Sample Case

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Apply your critical-thinking ability to the knowledge you’ve gained. These cases will provide you an opportunity to develop your research, analysis, judgement and communication skills. You also will work with other students, integrate what you’ve learned, apply it in real world situations, and consider its global and ethical ramifications. This practice will broaden your knowledge and further develop your decision-making abilities.

Judgement case 4-1 (earnings quality) * LO2 LO3

The financial community in the United States has become increasingly concerned with the quality of reported company earnings.

REQUIRED: 1. Define earnings quality. 2. Explain the distinction between permanent and transitory earnings as it relates to the concept of earnings quality. 3. How do earnings management practices affect the quality of earnings? 4. Assume that a manufacturing company’s annual income statement included a large gain from sale of the investment securities. What factors would you consider in determining whether or not this gain should be included in an assessment of the company’s permanents earnings?

Answers:

1. Earnings quality: * Refers to the ability of reported earnings (income) to predict a company’s future earnings. 2. The distinction between permanent and transitory earnings are as follows:
Transitory earnings: Effects result from transactions or events that are not likely to occur again in the foreseeable future or that are likely to have a different impact on earnings in the future.
Permanent earnings: Effects result from continuing transactions/operations. It would be a mistake to assume income from continuing operations reflects permanent earnings entirely. In other words, there may be transitory earnings effects included in both operating and non-operating income. 3. It may lead us to wrong economic decisions for the true earnings quality are not truly reported hence they are manipulated through the

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