Questions Chapter 13
13-1. Distinguish between earnings and cash flows. Why is there a distinction between these two measures?
Earnings consists of cash and noncash items; cash flows consists of only cash, and come from not only revenue, but also financing as well.
Complicating earnings measurement are differences between accrual and cash accounting. Accrual accounting recognizes revenue when earned expenses when incurred, while cash accounting recognizes inflows and outflows of cash irrespective of whether cash flows are earned or incurred.
13-2. What is meant by earnings quality? Why do users assess earnings quality? What major elements determine earnings quality?
Earning quality refers to the relevance of earnings in measuring company performance. Its determinants include a company's business environment and its selection and application of accounting principles.
Three factors are often determined a comprising earnings quality:
Accounting Principles. One determinant of earnings quality is the discretion of management in selecting accepted accounting principles.
This discretion can be liberal or conservative. The quality of conservatively determined earnings is perceived higher because they are less likely to overstate current and future performance expectations compared with those determined in a liberal manner. Conservatism reduces the likelihood of earnings overstatement and retrospective changes. However, excessive conservatism, while contributing temporarily to earnings quality, reduces the reliability and relevance of earnings in the long run. Examining the accounting principles selected can provide clues to management's propensities and attitudes.
Accounting Application. Application of accounting relates to decisions such as whether adequate provision is made for asset reinvestment or for maintaining and increasing earning power. Management has discretion over the amount of earnings through their application of accounting principles determining revenues and expenses.
Business Risk. A third determinant of earnings quality is the relation between earnings and business risk. It includes...