Question

1.1?Provide a critical overview of the three potential sources of noise and bias in the accounting data reported by companies, and explain the notion of earnings quality within the context of equity research.

1.2?A financial analyst comments: “Financial ratios by themselves are of little use. The choice of what to benchmark them against is what gives me vital information.” Explain how ratios can identify internal inconsistencies within the financial statements and critically assess the benefits of using benchmarks, illustrating your answer with potential benchmarks.

Answer 1

1.1)

i)

There are 3 major division of sources of noise and bias in accounting data

1.Inadequate Accounting Rules

2.Forecast Errors

3.Factors Affecting Managers’ Accounting Choices

• Debt Covenants
• Compensation
• Corporate Control
• Income Taxes
• Regulatory Concerns
• Capital Market Perceptions
• Competitive Considerations (Segments, etc.)

ii)

Earnings quality is defined as the earnings related to higher sales or lower costs rather than creating artficial earnings using some accounting anomalies like increasing the assets(inflation of inventory),etc.

Earnings quality analysis is important because it is very good at forecasting any ambiguities or changes in earnings.

Earnings quality is important in equity research as it depicts the actual profits aquired by the firm