GAAP and Earnings Quality

GAAP and Quality Spectrum

• GAAP (Generally Accepted Accounting Principles):

  • Provides a framework for financial accounting.

• Quality Spectrum:

  • Ranges from decision-useful, sustainable, and adequate returns to non-compliant accounting.

Earnings Quality

• Decision-Useful, Sustainable, and Adequate Returns:

  • Represents high-quality financial reporting.

• Low "Earnings Quality":

  • Occurs when financial reporting adheres to GAAP but raises concerns about sustainability.

Biased Choices Within GAAP

• Description:

  • Companies make accounting choices that technically comply with GAAP but introduce bias into the financial statements.

• Implication:

  • Reduces the quality of earnings by distorting the true financial performance and position of the company.

Earnings Management (EM)

• Definition:

  • Actions taken by management to manipulate earnings to present a misleading view of a company's performance.

• Types:

  • Real EM:

    • Involves altering actual business decisions, such as delaying research and development projects or reducing marketing expenses.

  • Accounting EM:

    • Involves manipulating accounting methods or estimates, such as changing depreciation methods or altering revenue recognition policies.

Non-Compliant Accounting

• Description:

  • Accounting practices that violate GAAP.

  • May involve fictitious transactions.

Fictitious Transactions

• Definition:

  • Transactions that are fabricated or lack economic substance.

• Use:

  • Used to manipulate financial statements and deceive stakeholders.