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Measuring the
Measuring the quality of earnings quality of
Khaled ElMoatasem Abdelghany earnings
Accounting Department, College of Business and Economics,
Qatar University, Doha, Qatar
1001
Abstract
Purpose – Although the academic research on the quality of earnings has been improved by
presenting different approaches of measurement, there is no agreed-upon generally accepted approach
to measure the earning quality. Aims to present results of an empirical study measuring the quality of
earnings on companies listed in NYSE.
Design/methodology/approach – Uses a sample of 90 companies listed in the NYSE. The analysis
is directed to reach a general assessment of the quality of earnings if there is a complete consistency
among the three approaches, and if not, the quality of earnings is questionable and needs further
analysis and investigations.
Findings – The results show that different approaches of measuring the quality of earning lead to
different assessment, and one industry or one company can not be labeled as having low or high
quality of earning based on the result of one approach only. The results also suggest that the
stakeholders before making any financing, investing decision or taking any corrective action, have to
use more than one approach to assess the quality of earnings.
Originality/value – Indicates that financial analysts and governmental agencies dealing with
companies should apply more than one measure for the quality of earning in order to have strong
evidence about the level of quality before taking any corrective action or making any decision related
to those companies.
Keywords Earnings, Financial analysis, Measurement
Paper type Research paper

1. Introduction
Generally accepted accounting principles (GAAP) offer some flexibility in preparing
the financial statements and give the financial managers some freedom to select among
accounting policies and alternatives. Earning management uses the flexibility in
financial reporting to alter the financial results of the firm (Ortega and Grant, 2003).
In other words, earnings management is manipulating the earning to achieve a
predetermined target set by the management. It is a purposeful intervention in
the external reporting process with the intent of obtaining some private gain
(Schipper, 1989).
Levit (1998) defines earning management as a gray area where the accounting is
being perverted; where managers are cutting corners; and, where earnings reports
reflect the desires of management rather than the underlying financial performance of
the company.
The popular press lists several instances of companies engaging in earnings
management. Sensormatic Electronics, which stamped shipping dates and times on
sold merchandise, stopped its clocks on the last day of a quarter until customer
shipments reached its sales goal. Certain business units of Cendant Corporation Managerial Auditing Journal
Vol. 20 No. 9, 2005
inflated revenues nearly $500 million just prior to a merger; subsequently, Cendant pp. 1001-1015
restated revenues and agreed with the SEC to change revenue recognition practices. q Emerald Group Publishing Limited
0268-6902
AOL restated earnings for $385 million in improperly deferred marketing expenses. DOI 10.1108/02686900510625334
MAJ In 1994, the Wall Street Journal detailed the many ways in which General Electric
20,9 smoothed earnings, including the careful timing of capital gains and the use of
restructuring chares and reserves, in response to the article, General Electric reportedly
received calls from other corporations questioning why such common practices were
“front-page” news.
Earning management occurs when managers use judgment in financial reporting
1002 and in structuring transactions to alter financial reports to either mislead some
stakeholders about the underlying economic performance of the company or to
influence contractual outcomes that depend on reported accounting numbers (Healy
and Whalen, 1999).
Magrath and Weld (2002) indicate that abusive earnings management and
fraudulent practices begins by engaging in earnings management schemes designed
primarily to “smooth” earnings to meet internally or externally imposed earnings
forecasts and analysts’ expectations.
Even if earnings management does not explicitly violate accounting rules, it is an
ethically questionable practice. An organization that manages its earnings sends a
message to its employees that bending the truth is an acceptable practice. Executives
who partake of this practice risk creating an ethical climate in which other
questionable activities may occur. A manager who asks the sales staff to help
accelerate sales one day forfeits the moral authority to criticize questionable sales
tactics another day.
Earnings management can also become a very slippery slope, which relatively
minor accounting gimmicks becoming more and more aggressive until they create
material misstatements in the financial statements (Clikeman, 2003)
The Securities and Exchange Commission (SEC) issued three staff accounting
bulletins (SAB) to provide guidance on some accounting issues in order to prevent the
inappropriate earnings management activities by public companies: SAB No. 99
“Materiality”, SAB No. 100 “Restructuring and Impairment Charges” and SAB No. 101
“Revenue Recognition”.
Earnings management behavior may affect the quality of accounting earnings,
which is defined by Schipper and Vincent (2003) as the extent to which the reported
earnings faithfully represent Hichsian economic income, which is the amount that can
be consumed (i.e. paid out as dividends) during a period, while leaving the firm equally
well off at the beginning and the end of the period.
Assessment of earning quality requires sometimes the separations of earnings into
cash from operation and accruals, the more the earnings is closed to cash from
operation, the higher earnings quality. As Penman (2001) states that the purpose of
accounting quality analysis is to distinguish between the “hard” numbers resulting
from cash flows and the “soft” numbers resulting from accrual accounting.
The quality of earnings can be assessed by focusing on the earning persistence;
high quality earnings are more persistent and useful in the process of decision
making.
Beneish and Vargus (2002) investigate whether insider trading is informative about
earnings quality using earning persistence as a measure for the quality of earnings,
they find that income-increasing accruals are significantly more persistent for firms
with abnormal insider buying and significantly less persistent for firms with abnormal
insider selling, relative to firms which there is no abnormal insider trading.
 Balsam et al. (2003) uses the level of discretionary accruals as a direct measure for Measuring the
earning quality. The discretionary accruals model is based on a regression relationship quality of
between the change in total accruals as dependent variable and change in sales and
change in the level of property, plant and equipment, change in cash flow from earnings
operations and change in firm size (total assets) as independent variables. If the
regression coefficients in this model are significant that means that there is earning
management in that firm and the earnings quality is low. 1003
This research presents an empirical study on using three different approaches of
measuring the quality of earnings on different industry. The notion is; if there is a
complete consistency among the three measures, a general assessment for the quality
of earnings (high or low) can be reached and, if not, the quality of earnings is
questionable and needs different other approaches for measurement and more
investigations and analysis.
The rest of the paper is divided into following sections: Earnings management
incentives, Earnings management techniques, Model development, Sample and
statistical results, and Conclusion.

2. Earnings management incentives

2.1 Meeting analysts’ expectations
In general, analysts’ expectations and company predictions tend to address two
high-profile components of financial performance: revenue and earnings from
operations.
The pressure to meet revenue expectations is particularly intense and may be the
primary catalyst in leading managers to engage in earning management practices that
result in questionable or fraudulent revenue recognition practices. Magrath and Weld
(2002) indicate that improper revenue recognition practices were the cause of one-third
of all voluntary or forced restatements of income filed with the SEC from 1977 to 2000.
Ironically, it is often the companies themselves that create this pressure to meet the
market’s earnings expectations. It is common practice for companies to provide
earnings estimates to analysts and investors. Management is often faced with the task
of ensuring their targeted estimates are met.
Several companies, including Coca-Cola Co., Intel Corp., and Gillette Co., have taken
a contrary stance and no longer provide quarterly and annual earnings estimates to
analysts. In doing so, these companies claim they have shifted their focus from meeting
short-term earnings estimates to achieving their long-term strategies (Mckay and
Brown, 2002)

2.2 To avoid debt-covenant violations and minimize political costs

Some firms have the incentive to avoid violating earnings-based debt covenants. If
violated, the lender may be able to raise the interest rate on the debt or demand
immediate repayment. Consequently, some firms may use earnings-management
techniques to increase earnings to avoid such covenant violations. On the other hand,
some other firms have the incentive to lower earnings in order to minimize political
costs associated with being seen as too profitable. For example, if gasoline prices have
been increasing significantly and oil companies are achieving record profit level, then
there may be incentive for the government to intervene and enact an excess-profit tax
or attempt to introduce price controls.
MAJ 2.3 To smooth earnings toward a long-term sustainable trend
20,9 For many years it has been believed that a firm should attempt to reduce the volatility
in its earnings stream in order to maximize share price. Because a highly violate
earning pattern indicates risk, therefore the stock will lose value compared to others
with more stable earnings patterns. Consequently, firms have incentives to manage
earnings to help achieve a smooth and growing earnings stream (Ortega and
1004 Grant, 2003).

2.4 Meeting the bonus plan requirements

Healy (1985) provides the evidence that earnings are managed in the direction that is
consistent with maximizing executives’ earnings-based bonus. When earnings will be
below the minimum level required to earn a bonus, then earning are managed upward
so that the minimum is achieved and a bonus is earned. Conversely, when earning will
be above the maximum level at which no additional bonus is paid, then earnings are
managed downward. The extra earnings that will not generate extra bonus this current
period are saved to be used to earn a bonus in a future period. When earnings are
between the minimum and the maximum levels, then earnings are managed upward in
order to increase the bonus earned in the current period.

2.5 Changing management

Earnings management usually occurs around the time of changing management, the
CEO of a company with poor performance indicators will try to increase the reported
earnings in order to prevent or postpone being fired. On the other hand, the new CEO
will try shift part of the income to future years around the time when his/her
performance will be evaluated and measured, and blame the low earning at the
beginning of his contract on the acts of the previous CEO.

3. Earnings management techniques

One of the most common earnings management tools is reporting revenue before
the seller has performed under the terms of a sales contract (SEC, SAB No. 101,
1999).
Another area of concern is where a company fails to comply with GAAP and
inappropriately records restructuring charges and general reserves for future losses,
reversing or relieving reserves in inappropriate periods, and recognizing or
not recognizing an asset impairment charge in the appropriate period (SEC, SAB
No. 100, 1999).
Managers can influence reported expenses through assumptions and estimates such
as the assumed rate of return on pension plan asset and the estimated useful lives of
fixed assets, also they can influence reported earnings by controlling the timing of
purchasing, deliveries, discretionary expenditures, and sale of assets.

3.1 Big bath

“Big Bath” charges are one-time restructuring charge. Current earnings will be
decreased by overstating these one-time charges. By reversing the excessive reserve,
future earnings will increase.
Big bath charges are not always related to restructuring. In April 2001, Cisco
Systems Inc. announced charges against earnings of almost $4 billion. The bulk of
the charge, $2.5 billion, consisted of an inventory write down. Writing off more than Measuring the
a billion dollars from inventory now means more than a billion dollars of less cost in quality of
the future period. This an example of what ultra-conservative accounting in one period
makes possible in future periods. earnings

3.2 Abuse of materiality

Another area that might be used by accountants to manipulate the earning is the 1005
application of materiality principle in preparing the financial statements, this principle
is very wide, flexible and has no specific range to determine where the item is material
or not. SEC uses the interpretation ruled by the supreme court in identifying what is
material; the supreme court has held that a fact is material if there is a substantial
likelihood that the fact would have been viewed by reasonable investor as
having significantly altered the “total mix” of information made available (SEC, SAB
No. 99, 1999).
The SEC has also introduced some considerations for a quantitatively small
misstatement of a financial statement item to be material:
.
whether the misstatement arises from an item capable of precise measurement or
whether it arises from an estimate and, if so, the degree of imprecision inherent in
the estimate;
.
whether the misstatement masks a change in earnings or other trends;
.
whether the misstatement hides a failure to meet analysts’ consensus
expectations for the enterprise;
.
whether the misstatement changes a loss into income or vice versa;
.
whether the misstatement concerns a segment or other portion of the registrant’s
business that has been identified as playing a significant role in the registrant’s
operations or profitability; and
.
whether the misstatement involves concealment of an unlawful transaction.

3.3 Cookie jar

“Cookie jar” reserve – sometimes labeled rainy day reserve or contingency reserves,
in periods of strong financial performance, cookie jar reserve enable to reduce
earnings by overstating reserves, overstating expenses, and using one-time
write-offs. In periods of weak financial performance, cookie jar reserves can be
used to increase earnings by reversing accruals and reserves to reduce current period
expenses (Kokoszka, 2003).
The most famous example of use of cookie jar reserves is WorldCom Inc. In August
2002, an internal review revealed that the company had $2.5 billion reserves related to
litigation, uncollectible and taxes. The company used most of them in a series of
so-called reserve reversals in order to have higher earnings.

3.4 Round-tripping, back-to-back and swaps

The practice of selling an unused asset to another company while at the same time
agreeing to buy back the same or similar assets at about the same price is known as
round-tripping. Back-to-Back is the same process but with a short time lag – the two
transactions are not scheduled to occur at precisely the same time. Swaps occur when
two companies sell each other virtually identical assets to recognize revenue.
MAJ These techniques artificially inflate the revenue of both the buyer and the seller
20,9 (Kokoszka, 2003).
Qwest Communication International allegedly was one of the most aggressive users
of swap transactions – selling long-term capacity on its fiber network to another carrier,
buying the same amount of fiber on another carrier’s net work, and then booking the
contract as revenue. Qwest is also alleged to have boosted sales by selling equipment to
1006 another companies and then leasing services back from those same concerns.

3.5 Timing of adoption of mandatory accounting standards

Since its formation in 1973 the Financial Accounting Standards Board (FASB) has
issued 151 accounting standards – an average of five new standards per year.
Typically, the FASB standards are enacted with a two-to-three-year transition period
prior to mandatory adoption but with early adoption encouraged.
While not all firms are affected by each standard issued, the relative frequency of
new standards combined with long adoption windows provides an opportunity for
managers to select an adoption year most favorable to the firm’s financial picture
(Ayres, 1994).
Ayres (1986) provides the empirical evidence that the firms who adopted the
Statement of Financial Accounting Standard (SFAS) #52 “Accounting for Foreign
Currency Translation” early had the opportunity to increase earnings with an average
of $0.38 per share. In comparison to firms that adopted the standard later, the
early-adopting firms were smaller, closer to debt and dividend constrains, and less
profitable than later-adopting firms.
Early adoption of accounting standard that increase income may convey an
impression that a company needs to find income from wherever possible. Early
adoption can lower investors’ perception of earning quality.

3.6 Voluntary accounting changes

Another method of managing earnings is to switch from one generally accepted
accounting method to another. While a firm cannot make the same type of accounting
changes too frequently, it is possible to make several different types of accounting
changes either together or individually over several periods.

3.7 Conservative accounting

Conservative accounting means choosing the accounting method that keeps the
carrying values of the assets relatively low. Therefore, LIFO accounting for inventories
is conservative relative to FIFO (if inventory prices are increasing); expensing research
and development expenditures rather than capitalizing and amortizing them is
conservative; and policies that consistently overestimate allowances for doubtful
accounts, sales returns or warranty liabilities are conservative.
Conservative accounting affects not only the quality of numbers reported on the
balance sheet, but also the quality of earnings reported on the income statement. When
the firm increase investment, conservative accounting leads to reported earnings that
are lower than would have been had management made more liberal accounting
choices. These lower earnings, however, create unrecorded reserves that provide
managers more flexibility to report more income in the future. Management can
increase these reserves, and so reduce earnings, by increasing investment.
Management can also release the reserves and create additional earnings, by Measuring the
subsequently reducing investment (Penman and Zhang, 2002). quality of
3.8 Using the derivatives
earnings
According to the SFAS #133 “Accounting for Derivative Instruments and Hedging
Activities”, if the company has fair value hedge on the available for sale securities, the
unrealized holding gain or loss on the available for sale securities will not be reported 1007
in the comprehensive income statement and will be reported in the income statement to
offset the gain or loss on the change of the fair value of the hedging instrument. So the
manager can manipulate the income by buying a hedging instrument (for example, put
option) for a specific period of time in order to switch the unrealized gain or loss from
the comprehensive income statement to the income statement. Thus, the manager will
realize a controlled amount of gain or loss when selling the available for sale securities
at a certain point of time.

4. Model development
Although the phrase “earnings quality” is widely used, there is neither an agreed-upon
meaning assigned to the phrase nor a generally accepted approach to measuring
earnings quality. There are three basic approaches to measure the quality of earnings
which control three different dimensions of earning management.
The first approach is focusing on the variability of earnings based on the idea that
managers tend to smooth income because they believe that the investors prefer
smoothly increased income. The notion of this approach is the relative absence of
variability – is sometimes associated with higher-quality earnings. Leuz et al. (2003)
measures the variability of earnings by calculating the ratio of the standard deviation
of operating earnings to the standard deviation of cash from operations (smaller ratios
imply more income smoothing).
The second approach is suggested by Barton and Simko (2002), which is focusing
on the idea of earnings surprise as reflected in the beginning balance of net operating
assets relative to sales. They provide empirical evidence that firms with large
beginning balance of net operating assets relative to sales are less likely to report a
predetermined earnings surprise.
The third approach is focusing on the ratio of cash from operation to income, this
measuring of earnings quality is based on the notion that the closeness to cash means
higher quality earnings, as mentioned by Penman (2001), this is the simplest technique
to measure the earnings quality.
The model will use these three approaches to measure the quality of earnings, the
notion is; the result of each measure will be different based on the type of industry,
market capitalization, number of employees, and many other factors. If one industry
(company) is showing low quality of earnings according to the three approaches, that
will confirm the existence of earnings management in that industry (company). On the
other hand if there is no consistency among the three measures for one industry or
company, the quality of earning will be questionable and needs further investigations
and analysis. Finally, if there is consistency among the three measures for one industry
(company) that will confirm that the accounting information represents the real
economic performance of the industry without any interference from the management.
Table I presents the three-dimension model.
MAJ
Leuz et al. (2003) Barton and Simko (2002) Penman (2001)
20,9 approach approach approach

Quality of earnings is measured Quality of earnings is measured Quality of earnings is measured

by variability of earnings which
is equal to the standard
1008 deviation of operating income
divided by the standard
deviation of cash flow from
Table I. operation
The three-dimension The smaller the ratio the lower
model the quality of earnings
by the earning surprise indicator
which is the ratio of the
beginning balance of net
operating assets relative to sales
The smaller the ratio the higher
the quality of earnings
by the ratio of cash flow from
operation divided by the net
income
The smaller the ratio the higher
the quality of earnings

5. Sample and statistical results

One hundred companies listed in NYSE were selected randomly using the data base of
the Wall Street Journal for the period 1999-2003, the available complete data was for
only 90 companies. Table II presents classification of the companies according to their
activities and the mean and the standard deviation for the variables used in the model.
The research design is structured primarily on the basis of calculating three
different measures of the quality of earnings on the industry level and on the company
level. The analysis is directed at testing whether there is consistency among the three
measures for one industry or one company in order to have strong evidence about
whether the quality of earnings is low or high. The quality of earnings will be marked
as questionable if there is no consistency among the three measures. In this case, the
quality of earnings measure needs more analysis and investigations and may be in
some cases different techniques to confirm whether it is high or low.
Table III presents the results of the empirical study for the industry level.
As shown in Table III, there is consistency among the three measures of the quality
of earning for the full sample, the banks, insurance, and investment industry and for
the technology industry. For the manufacturing companies and the mining, oil and gas
companies the quality of earnings is questionable and cannot be assessed based on
these three measures.
Table IV presents the empirical study results for the company level.
As shown in Table IV, the manufacturing industry has 13 companies (42 percent)
with high quality of earnings, one company with low quality of earnings, and 17
companies (55 percent) their quality of earnings measure is questionable and cannot be
assessed based on this model and needs further investigation and analysis.

Industry No. of companies Variable name Mean Std. dev.

Manufacturing 31 Sales 1771269.13 365,557

Table II. Mining, oil, and gas 9 Operating income 248786.55 554186.4
Industrial classification Service 28 Net income 128049.99 423,625
and variables description Banks, insurance, and investment 15 Total assets 3904900.73 12341846.5
(n ¼ 90) Technology 7 Operating cash flow 3390458.2 695952.7
 Barton and Simko
Leuz et al. approach approach Penman approach
Earnings Earnings Earnings General earnings quality
Industry classification n Measure quality Measure quality Measure quality assessment

Full sample 90 0.163 Low 2.281 Low 5.435 Low Low

Manufacturing 31 1.042 High 2.031 Low 1.236 High Questionable
Mining, oil, and gas 9 1.014 High 1.462 High 4.042 Low Questionable
Service 28 0.385 Low 0.584 High 5.641 Low Questionable
Banks, insurance, and
investment 15 0.09 Low 11.40 Low 13.952 Low Low
Technology 7 1.107 High 0.958 High 2.288 High High
earnings
Measuring the

results: industry level

The empirical study
Table III.
1009
quality of
 20,9
MAJ

1010

Table IV.
The empirical study
results: company level
Leuz et al. approach Barton and Simko approach Penman approach
No. Company symbol Measure Earnings quality Measure Earnings quality Measure Earnings quality General assessment

Panel A: manufacturing companies

(n ¼ 31)
1 RPM 1.635 High 0.836 High 1.928 High High
2 CSS 1.719 High 0.897 High 21.890 Low Questionable
3 CAE 14.344 High 0.991 High 2.859 High High
4 SSD 1.686 High 0.805 High 1.139 High High
5 HAN 0.122 Low 2.045 Low 16.561 Low Low
6 AEP 0.471 Low 1.995 High 5.515 Low Questionable
7 MAG 1.133 High 1.553 Low 1.930 High Questionable
8 PPL 1.047 High 2.716 Low 2.256 High Questionable
9 DPL 1.090 High 3.506 Low 5.351 Low Questionable
10 MSC 0.947 Low 1.130 High 3.289 Low Questionable
11 MNC 52.92 High 0.409 High 0.199 High High
12 ACV 1.687 High 0.639 High 1.364 High High
13 COH 1.722 High 0.571 High 1.803 High High
14 AQA 1.140 High 2.602 Low 0.522 High Questionable
15 COA 1.362 High 0.041 High 2.289 High High
16 AZZ 1.629 High 0.812 High 1.998 High High
17 CCE 1.011 High 1.532 High 6.248 Low Questionable
18 INTC 0.967 Low 1.552 High 1.949 High Questionable
19 SAM 1.728 High 0.524 High 1.702 High High
20 CCH 1.588 High 2.345 Low 3.509 Low Questionable
21 DDR 0.303 Low 8.184 Low 1.521 High Questionable
22 DRS 1.949 High 1.268 High 2.010 High High
23 AED 0.963 Low 1.353 High 1.764 High Questionable
24 MON 0.159 Low 2.169 Low 2.169 High Questionable
25 AAA 1.591 High 09367 High 1.262 High High
26 ARA 2.44 High 4.224 Low 1.985 High Questionable
27 MOT 1.270 High 1.156 High 2.127 High High
28 EON 2.726 High 2.405 Low 1.044 High Questionable
29 BDR 0.901 Low 1.115 High 5.579 Low Questionable
(continued)
 Leuz et al. approach Barton and Simko approach Penman approach
No. Company symbol Measure Earnings quality Measure Earnings quality Measure Earnings quality General assessment

30 SSI 0.537 Low 11.189 Low 0.077 High Questionable

31 TTG 1.683 High 1.073 High 0.761 High High
Panel B: mining, oil, and gas companies
(n ¼ 9)
1 MEF 1.079 High 1.572 High 2.776 High High
2 MMR 0.402 Low 2.370 Low 0.114 High Questionable
3 RES 1.378 High 1.48 High 2.583 High High
4 EEP 1.346 High 1.974 High 1.845 High High
5 GAS 1.544 High 1.378 High 2.351 High High
6 GGY 1.016 High 1.291 High 1.218 High High
7 GSS 1.840 High 2.683 Low 4.443 Low Questionable
8 CCJ 0.497 Low 4.041 Low 3.183 Low Low
9 OGE 1.608 High 1.385 High 2.627 High High
Panel C: service companies
(n ¼ 28)
1 TOO 1.485 High 0.494 High 1.694 High High
2 ESC 0.498 Low 1.185 High 0.067 High High
3 AMR 1.177 High 1.567 High 1.071 High High
4 NNN 0.894 Low 11.005 Low 1.219 High Questionable
5 CCC 0.860 Low 1.190 High 7.575 Low Questionable
6 MAN 1.478 High 0.317 High 1.069 High High
7 TCN 0.445 Low 1.688 High 17.550 Low Questionable
8 URS 1.587 High 0.755 High 1.237 High High
9 CSK 0.232 Low 5.754 Low 0.128 High Questionable
10 RRD 1.513 High 0673 High 2.968 High High
11 DDE 1.782 High 0.774 High 1.144 High High
12 LEE 0.197 Low 0.437 High 1.5627 Low High
13 ATR 0.980 High 1.381 High 2.045 High High
14 AGL 0.545 Low 0.648 High 6.810 Low Questionable
15 BOO 0.817 Low 0.479 High 0.860 High Questionable
16 LIC 1.441 High 3.364 Low 30.589 Low Questionable
(continued)
earnings
Measuring the

1011

Table IV.
quality of
 20,9
MAJ

1012

Table IV.
Leuz et al. approach Barton and Simko approach Penman approach
No. Company symbol Measure Earnings quality Measure Earnings quality Measure Earnings quality General assessment

17 WLP 1.715 High 0.593 High 1.918 High High

18 UNH 1.577 High 0.556 High 1.850 High High
19 AES 0.775 Low 4.789 Low 3.881 Low Low
20 EE 2.646 High 2.385 Low 3.692 Low Questionable
21 ABT 1.252 High 1.283 High 1.430 High High
22 GGI 0.512 Low 0.572 High 32.853 Low Questionable
23 DQE 0.901 Low 3.233 Low 2.457 High Questionable
24 SAL 1.045 High 0.438 High 3.768 Low Questionable
25 BAY 1.381 High 1.302 High 4.020 Low Questionable
26 HCA 1.532 High 0.990 High 2.604 High High
27 ATH 1.712 High 0.768 High 1.907 High High
28 LLL 1.937 High 1.200 High 1.051 High High
Panel D: banks, insurance, and investment companies
(n ¼ 15)
1 KEY 0.9411 Low 0.016 High 1.905 High High
2 BBT 1.293 High 16.153 Low 0.741 High Questionable
3 XL 1.173 High 5.590 Low 7.031 Low Questionable
4 BCH 1.211 High 12.990 Low 0.803 High Questionable
5 JLG 0.524 Low 0.894 High 1.776 High Questionable
6 CHC 0.964 Low 16.839 Low 2.709 High Questionable
7 MAA 0.507 Low 3.670 Low 3.014 Low Low
8 BAC 0.726 Low 18.050 Low 0.924 High Questionable
9 BRE 0.388 Low 7.603 Low 1.641 High Questionable
10 UBS 1.743 High 28.425 Low 1.003 High Questionable
11 ASA 0.122 Low 25.102 Low 0.529 High Questionable
12 NEN 0.902 Low 3.859 Low 1.790 High Questionable
13 FF 0.002 Low 38.220 Low 0.087 High Questionable
14 CBL 3.224 High 6.314 Low 2.473 High Questionable
15 FFH 1.132 High 3.309 Low 3.440 Low Questionable
(continued)
 Leuz et al. approach Barton and Simko approach Penman approach
No. Company symbol Measure Earnings quality Measure Earnings quality Measure Earnings quality General assessment

Panel E: technology companies

(n ¼ 7)
1 SAP 1.935 High 1.065 High 1.608 High High
2 IMCO 0.496 Low 1.315 High 3.851 Low Questionable
3 BMC 1.308 High 2.015 Low 21.468 Low Questionable
4 MMM 1.433 High 0.914 High 1.630 High High
5 DRS 1.949 High 0.253 High 2.010 High High
6 ASE 1.055 High 0.671 High 0.541 High High
7 ABB 1.310 High 1.564 High 3.130 Low Questionable
earnings
Measuring the

1013

Table IV.
quality of
MAJ For the mining, oil, and gas industry, there are six companies (67 percent) with high
20,9 quality of earnings, one company with low quality of earnings, and two companies
with questionable measure for the quality of earnings.
For the services industry, there are 15 companies (54 percent) with high quality of
earnings, one company with low quality of earnings, and 12 companies (43 percent)
their quality of earnings is questionable.
1014 For banks, insurance, and investment industry, there is one company with high
quality of earnings, one company with low quality of earnings, and 13 companies (87
percent) with questionable quality of earnings.
For the technology industry, there are four companies (57 percent) with high quality
of earnings, and three companies (43 percent) with questionable quality of earnings.
These results suggest that the financial analysts and the government before
reaching any conclusion about the quality of earnings for one company, they should
have a complete consistency among different measures from different prospective,
other wise the quality of earnings needs more investigations and research.

6. Conclusion
This research presents an empirical study about the use of different measure of quality
of earnings on different industries. The notion is; since there is no agreed-upon
definition or technique to measure the quality of earnings, one company or one
industry cannot be labeled as having low quality of earnings based on one technique of
measurement.
In another words, the company or the industry can be judged as having low or high
quality or earnings only if there is consistency among the results of more than one
approach or technique for measurement.
This research concludes that the financial analysts and any governmental agency
dealing with the company should apply more than one measure for the quality of
earning in order to have strong evidence about the level of quality before taking any
corrective action or making any decision related to that company. If one company is
having low quality of earning according to one technique and high quality of earnings
according to another, the stakeholders cannot have a final conclusion about that
company and they need more investigations and analysis to assess the quality of
earnings.

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Further reading
DeAngelo, L. (1986), “Accounting numbers as market valuation substitutes: a stud of
management buyouts of public stockholders”, The Accounting Review, Vol. 40 No. 1,
pp. 400-20.
Lipe, R. (1990), “The relation between stock returns and accounting earnings given alternative
information”, The Accounting Review, Vol. 65 No. 1, pp. 49-71.