KWAME NKRUMAH UNIVERSITY OF SCIENCE AND TECHNOLOGY

KWAME NKRUMAH UNIVERSITY OF SCIENCE AND TECHNOLOGY (IDL)
ASSIGNMENT ONE
PROGRAME : MSC. ACCOUNTING
COURSE : ACCOUNTINGTHEORY (ACC559)
NAME OF STUDENT : CLEMENT OSEI
NDEX NO : PG1024417
YEAR : 2018
SOLUTION
THE MEANING OF EARNINGS QUALITY
Chan et al. (2006) defined the quality of earnings as the degree to which reported earnings indicate operating fundamental of an entity. This measure of quality is interested on the ability of reported earnings to predict future performance of entity.
Vincent (2004) defined the quality of earnings as decision usefulness of the reported earnings to the users. In this context the quality of earnings is how earnings information is indispensible to markets participants in making decision of resources allocation in the capital markets.
Srinidhi et al. (2011), describes earnings quality as the ability of current reported earnings to reflect the future cash flow and earnings. In this context earnings quality refers to how best current reported earnings can predict future performance of entity. Similarly, Bellovary et al. (2005), Li (2011) defined earnings quality as the ability of earnings to reflect company permanent earnings
Techniques, numbers, trends and factors can be used to assess the quality of earnings and some of these tools are discussed below;
Accrual quality
The difference between cash from operating and recorded earnings generated by business indicates accrual quality (Richardson et al. 2001, Desai et al. 2006), likewise, errors on estimating the accrual has also been used in measuring the quality of accruals(Francis et al 2004, Jing 2007 and Johnston, 2009). The accrual quality focuses on the quantum or magnitude and error in estimating accrual.

The large the value obtained from each method imply poor earnings and small value obtained from each method also indicates high quality earnings.
Persistence
Persistence of the reported earnings is commonly used measure of earnings quality which is measured by the sustainability of the reported earnings of the firm (Penman and Zhang2002; Francis, et al. 2004)
Earnings which are more persistent are more sustainable and are of high quality, likewise earnings which are less persistent are more transitory are considered to be of low quality (Penman and Zhang 2002; Francis et al. 2004).

Predictability
Predictability of earnings represents the ability of the reported earnings to predict future component of operating income. The higher ability to predict future earnings indicates high earnings quality and poor ability to predict future earnings indicates poor earnings quality. ( Lipe 1990, and Penman and Zhang 2002)
Smoothness
The term income smoothing refers to effort done by managers of entity to reduce irregular variation in earnings. Managers exercises their power to reduce abnormality on the earnings as means to inform interested users about their assessment of the future earnings to the degree allowed by accounting standards.(Trucker and Zarowin, 2006). Smoothened earnings indicates high earnings quality that users of accounting information need, un-smoothened represents poor quality earnings

QUALITY EARNINGS ASSESSMENT OF GBBL FOR THE YEAR 2017

Basis of Auditor’s opinion
Basis of the Auditor’s opinion can give a clue as to the quality of the financial statement of GGBL.

Thus, audit of the company was conducted in accordance with International Standards on Auditing (ISAs).

The auditor obtained sufficient audit evidence that were appropriate to provide a basis for their opinion. The audit was done on the principle of independence

Depreciation
Depreciation is recognized in profit or loss on a straight-line basis over the estimated useful lives of each part of an item of property, plant and equipment. Leased assets are depreciated over the shorter of the lease term and their useful lives. Leaseholds are depreciated over the unexpired period of the lease
The adoption of the straight-line method of depreciation of property, plant and equipment has impact on the quality of earnings of the company which may lead to low earnings quality
Inventories valuation
Inventories are measured at lower of cost and net realizable value using the weighted average cost principle. The cost of inventories includes expenditure incurred in acquiring inventories and bringing them to their existing location and condition. Net realizable value is the estimated selling price in the ordinary course of business, less estimated selling expenses. Inventories are stated at the lower of cost and net realizable value less allowance for obsolescence and slow moving items. This imply that cost of sale of GGBL if influence by the choice of inventory valuation method adopted which will impact on the quality of earnings of the company
Revenue
Revenue – Sale of goods
Revenue from the sale of goods is measured at the fair value of consideration received or receivable, net of returns, trade discounts, taxes and volume rebates. Revenue is recognized when significant risks and rewards of ownership have been transferred to the buyer, there is no continuing management involvement in the goods, recovery of the consideration is probable, associated costs and possible return of goods can be estimated reliably and the amount of revenue can be measured reliably. Transfer of risks and rewards occurs when the goods are delivered to the customer. If the company tied a lot of receivables in its books, this could have low quality earnings on the firm.

Earnings per share
The Company presents basic and diluted earnings per share (EPS) data for its ordinary shares. Basic EPS is calculated by dividing the profit or loss attributable to ordinary shareholders of the Company by the weighted average number of ordinary shares outstanding during the period. Diluted EPS is determined by adjusting the profit or loss attributable to ordinary shareholders and the weighted average number of ordinary shares outstanding for the effects of all dilutive potential ordinary shares.

The company’s earning per shares has not been consistent. Since 2014, GGBL recorded negative earnings per share with the exception on 2013 and 2017 which the company was able to record a positive earnings per share. Due to this trend, the company was incapable of declare dividend consistently
GGBL net asset per share for 2017 was on a high side as compared with 2016, 2015, 2014 and 2013
The statistics included in the financial report of the company signals a trend which can guide investors to make prediction on the future earning capacity of the firm.
Earning statistic table
2017 2016 2015 2014 2013
EPS (GH¢) 0.022 (0.036) (0.215) (0.041) 0.086
Dividend per share (GH¢) – – – 0.02 0.02
Net asset per share (GH¢) 0.88 0.86 0.45 0.67 0.72
Current ratio 1.35:1 1.20:1 0.81:1 1.22:1 0.56:1
Return on shareholders’ fund (%) 2.55 (2.91) (47.77) (6.13) 11.96
Return on net sales value (%) 1.18 (1.36) (10.40) (2.61) 5.69
Source: GGBL 2017, financial report
DuPont method of financial analysis
Whiles each ratio gives an indication of one factor of a firm’s operation, they may be combined to show the impact of interrelations of a firm’s operations on its earning power.

This is achieved by the use of DuPont system of financial analysis, which combines profitability, asset management, and leverage to determine the return on a firm’s equity
Return on Equity (ROE) = Net profit Margin * Asset Turnover * Equity Multiplier
Net Income * Revenue * Assets
Revenue Assets Equity
GH ¢6,914,000 * GH¢587,447,000 * GH¢527,907,000
GH¢587,447,000 GH¢527,907,000 GH¢270,949,000
0.01 1.11 1.95
= 0.02 or {2%}
GGBL is generating low sales due to high cost of sales as indication by its profit margin, is asset turnover ratio is an indication of inefficient utilization of assets to generate revenue.
High asset turnover ratio is an indication of better or quality of earnings. The company’s equity multiplier showed a higher financial leverage position.

Profitability Ratio
Gross profit margin = Revenue – Cost of goods sold/Revenue
GH ¢587,447,000 – 437,111,000
GH ¢587,447,000
= 0. 2559 {25.59%}
This ratio indicates that GGBL earns 25% of gross profit margin on its cost of sales in order to generate revenue for the year 2017.
Operating profit Margin = operating earnings/ Revenue

41,857,000 * 100
587,447,000
= 71.25%
GGBL earns 71.25% margin from operating activities and the is an indication of high quality earnings since it is not highly due to manipulation on accounting policies adopted by the firm
Quality of income = cash flow from operating activities
Net income
= GH¢88,804,000 * 100
GH¢ 6,914,000

=12.84%
This ratio establishes the relationship between cash income and the firm’s total income.
Out of the net earnings of the company GGBL has 12.84% as cash income and this demonstrate low quality earning, but it is largely dependent on the industry within which the firm operates.

Reference
European Journal of Accounting Auditing and Finance Research Vol.2, No.6, pp.17-28, August 2014
Lipe, R. (1990) The relationship between stock returns and accounting earnings alternative information, The Accounting Review, 65(1) 49-71.

Penman. S. and Zhang, X, J. (2002) Accounting conservatism, the quality of earnings and stock returns” The Accounting Review, 77(2) 237-264.
Richardson, A, Sloan, R, Soliman, M, and Tuna, I, (2001) Information in accruals about the quality of earnings, University of Michigan Business school Available atSSRNwww.investopedia.comwww.myaccountingcourse.com/financial-ratios/dupont-analysis