persistence of a firm’s earnings can also be influenced by attitudes and rationalizations, where the firms tend to save for the perceived better future by reducing or current reported net income, by such means as writing off assets and setting up provisions for expected future costs. Income smoothing by firms also includes attempts to decrease reported net income volatility. Some researchers such as Collins and Kothari (1989) have a different opinion observing that normally investors do not respond exceptionally to earnings persistence, arguing that unforeseen earnings transformation may be induced by unsystematic risk factors. Possible motivations for examining persistence of earnings are the apparent differences in organizational projected earnings and the actual earnings. In this case, there exists a probable growth rate inherent in a stock’s valuation however; the expected projection may not essentially be achieved. The relationship between the earnings persistence and the quality of earnings also formed the basis for the motivation; this was fostered by the need to appraise the empirical methods employed by researchers to determine the persistence of earnings. There are several influences on the persistence and quality of earnings, the relationship between the quality of earnings and persistence of earnings is therefore evaluated from a diverse perspective and angles of view. Among the agile evaluation metrics are the level, trend, and stability of earnings, where fluctuations in earnings call for in-depth analysis on determining the cause of the fluctuations in an attempt to estimate future earnings. An important evaluation metric is also on the quality and sources of earnings where the primary sources of income as determined for their recurrence in future. Earnings that are a result of non-recurring sources are more likely to be viewed as being of relatively lower quality, furthermore earnings quality is influenced by the provisions for loan losses, where the provisions should substantively cover the risk identified in the loan portfolio. The quality is also influenced by the ability to augment capital through retained earnings more so during rapid growth or escalating risk times. Exposure to market risks, also influences the quality of the earnings, such as in banking scenario where exposure is focused in interest rate risks. The influence of persistence of time is therefore of limited concern, Lopez and Rees, (2002). Persistence quantity versus quality consideration In most earnings reports quantity (not quality) tends to be more considered in annual reporting seasons, where share prices are influenced by the achievement of the estimates and inexpert investors tend to focus on the actual monetary earnings. However, savoir-faire investors focus on the quality of those earnings, since it is to a large extent superior metric of future earnings performance. Elevated earnings generate more Price to Earnings (P/E) multiples and within a longer span of time, be predisposed to outperform the average market earnings. Some researches have argued that the time span of organizational earnings play a role in defining quality, where other measures such as repeatability, controllability and the possibility of the being bankable being the measurement criterions. Time is an imperative influence in the quality of earnings considering that repeatable earnings are more likely to influence the quality. There some sources of earnings, which may portray a positive inclination on the earnings, however if the source is not repeatable, then the quality of the earnings is arguable, these includes the sale of assets which is under no circumstances repeatable since assets cannot be resold to generate more earnings once sold. There are some sources of quality earnings which are repeatable such as cost cutting measures including the installation of new technologies, and sales growth. Controllable Earnings also affect the quality of earnings; there exists diverse factors affecting organization’s earnings which cannot be internally controlled by the organization, whereas the issue of persistence of the earnings may be due to external constructs. The persistence of earnings may be influenced by the alternations and dynamics associated with exchange rates which cannot be essentially controlled by a single organization, the effects of the exchange rates cannot be influenced by the organization to enhance the persistence of earnings in future, this influence is more profound in organizations whose operations traverse monetary boundaries, and have to convert from one currency to another. The quality of earnings cannot therefore be ultimately be defined to be due to persistence if the dynamics and influences of the changes on foreign currency rates are put in place. In a multinational organizations scenario, the earnings in one currency may be persistent, but the rates of exchange between two countries may change, hence whereas the earnings in one currency may have improved, if the same earnings have to be offered in the currency of mother country, the earnings may relatively be lower than the previous years. Furthermore, the earnings can be positively or negatively influenced by factors not within organizations control domain, such as inflation, regardless of the persistence of the past earnings. As an exemplar, Inflation can provide companies with concise profits increase when due to inflation, prices of their products increase. Regardless of the persistence of earnings, organizations cannot control the price of inputs. Airlines may achieve incremental profits due to reduction in jet fuel prices, or government incentives. In addition, the quality of earnings can be fostered or decremented by acts of natural phenomena and occurrences, such as changes in weather or occurrences of natural catastrophes which can substantially affect the quality of earnings, regardless of the past persistence. The extent of the earnings being bankable also affects the quality of the earnings. Reliable revenues and earnings affect the quality of the earnings in that some earnings may be potentially reflected in accounting books, without a merging actual bankable representative. Dhaliwal and Reynolds, (1994) observes that sales may be potentially reflected as revenues, when in reality customers may fail to pay for the sales, or cancel the sales hence creating uncertainties. Some firms potentially reflect high earnings, but in reality of low quality since there exists possibility of organizations counting their eggs before they hatch, which may not mature in the long run. Conclusion The study considers several empirical researches that have scrutinized the performance and conduct of earnings based on earlier theories suggested by Beaver in the 1970s. However, the persistence of earnings are instituted and influenced by diverse influences, which may not necessary be due to the performance in the past of the firm. There are various motivations which call for examining earnings persistence and quality, considering that in most cases, investors tend to rate the performance of the earnings on the quantity of the earnings but not on the quality of such earnings. Furthermore, the research is motivated by the existence in discrepancy between projected earnings and the actual earnings, and the envisioned attributes of quality earnings. The research is therefore draws that the relationship between earnings persistence and earnings quality is two way, since quality in persistence of earnings is a desired characteristic, just as persistence in quality earnings. Reference list Ahmed, A.1994, "Accounting Earnings and Future Economic Rents," Journal of Accounting and Economics, 1994, pp.377-400. Ball, R., & Brown, P., 1968, ‘An empirical evaluation of accounting income numbers’, Journal of Accounting Research, Vol. 6, no. 2, pp. 159-178. Beaver, W. 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Yeo Hwan Kim,2002, ‘Default Risk as a Factor affecting the Earnings Response Coefficient : Evidence from South Korean Stock Market’, Dankook University School of Accounting Journal, Vol.6 Read More