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Quality of Earnings: Definition – Explanation – Example

What Is Quality of Earnings?

Quality of EarningsQuality of earnings refers to the portion of income realized from a company’s core operations that generate sustainable free cash flow.  The quality of a corporation’s earnings is revealed by excluding data that may affect the true bottom-line performance. For example, abnormalities, accounting deception, or one-time events. When these are removed, the earnings gained from more sales or cheaper costs are plainly visible. Even circumstances outside of the organization can influence an assessment of the quality of earnings. For example, during periods of excessive inflation, the profit quality of many companies declines. This is because their sales figures are also overstated.

Earnings that are calculated conservatively are often seen as more dependable than earnings calculated using aggressive accounting techniques. Fringe accounting methods that conceal low sales or increased business risk can undermine earnings quality. Fortunately, broadly acknowledged accounting rules exist (GAAP). The more closely a corporation adheres to those guidelines, the higher the quality of its earnings will be. Several big financial scandals, such as Enron and Worldcom, were extreme cases of low earnings quality that misled investors.

Quality of Earnings – A Closer Look

Net income is a key figure that analysts like to keep track of. It serves as a benchmark for how well the company is performing in terms of earnings. Net income that is larger than it was in the previous quarter or year indicates a company’s growth. If it exceeds analyst expectations, the company can see a substantial boost in share price. But those earnings figures are not always trustworthy. Companies can alter profit numbers up or down to suit their own requirements.  One way they can do this is by employing questionable accounting techniques.

Some businesses falsify earnings in order to lower their tax liability. Others discover ways to artificially exaggerate earnings in order to appear more appealing to analysts and investors. Companies with weak or low earnings quality tend to manipulate their earnings. Companies that do not manipulate their earnings are considered to have higher earnings quality. As a company’s quality of earnings improves, its need to alter profits to reflect a specific financial situation diminishes. Nevertheless, many companies with good quality earnings will still adjust their financial reporting to reduce their tax burden.

Companies with high-quality earnings adhere to Generally Accepted Accounting Practices and GAAP norms. Investors like to see high-quality earnings.  These results tend to be repeated in future periods and provide more cash flows for investors. Thus, entities that have high-quality earnings are also more likely to have high stock prices. Conversely, those entities reporting lower-quality earnings will not attract investors, resulting in lower stock prices.

How Quality of Earnings Works

Examining a company’s annual report provides numerous opportunities to assess the quality of earnings. Typically, analysts begin at the top of the income statement and work their way down. Companies that report high sales growth, for example, may also record high credit sales growth. Analysts are skeptical of sales that are merely due to looser credit terms. Changes in credit sales or accounts receivable appear on the balance sheet and cash flow statement. Working their way down the income statement, analysts may search for differences between operating cash flow and net income. Consider a corporation with a high net income but negative operating cash flows. It stands to reason that the company is generating those apparent earnings somewhere other than sales.

Net income is not always a 100% accurate indicator of a company’s financial performance. A quality of earnings report evaluates how a company generates revenue, whether it is cash or non-cash, recurring or nonrecurring. Another red flag is one-time adjustments to net income, commonly known as nonrecurring income or expenses. For example, a corporation may reduce its current-year expenses by refinancing its debt into a future balloon payment. This would reduce debt expenses and improve net income for the current year.  However, it defers the repayment of the debt to future periods. Long-term investors are negatively affected when management kicks the can down the road so to speak.

Characteristics of High-Quality Earnings

High-quality earnings are the result of core business activities and are easily repeatable across a series of reporting periods.  This is compared to earnings that are only reported as a result of a one-time event. Furthermore, a firm should publish full data on the sources of its earnings.  Additionally, it should highlight any changes in the future patterns of these sources on a regular basis. Another distinguishing feature is that the reporting business employs conservative accounting standards as outlined by GAAP.  This ensures that all relevant expenses are properly recorded in the right period and revenues are not artificially inflated.

Generally accepted accounting principles (GAAP) are uniform minimum standards of and guidelines to financial accounting and reporting. GAAP establishes appropriate measurement and classification criteria for financial reporting. Adherence to GAAP provides a reasonable degree of comparability among the financial reports of state and local governmental units. (Source: omf.wa.gov)

Quality of Earnings Report vs a Financial Audit

Audited financial statements are concerned with conformity with GAAP accounting standards. Whereas, A Quality of Earnings Report is concerned with the company’s earnings history and future prospective. Financial audits do not examine or address the company’s outlook.  A QofE Report does. A Quality of Earnings Report is recommended when entering into a preliminary agreement to purchase a going business.  The buyer should hire independent consultants to conduct a thorough analysis to support the buyer’s potential investment. A proper quality of earnings study takes into account a number of factors. When the subject company has previously been audited, there is still a need to conduct a quality of earnings analysis. An audit and a quality of earnings research differ in various ways. Among these distinctions are the following:

  • Quality of Earnings Report – focuses on economic earnings rather than the balance sheet. A quality of earnings study is a consulting engagement rather than a verification service.  It allows for greater flexibility in approach and scope.  Also, the materiality and focus are much narrower in an earnings study than in an audit.
  • Financial Audit – Businesses generate financial statements, especially publicly traded companies.  For example, income statements, balance sheets, cash flow statements, and so on. In turn, these tell stakeholders about the company’s financial performance. This includes investors, employees, banks, and regulatory authorities. A financial audit is an unbiased assessment of a company’s financial accounts. Audits are often held on an annual basis. The majority of the time, stakeholders prefer an audit conducted by an independent organization. Ultimately, the goal of a financial audit is to ensure that an organization’s financial records are an accurate picture of its financial performance.

Examples of Earnings Manipulation

A corporation can easily manipulate its reported profitability by lowering its capitalization limit.  This causes more expenditures to be classed as fixed assets. It also means that expenses are carried forward to later periods and recognized through depreciation. Ultimately, the practice leads to a bloated fixed asset register, although it can offer a short-term boost in profits.

A firm can manipulate common profits measurements like earnings per share and the price-to-earnings ratio by repurchasing shares of its own stock.  This common practice reduces the number of shares outstanding. A corporation with diminishing net income may be able to post earnings-per-share growth in this manner. When earnings-per-share rise, the price-to-earnings ratio falls.  It is especially concerning when a corporation incurs more debt to support stock repurchases. Nevertheless, companies may do this to artificially inflate their stock’s per-share price. Lowering the number of shares available for purchase gives the impression that the stock’s value has increased.

Up Next: What Is Other Comprehensive Income?

Other Comprehensive IncomeNet income and other comprehensive income (OCI) are both included in comprehensive income on the Income Statement. However, OCI is made up of revenues, expenses, profits, and losses that are to be included in comprehensive income but not in net income.

In business accounting, other comprehensive income (OCI) includes revenues, expenses, gains, and losses that have yet to be realized.  Therefore, they are excluded from net income on an income statement. OCI is the difference between net and comprehensive income. A portfolio of bonds that have not matured and have not been repaid is a common example of OCI. Gains or losses from fluctuating bond values cannot be fully determined until the bonds are sold.  As a result, interim adjustments are reported in other comprehensive income.

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