Reference no: EM132648363

Behavioural Research in Accounting Cash flow the key to a beautiful bottom lineBy James Dunn Like any profit-reporting season, the current period has thrown up the good, the bad and the ugly.

• There is no prize for guessing the best example of the last: GIO- Australia Holdings Limited's shocker takes some beating. For the bad, look no further than AMP Limited's GIO-induced write-down. But outside the insurance sector, the season has been generally good.
• Telecommunications provided the highlights. Telstra generated an Australian record of $5.32 billion in pre-tax profit and $3.49 billion at net level; and Cable & Wireless Optus brought in a maiden net profit that exceeded prospectus forecasts by 80%.
• Earnings are running about 4% higher than analysts' expectations. But beyond the numbers, the season has delivered good quality earnings.
• The 'quality' of the earnings refers to the extent to which they are derived from actual operational cash flow. Depreciation, tax rates, abnormal items detract from the quality: cost-cutting enhances it.
• 'We have seen several special dividends, and that is the best indication you can have of high-quality earnings,' Merrill Lynch Australia investment strategist Hugh Dougherty says. 'Those companies have cash pouring in and are directing it to shareholders. If there was any question about the quality of their earnings, they could not pay a special dividend.'
• Telstra, West Australian Newspapers and Tabcorp are examples of companies' dispensing cash flow largesse in this fashion.
• 'Telstra, for example, was simply an outstanding performance. These companies are at the one extreme of quality of earnings, but there are serial abnormal item offenders at the other,' Dougherty says.
• 'Pacific Dunlop and Mayne Nickless spring to mind here. Apart from what we've seen in insurance recently, manufacturers who have been forced to restructure their operations continue to be plagued by abnormal.'
• If the bad old days of abnormal items were in the 1980's and early 90's, companies don't get away with it any more', AXA Australia portfolio manager Tony Wilson says.

Questions

Question 1. If cash flow is the best measure of performance, why have the accounting profession and regulators persevered with accrual accounting?

Question 2. What do the analysts mean by the term 'good quality' earnings?

Question 3. Why can the market so readily 'see through' these abnormal adjustments today, but was apparently fooled by the practice for a number of decades?

Question 4. The article refers to the need to beat 'expectations'. How are such expectations developed?