Deloitte & Touche is taking a leadership role in helping companies and investors understand and move beyond the reasons for today's "crisis in confidence." It recently released "Quality of Earnings," the second in a series of papers designed to help restore investor confidence through the sharing of knowledge and best practices. The paper contains an innovative tutorial that helps companies and investors boost their own financial IQs to a level that complements the Integrity and Quality (IQ) of their independent auditors.
Although D&T acknowledges there are as yet no definitive criteria to evaluate quality of earnings, its paper provides readers with a solid foundation in current thinking. This consists of an overview of the characteristics affecting the quality of a company's earnings, examples of how to apply the characteristics to specific types of income and expenses, and key questions for companies to address in financial reports.
- Characteristics. "The quality of earnings can generally be summarized," says D&T, "as the degree to which earnings are cash or noncash, recurring or nonrecurring, and based on precise measurement or estimates that are subject to change."
- Examples. At one end of the spectrum are such items as recurring sales of tangible delivered products for which cash has been received. At the other end are mark-to-market derivative contracts and goods sold in exchange for stock of another company.
- Questions. Did nonrecurring transactions affect earnings in the current period? What was the impact of related-party transactions? How close was the company to meeting or violating any debt covenants or other contractual commitments?
To avoid confusion over the distinction between quality of earnings and quality of reporting, D&T explains that lower quality earnings are not necessarily indicative of poor financial reporting. In many cases, lower quality earnings relate to transactions that are more subjective or have a higher degree of risk or uncertainty. When assessing a particularly subjective or risky set of circumstances, users of financial reports should keep in mind that often it is the object being measured that contributes to the "fuzziness" rather than the camera (i.e., the accounting in the financial statements) or the photographer (i.e., management).