by Earnings quality, also known as quality of earnings (QoE), in accounting, refers to the ability of reported earnings (income) to predict a company’s future earnings. It is an assessment criterion for how “repeatable, controllable and bankable“A firm’s earnings are, amongst other factors, and has variously been defined as the degree to which earnings reflect underlying economic effects, are better estimates of cash flows, are conservative, or are predictable.
A company’s quality of earnings is revealed by dismissing any anomalies, accounting tricks, or one-time events that may skew the real bottom-line numbers on performance. Once these are removed, the earnings that are derived from higher sales or lower costs can be seen clearly.
Even factors external to the company can affect an evaluation of the quality of earnings. For example, during periods of high inflation, quality of earnings is considered poor for many or most companies. Their sales figures are inflated, too.
In general, earnings that are calculated conservatively are considered more reliable than those calculated by aggressive accounting policies. Quality of earnings can be eroded by accounting practices that hide poor sales or increased business risk.
Conversely, an organization can have low-quality earnings if changes in its earnings relate to other issues, such as:
- Elimination of LIFO inventory layers
- Aggressive use of accounting rules
- Inflation
- Increases in business risk
- Sale of assets for a gain
Factors
An assessment of earnings quality would therefore be based on other factors, such as:
- A correlation between reported earnings and underlying economic activity.
- The permanence and sustainability of reported earnings.
- The relationship between reported earnings and market valuation.
- The extent and impact of discretionary accruals.
- The transparency and completeness of disclosures.
- The impact of low reported earnings on corporate image.
- The company’s handling of “bad news,”
- The degree to which earnings are good estimates of cash flows.
Accruals
Accruals are a major consideration when evaluating earnings quality because they contribute to the difference between economic performance and reported earnings. Because accruals are non-cash, estimated journal entries, they may not always properly represent a company’s economic performance. For example, a company should record an estimate for sales returns and allowances. Accounting for future sales returns and allowances is appropriate and relevant because sales will be overstated if future returns are not considered. However, the subjective nature of this accrual, which is made before any return actually happens, makes it less reliable to investors. This trade-off between reliability and relevance is why earnings quality is such an important consideration.
Total Accrual to Assets Ratio
During a valuation, investors can use the following ratio to evaluate the prevalence of accruals in a company’s financial statements:
Total accruals to assets = (Net Income – Operating Cash Flow) / Beginning Total Assets
Net Income Vs. Cash Flow Ratio
Another way that investors analyze the effect of accruals on earnings quality is by comparing net income to operating cash flow. Analysts use these two measures to calculate the quality of earnings ratio as follows:
Quality of earnings ratio = Net cash from operating activities / Net income
Earnings Management
Public companies are under intense investor scrutiny, and the pressure to increase earnings every quarter can lead companies to engage in earnings management. Earnings management refers to the use of subjective estimates, changes in business practices, and accounting techniques to intentionally manipulate a company’s earnings. Because earnings management improves reported earnings without improving economic performance, increased earnings management leads to a decrease in earnings quality. Engaging in earnings management could damage investors’ perception of the reliability of your company’s financial statements. Private equity firms, hedge funds, and other investors will likely be hesitant to invest in a company that they believe is trying to artificially inflate earnings.
