Schweser Book 2 Page 119 says “Measuring earnings quality based on conservative earnings is an inferior measure when attempting to forecast future earnings because most accruals will self correct over time. For example, the lower earnings that result from accelerated depreciation will increase in the later years of the asset’s life. Focusing on accruals and deferrals is a more effective way of measuring earning quality.” That makes sense, but can anyone explain why in the question below, the non conservative method is designated as contributing to low quality earnings?" Labor officials believe that the management of Hatfield is attempting to understate its net income in order to avoid making any concessions in the labor negotiations. Which of the following actions by management will most likely result in low quality earnings? A) Lengthening the life of a depreciable asset in order to lower the depreciation expense. B) Lowering the discount rate used in the valuation of the company’s pension obligations. C) The recognition of revenue at the time of delivery rather than when payment is received. Your answer: A was correct! Certain GAAP rules can be exploited by companies in order to achieve specific goals, while still remaining within the letter of the law. Aggressive assumptions, such as lengthening the depreciable life of an asset, that are utilized to boost earnings results in a lower quality of earnings. (Study Session 7, LOS 26.d)
bcos the other two options do not lead to reduction in earnings. b. lower discount rate -> higher pension expense -> lower earnings. c. recognition of revenue at the time of delivery -> is postponing the recognition of revenue.
i agree and thats why i picked A because its the best answer. but as a rule of thumb, shuold we still consider conservatism as a poor measure of earnings quality and i guess only choose the answer if it is the best one there, as it is in this scenario
I think the point the book was making is just because something is conservative, doesn’t make it higher earnings quality. For example, lets say a company buys an asset that will generate cash flows over 5 years. Management should depreciate it over 5 years. But let’s say management decides to depreciate the asset over 3 years. Management is technically being more conservative by making the depreciable life 3 years instead of 5, but the earnings quality will be lower because it should be depreciated over 5 years. So while most of the time being more conservative will improve earnings quality, that is not always the case.
We had this case in university about Microsoft. Microsoft is a very conservative firm, two things which they did stayed in my mind: 1. Kept a lot of cash on balance sheet. Explanation was that they needed to pay employees for one year if any adverse events impact the firm. 2. Expense all R & D instead of capitalizing it. Would this be called low earnings quality?
^ R&D is supposed to be expensed as incurred in the majority of cases. They probably weren’t trying to be overly conservative, but rather, follow US GAAP where applicable. The nature of accruals are self-correcting, so being overly conservative in the short-term will lead to overstated earnings in later years. As such, I believe the CFAI text makes reference to be careful in assuming that overly conservative assumptions are indicative of high earnings quality.
so i think the point here is that conservatism is likely a sign of quality earnings but it need not always be
never really got an answer on this…can someone please confirm my theory that accruals ratio is a better determinant of earnings quality than conservatism is, but if no accruals ratio is present you can still look at conservatism although you must be careful not to infer too much from it.
There’s no hard and fast rule, you have to look at it on a case by case basis.