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Sarmad Kawkab Al-Jamel

 Prof  Department of  Banking and Finance Sciences ;College of  Administration and Economic; University of Mosul Iraq

 

Mohammed Fawzi Mohammed

Assistant Lecturer ; Ph .D student; Department of  Banking and Finance Sciences ;College of  Administration and Economic;University of Mosul Iraq

 

EARNINGS QUALITY APPROACH TO THE ANALYSIS OF FINANCIAL STATEMENT : EVIDENCE FROM JORDAN

 

Introduction

     The focus on the earnings quality by financial analysts is one of the objectives of financial analysis. It is the evaluation current performance, which is an indicator of future performance of the company. From this perspective, High-quality earnings Explains the current operational performance of the company, At the same time, a good indicator of operating performance in the future, and the measure summarizes the value of the company. Consistent with this idea ,we most measure earnings quality by attributes of earnings on a sample of corporations listed in Amman stock exchange.                                                                                                                      

What Is Earnings Quality ?

The researchers used several definitions of quality of earnings According to their perceptions of the special nature of the objectives to be achieved from the use of financial statements,Such objectives on the use of financial statements to evaluate the financial performance of the company, as well as, its ability to continue to predict and achieve future earnings. Richardson (2003) referred to quality of earnings through the ability of current earnings to continue in future periods, Whenever earnings become more Persistence, it refers to the high level of earnings quality in future [9,p.50]. Consistent with the above definition was defined Penman(2003) earnings high-quality as the earnings that contain a good indicator for future returns, and reflect well on the economic substance of operations [8,p.80-81].The quality of earnings as an indicator summarizes the quality of financial reporting which in turn determines the quality of financial disclosure [3,p.14] .                                      

Defined the quality of earnings by Dechow& Dichev (2002) in the form of accruals related to cash flow [1,p.39].Sloan finds earnings of cash flows more Persistence of the accruals earnings, By linking the between the quality of earnings and size of accruals,and From a scientific point of the quality of earnings must distinguish it as the difference between net income and cash flows from operating activities [10,p.289] . We believe that, the  quality of earnings means avoid earnings management practices, In other words, quality of earnings means the degree of trust in achieving income, As a reflection of the degree of deviation of the actual income of the company for the income reported, Also, earnings with poor quality Means that,the earnings reported Contains non-reality earnings.                                                                                                              

Earnings Attributes Measures

Accruals quality

     Several measures to assess earnings quality indicate that earnings which maps more closely into cash is more desirable ( e.g.[4,p.972] ; [5,p.302] ). The gap between earnings and cash is from accruals. One role of accruals is to shift or adjust the recognition of cash flows over time so that the adjusted numbers (earnings) better measure firm performance. However, accruals require assumptions and estimates of future cash flows. Thus, accruals are the product of judgments, estimates, and allocations. Dechow and Dichev (2002) (hereafter, DD) develop a measure of accruals quality and argue that the quality of accruals and earnings is decreasing in the magnitude of estimation error in accruals. The DD model uses firm-specific regressions of changes in working capital on last year, present, and one-year ahead cash flows from operations and defines accruals quality as a standard deviation of the residual from this firm-specific regression [1,p.40]. However, McNichols (2002) proposes a modified Dechow and Dichev (2002) model, arguing that the changes in sales revenue and property, plant, and equipment are important in forming expectations about current accruals, over and above the effects of operating cash flows [7,p.65]. She shows that applying variables from the Jones (1991) model and modified Jones model [2,p.199]. into the cross-sectional DD model significantly increases its explanatory power and thus reduces measurement error. The accrual estimation errors using a residual (ε t ) is measured from the following equation:

 

              (1)

 

Where:

TCA j ,t

=

Firm j’s total current accruals in year t.

 

=

ΔCA j ,t  – ΔCL j ,t – Δ cash j ,t + Δ STDEBT j ,t

CA j ,t

=

Firm j’s current assets in year t.

CL j ,t

=

Firm j’s current liabilities in year t.

cash j ,t

=

Firm j’s cash in year t.

 STDEBT j ,t

=

Firm j’s debt in current liabilities in year t.

CFO j ,t

=

Firm j’s cash flow from operations in year t.

 

=

NIBE j ,t  - TA j ,t  

NIBE j ,t

=

Firm j’s net income before extraordinary items in year t.

TA j ,t

=

Firm j’s total accruals in year t.

 

=

ΔCA j ,t  – ΔCL j ,t – Δ cash j ,t + Δ STDEBT j ,t - DEPN j ,t

DEPN j ,t

=

Firm j’s depreciation and amortization expenses in year t.

 

    All the equation (1) variables divided by total assets. Using the cross-section analysis For each year, we estimate Equation (1) using data for (103) companies. The measure of accruals quality is based on this standard deviation of estimated residual ( s (ε j, t) ) from equation (1) as it refers to the extent to which working capital accruals map into operating cash flow realizations. Large (small) values of standard deviation of estimated correspond to lower (higher) accruals quality and lower (higher) earnings quality.

Earnings Persistence

     Persistence of earnings mean high quality earnings, This study employs the measure in  [4,p.980], we measure earnings persistence as the slope coefficient estimate (Ø1) from the following equation:

 

 

Where:

Earn j ,t

=

Net income before extraordinary items in year t divided by the weighted average number of outstanding shares during year t .

 

     Using the cross-section analysis For each year, we estimate Equation (2) using data for (103) companies. The measure capturing earnings persistence is based on the slope coefficient Estimate (Ø1) from equations (2). Values of (Ø1) close to one indicate highly persistent earnings while values close to zero imply highly transitory earnings. Persistent earnings are viewed as higher quality, while transitory earnings are viewed as lower quality.

Earnings Predictability

     Lipe (1990) provides a measure of earnings predictability as it is reflected in the variance of the earnings shocks (as variance increases, the predictability decreases) [4,p.980]. also follow his study by measuring earnings predictability using the square root of the estimated error variance from the earnings persistence equation. In this study, earnings predictability is calculated using the square root of the error variance from equation (2). Predictability is:

Where:

Predictability t, j

=

Firm j’s earnings predictability in year t, captured by the square root of the error variance from equation (2).

=

Estimated error variance of firm j in year t, calculated from equation (2).

     Large (small) values of Predictability imply less (more) predictable earnings. More predictable earnings are viewed as higher quality, while less predictable earnings are viewed as lower quality.

Earnings Smoothness

     (Francis et al. 2004) defined smoothness as the ratio of firm j standard deviation of net income before extraordinary items divided by beginning total assets, to its standard deviation of cash flows from operations divided by beginning total assets [4,p.980]. This measure is also similar to the one found in [6,p.30], from the following equation:

 

                                          (4)

 

     large (small) values of Smooth indicate more (less) earnings smoothness and low (high)

earnings quality.

Sample, Data, and Hypothesis

Sample and Data

     The research sample included 103 company listed on the Amman Stock Exchange, (53) companies in the industrial sector, (29) companies in the service sector, and21) companies in the financial sector. Our sample covers the 9 years, t = 2005-2013. Search requests provides data covering the years before the measurement period (2005) and The year after a period of measurement (2013) to calculate some models, Therefore, included the measurement period (2006-2012).                                                        

Hypothesis

     The earnings shown in the financial statements published is not real, but rather the product of accounting principles, Accordingly, can formulate the following hypothesis : 

H1: There is a relationship between earnings quality attributes and analysis of financia statements .

Test the Earnings Attributes

     Table (1) shows the results of the attributes of earnings During the period (2006-2012), Shows a low the standard deviation of the residuals values (Accruals quality) In the years (2006-2007-2008-2010-2012) from the mean (1.084) percent, and the standard deviation was (0.093) percent , Which indicates the high quality of the accruals Amman Stock Exchange during those years. As can be seen in the high coefficient estimate for  years (2006 2007, 2009.2010) from the mean (0.856) percent, and the standard deviation was (0.360) percent, Indicating a high Persistence of earnings Amman Stock Exchange, And poor Persistence in the past (2008 2011.2012). And indicated the Predictability test results, poor quality, In the past (2006.2007, 2009) because of the high values of the square root of the variance estimation error, The mean of these values (1.103) percent, and standard deviation ability (0.099) percent . Thus, the earnings of Predictability of a medium in the past (2008 2010.2011, 2012). indicated the Earnings Smoothness test results, It is observed during the study period, It is observed during the study period increased Smoothness, Recorded a year (2008), the highest percentage of Smoothness , and Recorded in the year (2012) the lowest percentage of Smoothness, And Figure 1 illustrates the quality of earnings Amman Stock Exchange from 2006 to 2012.

TABLE (1 )

Results of the attributes of earnings During the period (2006-2012)

ــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــ

Attributes

Accruals quality

 

Persistence

Predictability

Smoothness

2006

1.007

1.16

1.123

1.151

2007

1.036

1.07

1.155

1.686

2008

1.063

0.66

1.000

2.173

2009

1.160

1.12

1.291

1.804

2010

1.065

1.17

1.083

1.386

2011

1.259

0.29

1.022

1.301

2012

1.001

0.52

1.047

0.940

mean

1.084

0.856

1.103

1.492

Std. Dev.

0.093

0.360

0.099

0.422

Lowest

1.001

0.290

1.000

0.940

Higher

1.259

1.170

1.291

2.173

ــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــ

Figure (1) illustrates the quality of earnings Amman Stock Exchange from (2006-2012)

     In order to assess the quality of earnings form aggregate, We use the mean of the group's four attributes values, Thus, the quality of the earnings are high whenever the value of the attributes of earnings decreased aggregate formula for the mean, and the quality of the earnings are poor whenever the value of the attributes of earnings increased aggregate formula for the mean.

Conclusions

     The test results indicate the high quality of the attributes for the majority of companies, and that corporate earnings research sample temporary rather than a permanent, low Persistence earnings, As a result, Predictability of these earnings is poor as intertwined with the concept of Persistence. As we pointed out the results tests of Smoothness  in accounting earnings, high smoothing, and this result indicate that net income has been subjected to manipulation by management in order to make it more stable.

 

 

References

1.

Dechow, P., Dichev, I., 2002. The quality of accruals and earnings :The role of accrual estimation errors .The Accounting Review, Vol 77, 35-59.

2.

Dechow, P., Sloan, R., Sweeney, A., 1995. Detecting earnings management, The Accounting Review, vol 70, No2, 193-225.

3.

Francis, J., LaFond, R., Olsson, P., Schipper, K., 2006, Earnings Quality, Foundation and Trends in Accounting , vol.1, Issue.4

4.

Francis, J., R. LaFond, P. Olsson, and K. Schipper., 2004, Costs of equity and earnings attributes . The Accounting Review 79, 967–1010.

5.

Francis, J., R. LaFond, P. Olsson, and K. Schipper., 2005, The market pricing of accruals quality . Journal of Accounting and Economics 39, 295–327.

6.

Leuz,C., Nanda, D., Wysocki. D., 2003, Investor Protection and Earnings Management: An International Comparison, Working paper, University of Pennsylvania.

7.

McNichols, M.F., 2002, Discussion of The Quality of Accruals and Earnings: The Role of Accrual Estimation Errors., Accounting Review (American Accounting Association).

8.

Penman, S., 2003, The quality of financial statements: Perspectives from the recent stock market bubble. Accounting Horizons, vol 17,  77-96.

9.

Richardson, S., 2003, Earnings quality and short sellers. Accounting Horizons, vol 17, 49-61.

10.

Sloan, R., 1996. Do stock prices fully reflect information in accruals and cash flows about future earnings?. The Accounting Review, vol 71, 289-315.