High-Quality Reporting—Useful Information but Not Sustainable

On the quality spectrum, reports that conform to GAAP and are useful for decisions are near the top. The difference between being the best compared to second-best relates to the quality of the earnings. __High-quality reporting__ is necessary to remain at or near the top of the spectrum. Some reports may conform to GAAP and provide much information useful for making decisions, but the quality of earnings may be low. Low-quality earnings might be from circumstances that are not sustainable in the future.

Assume that Crazy Bill's Hay Wagon company buys his wagons in Canada for resale in the United States. He pays for the wagons in Canadian currency. The cost of each wagon is CAD 1,000, and he sells the wagons for USD 1,500. Average exchange was equal at USD 1.00 = CAD 1.00. This year, the exchange is USD 1.00 = CAD 1.30. If Crazy Bill's sells 50 wagons in both years, what do you think the impact is on the quality of his earnings?

No. Earnings would have increased due to the buying power of the US dollar, but the increase in earnings may not be sustainable in the future as exchange rates fluctuate over time. As long as this information is disclosed and presented in conformance with GAAP, the report is still a high-quality report and provides the information for the reader to determine whether these earnings are sustainable.

Correct. The increase in earnings relates entirely to foreign currency exchange which may be different in the future. As long as the information related to the currency exchange is disclosed and presented in conformance with GAAP, the report is still a high-quality report and provides the information for the reader to determine whether these earnings are sustainable.

Another factor to consider when determining the quality of earnings is whether the company is generating enough of a return on the investment to continue its business. Assume that Crazy Bill’s Hay Wagon company has USD 100,000 invested in fixed assets and USD 20,000 in fixed expenses each year. Financial statements are issued in February for the previous December's year end and include the two years of comparative statements. In February, exchange has now changed to USD 1.00 = CAD 0.80, and Crazy Bill’s is expected to sell approximately the same number of wagons at the same price. What do you think might be a factor to consider?

No. Buying power is decreasing as the US dollar is becoming weaker than the Canadian dollar.

Correct. Earnings for the company appear to be highly dependent upon exchange rates given that Crazy Bill’s pays in Canadian dollars and does not adjust its selling price in fluctuation with the exchange rates.

Incorrect. Even if earnings do average out over time, you have no way of knowing if they will at the time of your analysis.

If Crazy Bill’s was able to adjust its selling prices as exchange rates changed to always ensure a USD 500 profit per wagon and still maintain sales volume with the higher sales prices, how do you think that would move Crazy Bill’s financial reports along the quality spectrum?

No. If the company is able to increase prices to adjust for exchange rates and still maintain volume, this provides for better earnings quality.

No. A higher quality of earnings indicates a higher placement on the quality spectrum.

Exactly. Because Crazy Bill’s is able to increase prices to reflect exchange rates without losing business, the earnings appear to be of higher quality and would be higher on the quality spectrum.

In summary: [[summary]]

Earnings decrease, not related to sales volume but from foreign currency exchange which does not impact the quality of the earnings

The increase in earnings is not related to increased sales but from currency exchange which can fluctuate and which may indicate increased earnings that are not sustainable

Earnings will average out over time, indicating high-quality earnings

Earnings appear highly dependent upon exchange rates and may indicate low-quality earnings

Buying power is increasing, indicating increased profits in the upcoming year

Crazy Bill’s financial reports would move closer to the bottom of the spectrum

Crazy Bill’s financial reports would remain in the same location on the spectrum

Crazy Bill’s financial reports would be closer to the top of the spectrum

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