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Quality Of Earnings

What is 'Quality Of Earnings'

The quality of earnings refers to the amount of earnings attributable to higher sales or lower costs rather than artificial profits created by accounting anomalies such as inflation of inventory. Quality of earnings is considered poor during times of high inflation. Also, earnings that are calculated conservatively are considered to have higher quality than those calculated by aggressive accounting policies.

Explaining 'Quality Of Earnings'

One measure of fundamental analysis that analyst like to track is net income. It provides an overview of how well the company is doing from an earnings perspective. If net income is higher than it was last year and/or beats analyst estimates, it represents a win for the company, but how reliable are these earnings? Due to myriad accounting conventions, companies can manipulate earnings to serve their own needs. Some companies seek to manipulate earnings down to pay lower taxes, while others find ways to artificially inflate earnings, especially in times of earnings decline. Companies that manipulate earnings are said to have poor or low earnings quality, conversely, companies that do not manipulate earnings have a high quality of earnings.

How To Gauge The Quality of Earnings

There are many ways to gauge the quality of earnings. Start with the top of the income statement, which can be found in the annual report, and work down. Companies with high or growing sales may also have high growth in credit sales. Changes in credit sales or accounts receivable can be found on the cash flow statement. Analysts don't like sales growth due to a loosening of credit terms. Working down the income statement, analysts also look for variations between cash flow and net income. A company that has a high net income and negative cash flows from operations may be achieving earnings through artificial means. One-time adjustments to net income, also known as non-recurring expense, are also a red flag. It is not unusual for companies to make supposedly one-time adjustments for several quarters and years in a row.

Quality of Earnings Measures

It should also be noted that companies can manipulate popular earnings measures such as earnings per share and price to earnings ratio by buying back shares of stock, which reduces the number of shares outstanding. In this way, a company with declining net income may be able to post earnings per share growth. Since earnings go up, the price-to-earnings ratio goes down as well, signaling that the stock is undervalued or on sale. In actuality, the company simply repurchased shares. It is particularly concerning when companies take on additional debt to finance stock repurchases.


Further Reading


Corporate governance quality and earnings management: Evidence from Jordan
ro.uow.edu.au [PDF]
… quality of financial statements through ensuring that each nominated director has the … Healy and Wahlen (1999) provide a comprehensive definition: “Earnings management occurs when … reports to either mislead some stakeholders about the underlying economic performance of …

Audit quality and earnings management for Taiwan IPO firmsAudit quality and earnings management for Taiwan IPO firms
www.emerald.com [PDF]
… quality of financial statements through ensuring that each nominated director has the … Healy and Wahlen (1999) provide a comprehensive definition: “Earnings management occurs when … reports to either mislead some stakeholders about the underlying economic performance of …

Measuring the quality of earningsMeasuring the quality of earnings
www.emerald.com [PDF]
… quality of financial statements through ensuring that each nominated director has the … Healy and Wahlen (1999) provide a comprehensive definition: “Earnings management occurs when … reports to either mislead some stakeholders about the underlying economic performance of …

Disclosure quality and earnings managementDisclosure quality and earnings management
www.tandfonline.com [PDF]
… quality of financial statements through ensuring that each nominated director has the … Healy and Wahlen (1999) provide a comprehensive definition: “Earnings management occurs when … reports to either mislead some stakeholders about the underlying economic performance of …

The effect of audit quality on earnings managementThe effect of audit quality on earnings management
onlinelibrary.wiley.com [PDF]
… quality of financial statements through ensuring that each nominated director has the … Healy and Wahlen (1999) provide a comprehensive definition: “Earnings management occurs when … reports to either mislead some stakeholders about the underlying economic performance of …

Auditor quality and earnings management: Singaporean evidenceAuditor quality and earnings management: Singaporean evidence
www.emerald.com [PDF]
… quality of financial statements through ensuring that each nominated director has the … Healy and Wahlen (1999) provide a comprehensive definition: “Earnings management occurs when … reports to either mislead some stakeholders about the underlying economic performance of …

The impact of audit quality on earnings predictabilityThe impact of audit quality on earnings predictability
www.emerald.com [PDF]
… quality of financial statements through ensuring that each nominated director has the … Healy and Wahlen (1999) provide a comprehensive definition: “Earnings management occurs when … reports to either mislead some stakeholders about the underlying economic performance of …

The impact of audit quality on earnings rounding-up behaviour: some UK evidenceThe impact of audit quality on earnings rounding-up behaviour: some UK evidence
www.tandfonline.com [PDF]
… quality of financial statements through ensuring that each nominated director has the … Healy and Wahlen (1999) provide a comprehensive definition: “Earnings management occurs when … reports to either mislead some stakeholders about the underlying economic performance of …

Does it pay to attend an elite private college? Cross cohort evidence on the effects of college quality on earningsDoes it pay to attend an elite private college? Cross cohort evidence on the effects of college quality on earnings
www.nber.org [PDF]
… quality of financial statements through ensuring that each nominated director has the … Healy and Wahlen (1999) provide a comprehensive definition: “Earnings management occurs when … reports to either mislead some stakeholders about the underlying economic performance of …