Quality Of Earnings

Quality of earnings refers to the income generated from the business's core operations (recurring) and does not include the one-off revenues (nonrecurring) generated from other sources. Evaluating the quality will help the financial statement user make judgments about the "certainty" of current income and the prospects for the future.

There is no single characteristic to measure the quality of earnings. However, the financial statement users, especially audit committees and management, should be prudent in evaluating the quality of financial reporting. Therefore, specific indicators and characteristics should be focused on assessing its quality.

Quality of earnings report refer to assessing the part of profit that can be attributed to the core business operations. It is considered high is the profits rise due to cost reduction and rise in sales.

• The quality of earnings report is primarily used to assess the accuracy and sustainability of historical earnings and the achievability of future projections.
• In the case of acquisitions, valuations are typically based on a multiple of EBITDA (earnings before interest, taxes, depreciation, and amortization). It is, therefore, critical for a buyer to understand historical revenues, trends, critical assumptions used in forecasts, and the sustainability of earnings.
• A high quality of earnings must reflect cash flow and sustainability. Earnings that are "tied up" in accounts receivable, for example, do not have much value because, despite being recognized, they have not yet been realized. Similarly, earnings that are not sustainable due to understated expenses due to an unfilled executive position, as an example, would overstate sustainable earnings. Therefore, a quality of earnings checklist always helps in better company assessment.

Let's say that Company ABC's net income increased by 130%. This is because its sales jumped up by 200%, while it managed to bring down its general and administrative expenses by 10%. On the contrary, say that Company XYZ's sales were more or less flat, its expenses rose only by 5%, and its net income increased by 130% after it changed the way some of its assets and inventory depreciated.

• It is prudent to say that company ABC has a better earnings quality than XYZ because Company ABC's earnings are from genuine improvements in core operations, i.e., the sale of products.
• Company XYZ recorded a similar rise in its net income mainly due to the accounting changes (changing the depreciation calculation); the earnings increases are little more than paper profits. It is important to note that company XYZ hasn't done anything illegal or wrong, but its quality is lower than company ABC.

According to a survey conducted by the Emory University, 94.7% of CFOs think that earnings are either very important or necessary for investors in valuing the company. However, it isn't easy to define the quality of earnings report. Although no definitive criteria exist to evaluate it, a quality of earnings checklist can be considered in assessing the earnings.

• Taken as a whole, it can be summarized as the degree to which earnings are cash or noncash, recurring or nonrecurring, and based on precise measurements or estimates that are subject to change.
• If a company has increased its earnings every year by improving cost efficiencies or sales generated from a marketing campaign, it would have a high-quality income. If a company's earnings are linked to outside sources, such as increasing commodity prices, the company would be seen as having a low quality of earnings.
• Also, a company may report a growth in sales, but this may be due to growing credit sales. Usually, analysts are not fond of loose credit policies and prefer organic growth in sales. A company may have a high net income but, at the same time, negative cash flows from operations. This can be done through artificial means.

The financial statements can provide a few signs that readers can use to assess earnings on a high level. These are (but are not limited to):

1. Year to year or quarter to the quarter, consistency of accounting policies
2. The overall degree of estimation or subjectivity in determining earnings
3. The trend in reserve balances
4. Transparency of disclosures
5. Discussion of nonrecurring, unusual transactions
6. Presence of pro forma measures of earnings
7. Disclosure of related-party transactions
8. The ratio of net income to cash from operations.

Thus the above are some indicators to assess a low or high quality of earnings.

It should also be noted that companies may manipulate earnings measures such as earnings per share and the price-to-earnings ratio by buying back shares of stock, which reduces the number of shares outstanding. Due to this, a company with declining net income may be able to post earnings-per-share growth. Because earnings go up, the price-to-earnings ratio goes down, signaling that the stock is undervalued or on sale. In actuality, the company repurchased shares. It mainly concerns when companies take on additional debt to finance stock repurchases. Thus, these are the measures of quality of earnings analysis.

Let us look at the differences between quality of earnings and audit.

• The former focusses on company core operations whereas the latter focusses on authenticity of financial statements.
• The quality of earning analysis helps in future planning and projections whereas the latter helps stakeholders make investment decisions.
• The former gives additional information future planning and projects, projected income, customer relations etc, whereas audit gives a true and fair view of only the financial statements.

This has been a guide to what is Quality of Earnings. We explain it with examples, indicators, differences with audit, measures and factors. You can learn more about accounting from the following articles –

• Pro-Forma Earnings
• DuPont ROE
• ROAE
• Earnings Per Share Formula