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Accounting Theory

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Accounting Theory

Introduction

The conceptual framework of Financial Accounting Standards Board (FASB) states that

the primary goal of financial reporting is to assist prospective and existing investors,

management and other stakeholders evaluate the timing and the amount of future cash flows.

Therefore, economic income in the company’s income statement is plays a vital role in

predicting financial performance of the company in the foreseeable future. In other words,

earnings provide a better basis for such prediction than using the current cash flows. Security

analysts usually utilize earning quality assessment as a technique for determining the relationship

between accounting earnings and actual economic income. This paper discusses measures used

in assessing the quality of a company’s earnings and perform a quality earning assessment for

US-based Sportswear company, NIKE, Inc.

Measures of Assessing the Quality of a Company’s Earnings

Also known as quality of earnings (QoE), earnings quality is the ability of income in the

company’s income statement to predict its future cash flows or earnings (Lyimo, 2014).

Therefore, the reported earnings must be relevant to users of financial statements in making

critical decisions regarding the company. Information about earnings is indispensable when

capital market participants are making informed decisions particularly in resource allocation. In

this case, quality of earnings is the degree in which the current economic income is reflective of

the future earnings and overall financial performance of the company.

Earnings quality is an elusive quality and thereby individuals interpret it differently.

Although there is no “generally accepted” measures of earnings quality, security analysts often
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use numbers and trends to assess the earnings quality of a firm. Some of the measures used in

this assessment include accrual quality, smoothness, surprise indicator, value relevance,

persistence and predictability. These measures focus on certain features that resemble quality of

earnings.

a) Accrual Quality

This measure is indicated by deducting ash from operating activities from the reported

earnings generated by the firm in a given period. Alternatively, the quality of accrual can be

measured by an error in estimating the accruals (Lyimo, 2014). Accrual quality maps working

capital accruals to the future cash flows. The better the mapping the lower “the residual from a

regression based on these cash flows and the higher is the earnings quality” (Perotti &

Wagenhofer, 2014). The measure has a superior economic appeal as it includes cash flows of one

period ahead and thereby commonly used by companies. Accruals can also be spilt into normal

and abnormal accruals depending on the forecast model. Abnormal accruals constitute the

balance between expected and actual accruals. High abnormal accruals equate lower earning

quality.

b) Smoothness

This measure is based on volatility of earnings or accruals relative to that of cash flows from

operating activities. In this measure, cash flows from operating activities are used a reference

proxy for financial performance to mean that cash flows are not subject to earning management

(Perotti & Wagenhofer, 2014). The bottom line is that earnings’ smoothness is inversely

proportional to earnings quality as it considered as a by-product of earnings management. The

latter is defined as efforts to mask the actual financial performance and thus reduces value of
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information in reported earnings. Earnings are considered as combination of accruals and

operating cash flow. Accruals are added to smooth out the cash flows to filter away any

volatility. Nonetheless, some smoothening is required to ensure that users of financial data do not

focus on cash flows and overlook the earnings.

c) Earning Surprise Indicator

This measure indicates the value of net operating assets relative to the total assets. The larger

the ratio of earning surprise indicator the poorer the earnings quality.

d) Value Relevance

This is a market-based measure of earnings quality through earnings response coefficient.

The latter is a slope coefficient in a regression of returns on earnings. The higher the value

relevance, the higher the earnings quality.

e) Persistence and Predictability

There are time-series measures of earnings quality. Persistence focuses in the extent to which

the current income recurs the future cash flows. Therefore, high persistence has positive

relationship with high quality of earnings as it indicates sustainability, stability and less volatility

in generation of income (Perotti & Wagenhofer, 2014). On the other hand, predictability suggests

the rationale that high earnings quality is more predictable. Therefore, the higher the

predictability, the higher the precision of forecasting earnings and thereby higher earnings

quality. Persistence and predictability are usually influenced by prevailing marketing conditions,

existing accounting systems and volatility of the firm’s operations.

Earnings Quality Assessment of NIKE. Inc.

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Analysis

 Accrual Quality = Cash from operating activities – reported earnings (income)

2018 ($ in 2019 2020

millions)
Cash from operating activities 4,955 5,903 2485
Net income 1,933 4,029 2,539
3,022 1,874 -54

The company had low earnings quality for 2018 and 2019 but a high one in 2020. As the

figures keep on declining, the company will experience higher quality of earnings.

 Persistence and predictability: The net income for NIKE, Inc. was $1.933 billion,

$4.029 billion and $2.539 billion in 2018, 2019, and 2020, respectively. Due to economic

environment before and during the Coronavirus pandemic, it is possible to predict this

performance. The company’s income more than doubled between 2018 and 2019 (NIKE,

Inc., n.d). However, the persistence of Coronavirus pandemic makes sportswear less

lucrative due to lockdowns and social distancing. Therefore, the earnings purged almost

be a half. Therefore, for there is low quality of earnings as users of financial information

can predict from these figure the future cash flows.

 Smoothness: From NIKE’s balance sheet, the accruals amounted to $5.010 billion and

$5.184 billion in 2019 and 2020, respectively. The cash flows from operating were $4.95

billion and $5.903 billion in the same periods (NIKE, Inc., n.d). Perotti and Wagenhofer

(2014) asserts that smoothening is a deliberate action by mangers to control earnings.

Therefore, it reduces volatility of firm’s performance through masking of actual

performance in terms of earnings. It is clear that NIKE is would be reporting almost zero
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or negative income for the year as it accrues the same amount as the actual earnings.

Therefore, there is low earnings quality for the company. Generally, the assessment

shows that NIKE, Inc. has low earnings quality for the last three years to predict its future

financial performance in the next three or five years.

References
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Lyimo, G. D. (2014). Assessing the measures of quality of earnings: Evidence from

India. European Journal of Accounting Auditing and Finance Research, 2(6), 17-28.

NIKE, Inc. (n.d). News, events and reports. https://investors.nike.com/investors/news-events-

and-reports/default.aspx

Perotti, P., & Wagenhofer, A. (2014). Earnings quality measures and excess returns. Journal of

business finance & accounting, 41(5-6), 545-571.