Financial Analyst Assessment of Company

Earnings Quality
ROBERTBRICKER”
**
GARYPREVITS
THOMASROBINSON***
STEPHENYOUNG* * * *

This study investigates sell-side jinancial analysts ’ interpretations of the

phrase ‘‘earnings quality” and their preference f o r accounting methods.
The data are a sample consisting of 479 sell-side jinancial analyst full-
text reports for a set of companies stratified on exchange, SIC code, and
size in three recent time periods. These reports illustrate the importance
placed by analysts on identifying companies’ core earnings. The results
show that analysts associate high earnings quality with near-term earn-
ings predictability. This predictability is dejined in an economic sense in
terms of a low level of earnings volatility, and in an accounting sense in
terms of management discretion over the establishment and adjustment of
certain conservative reserves, allowances, and of-balance-sheet assets.
Limited association was found between earnings quality and the appli-
catior, -f conservative accounting methods, per se.

1. Introduction
One of the goals of accounting is a congruence between economic events
affecting companies and their financial reports. SFAC No. 2 (FASB [ 1980]), Qual-
itative Characteristics of Accounting Information, describes desirable accounting
information features such as “representational faithfulness,” the association be-
tween reporting and economic events, and “neutrality,” among others. Solomons
(1978) comments on neutrality as follows:

*Ernst & Young Faculty Fellow, Associate Professor, Weatherhead School of Management, Case
Western Reserve University
**Professor, Weatherhead School of Management, Case Western Reserve University
***Assistant Professor, University of Miami, Coral Gables
****Graduate Student, Weatherhead School of Management, Case Western Reserve University
This study is derived from a project that studied sell-side financial analysts’ information needs.
We gratefully acknowledge the sponsorship and helpful comments of the AICPA’s Special Committee
on Financial Reporting chaired by Edmund Jenkins, the AICPA’s User Needs Subcommittee chaired
by Edmund Coulson, the firm of Ernst & Young, the editor, and an anonymous reviewer, and the use
of “Investext” by the Thomson Financial Group.

541

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542 JOUKNAL OF ACCOUNTING, AUDITING & FINANCE
It is the quality of neutrality which makes a map reliable; and the essential
nature of accounting, I believe, is cartographic. Accounting is financial map-
making. The better the map, the more completely it represents the complex
phenomena that are being mapped.
Similarly, Gellein states:
Financial reporting is more like a barometer than a rain-maker. . . . The diffi-
culty [with biasing the reporting] is that some would get wet because they did
not have umbrellas, others would beseech for rain not knowing that it was on
its way.” (Bernstein [1988, p. 461)
As applied to a company’s earnings report, then, it would appear reasonable
to establish accounting principles that lead to financial reports that best reflect
underlying economic events and conditions. From this perspective, reported earn-
ings could be described as having the highest quality when they most accurately
reflect underlying events and conditions. Accountants have also associated earnings
quality with the relationship between earnings and cash flows. For example, Chas-
teen et al. (1992, p. 329) write:
The quality of earnings refers to how closely income is correlated with cash
flows-the higher the correlation, the higher the earnings quality.
It is not clear, however, that financial analysts interpret “earnings quality” in
these ways. Bernstein (1988), for example, asserts that financial analysts view earn-
ings as having high quality when they can be expected to recur consistently and
with a high degree of predictability. Further, it appears that financial analysts may
define earnings quality in terms of more than this “economic” meaning. For ex-
ample, Gibson (1989) points out that, among financial analysts, “When a firm has
conservative accounting policies, it is said that its earnings are of high quality” (p.
5 15). This is echoed in Needles et al. (1990), who write, “In general, an accounting
method. . . that results in lower current earnings is considered to produce better
quality earnings” (p. 796). These assertions suggest (1) an accounting meaning of
earnings quality and (2) that financial analysts may not value features such as
representational faithfulness and neutrality in the same way as accountants. A po-
tential predicament of such differing interpretations of accounting earnings quality
is reflected by Bernstein (1988), who writes:
Generally, the quality of conservatively determined earnings is higher because
they are less likely to prove overstated in the light of future developments. . . .
On the other hand, unwarranted or excessive conservatism . . . actually results
in a lack of reporting integrity over the long run.” (p. 706)
In this study, we empirically explore the meanings of “earnings quality” to
financial analysts and correspondingly draw some inferences about their preferences
for accounting methods. Our data are a sample of full-text sell-side financial ana-
lysts’ reports from three recent time periods. We apply content analysis and in-

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ASSESSMENT OF COMPANY EARNINGS QUALITY 543
vestigate the implicit and explicit analysis of earnings quality in the reports. Our
findings show, first, that in evaluating profitability, analysts are particularly inter-
ested in identifying a company’s “core earnings,” which are more strictly defined
than “income from continuing operations.” Second, our findings suggest that fi-
nancial analysts define “earnings quality” in separate economic and accounting
terms. They are similar in that each associates high-quality earnings with the elim-
ination of ex ante forecasting risk to the analyst. They are different in the following
way: in the economic sense, financial analysts associate higher quality earnings
with a smaller range of values around a single-point earnings forecast. In the ac-
counting sense of “earnings quality,” there is some evidence linking earnings qual-
ity to conservative accounting principles. There is stronger evidence that financial
analysts associate high earnings quality with the capability of a company’s man-
agers to manage earnings so as to avoid negative earnings surprises. Financial
analysts consider a company to have high quality earnings when it has discretionary
reserves, allowances, or off-balance-sheet assets (OBSAs), which can be adjusted
if actual results are below forecasts.
Our results are important for accounting policy. Although accounting views
asset and income numbers as maximum-likelihoodestimators of a range of possible
values, financial analysts prefer values that have minimum downside risk.’ That is,
financial analysts seem to prefer “platform values” for assets and earnings that
have very high probabilities of expected occurrence, instead of expected values.
Similarly, analysts apparently prefer accounting methods that give managers some
capability to manage earnings. Overall, our results imply an analyst preference for
(1) better disclosure standards related to identifying recurring operating components
of net income and (2) management discretion in the establishment and subsequent
adjustment of certain conservative reserves, allowances, and OBSAs.

2. Background and Hypotheses

As noted, some textbooks and papers addressing the issue of “earnings qual-
ity” distinguish between its economic and accounting meanings. Arnold and
Moizer (1984) find that financial analysts establish PE ratios based in part on the
“quality of a company’s earnings, that is, whether or not there has traditionally
been a steady growth in earnings per share and thus a stable earnings stream.”
This is an economic form of earnings quality having to do with the predictability
of recurring revenues and earnings.
In this study we first identify sell-side financial analysts’ definition of recurring
or “core” earnings. The importance of identifying the recurring portion of a com-

1. One analyst wrote: “When we modeled the outlook for [the company] in early 1991, we
envisioned modest growth in [one product area] and high growth in [two other product areas]. Share
gains were likely and that was our hedge: if [the company’s] market shares improved as much as we
thought possible, the numbers would surprise on the upside. Unfortunately, our market growth as-
sumptions were too optimistic. Hence, while [the company] has met our earnings expectations, there
is less cushion in the numbers than originally expected, and we are therefore reducing estimates.”

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544 JOURNAL OF ACCOUNTING, AUDITING & FINANCE
pany’s earnings has been recognized in APB Statement No. 30 (1973), “Reporting
the Results of Operations.” This pronouncement reflects the usefulness to decision
makers of identifying the recurring component of historical results from which
future results can be forecast. There has remained, however, discussion about the
suitability of the current reporting distinctions on recurringhonrecurring results,
and the AICPA’s Users Needs Subcommittee continues to investigate how financial
analysts define core earnings. We pose the following research question.
Q , : How do sell-side financial analysts define company core earnings?
We then investigate how analysts’ value earnings predictability and the relationship
of earnings predictability to a core or base set of income numbers (revenue and
earnings). We test the following hypothesis relating earnings predictability and
earnings quality:
H , : Financial analysts regard companies with revenuedearnings that are recurring,
consistent and predictable as having earnings of high quality.
The accounting form of earnings quality has generally been described in terms
of the application of conservative accounting methods, as discussed (i.e., more
conservative accounting methods imply higher earnings quality (Imhoff [ 19921)).
One possible explanation for this apparent preference for conservatism is a reported
analyst skepticism about the forthrightness of management. Investors of all types
tend to be suspicious of company financial reports (SRI [ 19871). Hill and Knowlton
(1984) report that the vast majority of respondents agreed that “Annual reports
often play down bad news or hide it in the back of the report.” Similarly, the SEC
Advisory Committee (1977) stated:
While the reasons for emphasis of particular information may be completely
and objectively verifiable, they may also reflect the desire of management to
put its best foot forward.
This skepticism is somewhat paradoxical given the heavy reliance that financial
analysts report placing on management for information used in forecasting earnings
per share (SRI [ 19871). Their response to earnings disappointments is evidence of
this reliance. For instance, following Royal Appliance’s announcement of lower-
than-expected earnings, a sell-side analyst commented, ‘‘At this point, this com-
pany doesn’t have much credibility.” The related news article states further that
“[the analyst] had been led to believe the company would report improved earn-
ings” (Phillips [ 19931).
A financial analyst preference for conservative accounting methods also con-
trasts with their own behavior since “it appears that analyst forecasts tend to be
optimistic on average”’ (Schipper [ 1991]).’ Further, given the great uncertainty in

2. On the other hand, Peter Lynch asserts that financial analysts inadequately revise EPS estimates
for new information: Additional upward revisions are likely to follow initial upward revisions.
3. Schipper bases this conclusion on the results of a number of studies, including Brown et al.
(1985) and Butler and Lang (1991).

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ASSESSMENT OF COMPANY EARNINGS QUALITY 545

forecasting future corporate earnings per se, a possible explanation for financial
analysts’ definition of earnings quality in terms of accounting conservatism is to
reduce ex ante downside forecasting risk. With high certainty about the next per-
iod’s EPS, financial analysts’ forecasting risk is limited to the estimation of long
term earnings growth and stability in establishing an appropriate PE ratio and cor-
responding stock price. Thus, it is plausible that the degree of conservatism of a
company’s accounting methods serves as a signal to analysts and other parties about
(1) the probability of future negative earnings surprises or (2) the propensity of
management to inflate results (management forthrightness). Both provide a signal
about the degree of uncertainty of a company’s future results. Bernstein (1989, p.
67) refers to this as “accounting risk.” We formed a related hypothesis that
H2: Sell-side financial analysts regard all conservative accounting methods as ev-
idence of high earnings quality.
But such a linkage between accounting conservatism and high-quality earnings
may not be uniform. EPS forecasting uncertainty can be reduced by management
establishment of discretionary reserves, allowances, and OBSAs that can be ad-
justed in the face of worse-than-expected results. Previous writers have distin-
guished between “noncurrent” or “nondiscretionary” accruals, such as
depreciation and inventory adjustments, and “current” or “discretionary” accruals
(see Robinson [ 1992]), including asset write-down allowances and liability contin-
gencies that are used for managing earnings. Discretionary accruals may be partic-
ularly cogent for analysts since EPS forecast accuracy is a measure by which their
performance is evaluated. Although financial analysis requires an EPS forecast, the
estimation of an appropriate PE ratio, the prediction of a resulting estimated stock
price, and a corresponding buy, sell, or hold recommendation, it is the EPS forecast
against which the analyst can be most rigorously evaluated. If an analyst’s earnings
forecast is accurate but the price of the company’s stock does not change in the
manner forecast by the analyst, the analyst can reply that the market has irrationally
underpriced the security and that it is a good “buy.” Indeed, reports are full of
such explanations? Analysts whose earnings forecasts are overstated, however, can
blame no one but themselves (or management).5
This implies an analyst preference for companies with sufficiently large dis-
cretionary reserves, allowances, and OBSAs to compensate for shortfalls in actual
results. Therefore high earnings quality should be associated with discretionary
conservative accounting accruals. Furthermore, the establishment of discretionary
allowances, reserves, and OBSAs not requiring the use of cash in the near term
should be most closely associated with high earnings quality. Examples of the

4. One analyst wrote: “On [a certain date] we reiterated our purchase recommendation of [the
company] and designated it as a New Idea Flashback. The share price of [the company] has gone into
freefall because of general cable bashing, the stock’s relative obscurity, and the unusual nature of the
company making valuation more difficult.”
5. Such events include the economy, pestilence, and war, for example. It might be argued, how-
ever, that these are eventualities that should have been foreseen by the analyst.

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546 JOURNAL OF ACCOUNTING, AUDITING & FINANCE
former include accruals for bad debts and income taxes. The choice of LIFO/FIFO,
on the other hand, should not be associated with earnings quality, since the appli-
cation of this method requires consistency from year to year, and thus less flexi-
bility for managers. This is a dzrerent signal than that described by H2,in that
discretionary reserves are a signal about a company’s flexibility in managing earn-
ings so as to meet earnings forecasts. We formed the following hypothesis.
H3: Sell-side financial analysts regard discretionary conservative accounting accru-
als as evidence of high earnings quality.
Note the contrast with analysts such as O’Glove (1987) who equate high earnings
quality with an absence of earnings management.

3. Method
This study departs from a “technical” approach in favor of a “fundamental”
approach to studying financial analyst forecasting (F’revits et al. [1994]). Our in-
vestigation applied content analysis to a data set consisting of full-text sell-side fi-
nancial analyst reports. We first selected a set of 327 publicly traded firms
stratified on exchange (NYSE, ASE, OTC, WSJ Small Cap. listing), two-digit SIC
code, and company size (revenue). We chose three recent one-year time periods,
July 1, 1987, to June 30, 1988; January 1, 1990, to December 31, 1990; and July
1, 1991, to June 30, 1992. Using the Investext data base: we extracted sell-side
financial analyst reports for each of the three time periods, where available, vary-
ing the analyst (brokerage firm) when possible. Our resulting sample was com-
posed of 479 reports for 214 companies (113 of the companies had no analyst
reports listed).
We used content analysis software to assist us in analyzing the reports? The
occurrences of all words in each report and across all reports were indexed. This
allowed words and phrases (word combinations in proximity to one another) to be
accessed in the context of the complete report for analysis. We first searched the
data base for occurrences of words and phrases related to core earnings, including
‘‘base earnings” and “adjusted earnings,” and extracted the relevant sections. Next
we searched for occurrences of earnings predictability related phrases. The resulting
report sections were extracted and analyzed for discussions that explicitly or im-
plicitly related core earnings with earnings predictability. Finally, we searched the
data base for earnings quality related phrases, including related income-statement
type phrases (such as EPS or revenues) and “quality” synonyms such as “credi-
bility” and words and phrases related to the choice of particular accounting meth-
ods. We extracted all sections of reports that contained discussions relevant to

6. Investext is the proprietary brand name for a commercial data base operated by a unit of
Thomson Financial Service (Boston). All major brokers, with the exception of Goldman Sachs, have
arrangements to provide their reports to Investext.
7. The software employed in the content analysis is marketed under the brand name
‘‘Wordcruncher.”

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ASSESSMENT OF COMPANY EARNINGS QUALITY 547

earnings quality and analyzed the content of each report in terms of earnings quality
definitions generally and our hypotheses specifically.

4. Results and Discussion

4.1 Core Earnings
The search phrases referencing core earnings and earnings predictability are
listed in Table 1, Panel A. When analysts define core earnings, they exclude non-
recurring items included in operating income. One report defined core earnings as
“pre-tax income minus the gain on sale of assets and any nonrecurring expenses
or income, with the provision for loan and real estate losses adjusted to equal the
average trailing four-quarters provision for losses.” Although predictability is not
explicitly mentioned in this instance, the implication of extrapolation from past,
recurring items is evident.
Discussions of revenue/earnings “streams” also illustrate analysts’ interest in
recurring earnings. Examples include the following comments of analysts:
“[The company] has a blockbuster in its current release. . . which will pro-
vide a revenue stream for years to come.”
“Film distribution provides a less volatile revenue stream than film
production.’’
“Clearly, in choosing between the two stocks, investors would pay less for
the one with the more uncertain earnings stream.”
“Military projects . . . are providing a consistent revenue stream.”
“[This operation] provides a strong, more predictable revenue stream.”
It is also common for analysts to compute operating earnings per share or
adjusted earnings per share. These computations typically involve the removal of
items from continuing operations that analysts judge are nonrecurring, as well as
normalization of certain losses and expenses. Analysts often link core earnings and
earnings predictability in discussions of companies’ ‘‘operating earnings” (which
are not necessarily equivalent to ‘‘operating income’’) and operating revenue.
Finally, analysts’ attention to core earnings is evidenced by their treatment of
“restructuring charges” reported by companies. Restructurings are often catch-alls
for a variety of charges taken by companies and usually reported as a separate
item. Restructuring charges include long-lived tangible asset write-downs or retire-
ments, inventory write-downs, goodwill and other intangible asset write-downs,
legal expense accruals, workforce reduction costs, bad debt adjustments, and costs
associated with the disposition of business units. Analysts typically treat these
charges as one-time occurrences. One analyst wrote, for instance, ‘‘reversing the
[restructuring charge], domestic operating profits rose 22.6%,” whereas another
stated, “net of the restructuring charge. . . [the company] lost $.13 per share from
continuing operations.” This is further evidence of the interest of analysts in iden-
tifying the core operating results of companies.

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548 JOURNAL OF ACCOUNTING, AUDITING & FINANCE
TABLE 1
Search Words and Phrases
Panel A: Occurrence Frequency of Search Words and Phrases Related to
Earnings Predictability*

Earning(s) Revenue(s)

Predictability related phrases:

consistent 2
predictability 4
stable 10
unpredictability 2
volatility 11
Core earnings related phrases:
adjusted 13 14
base 18 31
core 10 1
on-going 4 0
operating 211 166
recurring 1 2
stream(s) 14 33

Panel B: Occurrence Frequency of Search Words and Phrases Related to Earnings Quality**

Search WordIPhrase Frequency

accelerated and depreciation 6

accrual(s) 66
allowance 29
bad and debt 26
conservative 221
conservatively 33
conservatism 8
credible 4
credibility 13
fifo 64
lifo 115
loss and provision 93
reserve 495
quality 403
uncollectible(s) 10
*Row and column terms comprise the search phrases to which the occurrence frequencies
occur. For example, “consistent” and “earning(s)” occurred two times, and “consistent” and
“revenue(s)” occurred three times.
**Note that occurrence frequencies refer to the absolute rates for words and phrases and
may include irrelevant references. For example, many occurrences of the word “quality” referred
to product quality and so on.

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ASSESSMENT OF COMPANY EARNINGS QUALITY 549

4.2 Earnings Predictability and Economic Earnings Quality

The extracted report sections generally confirm that analysts value economic
earnings predictability highly and associate earnings predictability with earnings
quality, consistent with hypothesis 1. One report, commenting on the market dis-
count of a particular company’s stock, stated: “Given our expectations for. . .
reduced earnings volatility . . . we do not believe this discount will persist.” Other
reports stated that ‘‘the utility segment has dramatically broadened its customer
base and, in turn, significantly reduced revenue and earnings volatility” and “be-
cause of the company’s historically erratic earnings record . . . [the market discount
of the stock should] narrow as revenue and earnings visibility continue to improve
and volatility declines.” Yet the preference for high earnings predictability is not
universal, as evidenced by the following analyst’s comment: “[Earnings] unpre-
dictability in theory should penalize the company’s multiple. In practice, there will
be times when the multiple is penalized and times when it is rewarded, because
the possibility of a runaway hit and break-out earnings will lead to speculation.”
Earnings predictability tends to be associated with core earnings type phrases
(Table 1, Panel A). Instances of terms associated with core earnings include the
following:
“The fourth quarter of 1989 was the inflection point for core earnings.”
“Core earnings [at these companies] will likely continue to be masked by
high commercial real estate credit costs.”
“[Even after] nonrecurring items.. . adjusted earnings were a very disap-
pointing $0.30 per share.”
The terms ‘‘inflection point,” “continue,” and “nonrecurring” suggest that core
earnings provide the basis for the formation of expectations about future perform-
ance (earnings predictions).
There is also evidence of a relationship between recurring, consistent, and
predictable earnings, and earnings quality. As shown in Panels A and B of Table
1, there were numerous references to both,* including occasional explicit comments
linking the two. For instance, in terms of revenue types, franchise fee revenue is
associated with low earnings quality, whereas items such as royalty fees and sales
of supplies and equipment (for a franchiser) are associated with high earnings
quality. One report commented: “Over this time frame the quality and predicta-
bility of earnings should improve as the proportion of revenue contributed by fran-
chise fees declines,” and “we expect the percentage of revenues contributed by
recurring royalties to increase from 27% today to over 40%, thereby improving the
quality and predictability of the company’s earnings stream.” More generally, an-
other report stated: “The ‘quality’ of the earnings advance was excellent, that is,

8. Panels A and B of Table 1 show only those search words and phrases that had a frequency of
occurrence that was greater than 1. Search phrases such as “depreciation method” had no occurrences
and are not listed in Table 1.

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550 JOURNAL OF ACCOUNTING, AUDITING & FINANCE
strong pretax income growth (up 42%) and operating income growth (up 28%).”
Earlier references relating higher earnings predictability to higher stock valuations
are additional evidence of a relationship between the economic form of earnings
quality and earnings predictability.

4.3 Accounting Earnings Quality

Search phrases and frequencies related to accounting earnings quality are in-
cluded in Panel B of Table 1. In the report sections extracted, we found limited
evidence that conservative accounting methods are a signal of high-quality earnings
per se. For example, one report contained the following heading: “Quality of Earn-
ings is High Because of Conservative Accounting.” Similarly, one report raised
questions about revenue quality because of the adoption of a new, less conservative
revenue recognition method. On the cost side, there was some evidence that con-
servative depreciation (accelerated methods over short lives) was equated with high
quality earnings. One report stated that the “Quality of earnings appears excellent,
with depreciation at about 13% of gross property and equipment.”’ Other reports
associated low earnings quality with the propensity of a company to capitalize costs
of the sort expensed by other firms: “[The company] has been extremely aggressive
in the amount of software it has capitalized,” and vice versa. The capitalization
evidence is difficult to interpret, since management may exercise discretion from
year to year in such capitalizations.
We examined analysts’ references to inventory costing methods for an asso-
ciation between conservative accounting methods and high earnings quality. In
terms of inventory valuation, we explored whether LIFO, as a more “conservative”
accounting method, was associated with higher quality earnings, which would be
consistent with hypothesis 2. The terms “LIFO” and “FIFO” were used 115 times
and 64 times, respectively. We found no relationship between earnings quality and
inventory costing method per se. Rather, discussions of earnings quality related to
inventory costing almost always involved companies’ quarterly LIFO reserve ad-
justment. For example, one report stated that “earnings quality could have been
better. As expected a positive LIFO inventory adjustment gave final-period profits
a slight boost.” That this is, at least in part, a discretionary adjustment is suggested
by the report that stated that “We view. . . the most likely source of a positive
earnings surprise as the fourth quarter LIFO adjustment [because the company]
tends to be conservative in these estimates during the year.”
There were many more report passages linking discretionary conservative ac-
counting accruals with earnings quality, consistent with hypothesis 3. One report
stated that “The results are very high quality . . . [the company’s] reported earnings
are not only good on the surface, they understate what was a phenomenal quarter
from operations.” The report recommended purchase of stock in the company, in

9. Some (e.g., Bernstein [1989]) would argue that this form of earnings quality relates more
cogently to capital maintenance.

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ASSESSMENT OF COMPANY EARNINGS QUALITY 55 1
part, because of the company’s “high quality of earnings.” Or more transparently,
one report stated that “In our view, [the company’s] reported earnings are of much
higher quality than for most companies. . . . With all its businesses booming, the
opportunity to ‘manage down’ earnings exists.” As examples, the report cited a
high book tax rate and inclusion of nonrecurring expenses in operating results
(charges for relocating headquarters included in operating expenses).
A company’s book tax rate was frequently associated with earnings quality,
such that higher rates were associated with larger discretionary reserves and higher
earnings quality. Analysts’ discussions suggest their view of management’s discre-
tion over this item. One report stated that “earnings quality is low because of
favorable tax treatment.” Other reports stated that a company’s tax accrual rate
decline “caused some to question the quality of earnings at [the company] . . . and
caused a sharp drop in the stock price,” and (in another report) that earnings quality
was low because of “a big drop in the tax rate.” Another company’s earnings
were described as “clean” because “although there was a $10 million LIFO profit,
this was more than offset by a $10 million charge to reduce employment. . . and
a $10-12 million inventory writeoff. Finally, the tax rate was 30.8% compared
with 6.5% a year ago.”
There was also evidence of an association between management discretion and
bad debt accyals. The discretionary ability to manage bad debt accruals is sug-
gested by the following passage: “the company is reserving conservatively for any
expected losses. The reserve for doubtful accounts is . . .more than 4.5 times what
the company wrote off in 1991.” Another report stated that “Excluding the costs
associated with bad debt reserves. . . we estimate [the company’s] SG&A expense
rate in Q1 was virtually flat” implying a belief in a degree of management discre-
tion over bad debts, although not linking this to earnings quality. The discretionary
accrual of bad debts during good times to create a reserve for future earnings-
increasing accruals is suggested by the following passage:
*“Included in the SG&A figure is a series of one-time charges [the company]
took in order to offset the one-time gain reported from [an overseas IPO]. The
charges . . . [include] $17.6 million for planned closure of underperforming res-
taurants, and $12 million in writeoff for potentially uncollectible account re-
ceivables.. . . we view [the receivable charge] as one of conservative
accounting.”
Other discretionary accruals, allowances, OBSAs also were associated with
earnings quality. One report questioned the quality of a company’s reported earn-
ings as follows: “Quarterly earnings received a boost of $10.5 million from gains
on the sale of securities, which we find puzzling since the investment portfolio had
$250-million in unrealized losses. . . . Furthermore, management opted to reduce
the loan-loss reserve. . . which we find equally perplexing.” Another commented:
“[The company’s] method for gains on sale of loans, and conservatively present-
valuing excess future value of servicing against assumed cost of servicing, has
generated off-balance sheet assets (potential profit).” One report, ostensibly ad-

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552 JOURNAL OF ACCOUNTING, AUDITING & FINANCE
dressing economic earnings quality, in fact addressed accounting earnings quality
as follows: “more aggressive recognition of problem assets could lead to reduced
earnings volatility and thus a reduction in the returns required by equity investors.”
Among the most telling comments was the following: “EPS were $0.57 compared
with . . . our estimate of $0.57. The company managed to make the numbers despite
lower revenues and weaker margins due to higher than expected other income and
a lower tax rate.” The analysts’ use of the phrases “opted” and “make” and
“puzzling” and “perplexing” imply not only the use of discretionary reserves to
manage earnings, but a value judgment by the analysts on the quality of the re-
ported earnings.
Finally, although restructuring charges were viewed as one-time occurrences,
they were not associated with either earnings quality or management discretion per
se. Some components of restructuring charges, however, were so interpreted, for
example, the establishment of specific reserves and allowances, as previously
discussed.

5. Conclusions
As to Q , (analysts’ definition of core earnings), the evidence of this study
establishes that analysts have a more restrictive definition of recurring or core
operations than is contained in APB No. 30. Core earnings are an important his-
torical basis that analysts use in forecasting EPS. Core earnings are more restrictive
than accounting continuing operations by (1) smoothing or “normalizing” revenue
and expense irregularities resulting from accounting accruals and changes in op-
erations and (2) adjusting for one-time items included in operating income and
continuing operations.
The evidence also shows that financial analysts consider earnings quality in
terms of the predictability of near-term earnings. The two components of predict-
ability are economic earnings quality, derived from a company’s product mix and
industry, and accounting earnings quality. This evidence supports H , unambigu-
ously (financial analysts regard companies with revenueslearnings that are recur-
ring, consistent and predictable as having earnings of high quality). With only one
cited exception, more predictable core earnings are associated with higher earnings
quality. The evidence as to H2 (sell-side financial analysts regard applications of
conservative accounting methods uniformly as evidence of high earnings quality)
is less convincing. Although there are some explicit references linking conservative
accounting to high earnings quality per se, reports more frequently associate high
earnings quality with discretionary conservative accounting accruals. Particularly
telling is the lack of an association between LIFO and earnings quality per se, but
rather only between the discretionary quarterly LIFO adjustment and earnings qual-
ity. Similarly, book tax rates, bad debt accruals, and similar discretionary items
were associated with earnings quality. Overall, these results suggest that analysts
do not view the application of conservative accounting methods per se as a credible
signal that management does not exaggerate performance.

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ASSESSMENT OF COMPANY EARNINGS QUALITY 553
The evidence presented here also strongly suggests that management uses dis-
cretionary accruals to meet earnings forecasts, consistent with the empirical findings
of Bannister and Newman (1992). This evidence similarly explicitly and implicitly
links these accruals and adjustments to earnings quality, and is generally consistent
with H3 (sell-side financial analysts regard only discretionary conservative account-
ing accruals as evidence of high earnings quality). In summary, we found that high
accounting earnings quality was less systematically associated with conservative
accounting methods per se and more consistent with the establishment of discre-
tionary reserves, allowances, and off-balance-sheet assets that can be adjusted by
management in order to manage future earnings. This suggests that financial ana-
lysts are indifferent about the application of nondiscretionary conservative account-
ing methods, and prefer accounting methods that permit management discretion in
establishing and adjusting certain conservative reserves, allowances and off-
balance-sheet assets.
We conclude that care must be taken so that different meanings of similar
terms and phrases do not become a barrier to understanding accounting preferences
of financial statement users. Kuhn (1970) has commented extensively on the prob-
lems associated with incommensurability; that is, the problems of different com-
munities using the same words to mean different things. It is important for all
parties involved with financial disclosure and analysis to understand the meanings
given to phrases such as “earnings quality.” Our study establishes the importance
to the accounting community, specifically, of learning to relate to the meanings of
terms employed by financial statement users, so as to better promote effective
communication in accounting and reporting standards.

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