Quality of earnings definition
/What is the Quality of Earnings?
Quality of earnings refers to the proportion of income attributable to the core operating activities of a business. Thus, if a business reports an increase in profits due to improved sales or cost reductions, the quality of earnings is considered to be high. Conversely, an organization can have low-quality earnings if changes in its earnings relate to other issues, such as the aggressive use of accounting rules, the elimination of LIFO inventory layers, inflation, the sale of assets for a gain, or increases in business risk. In general, any use of accounting trickery to temporarily bolster earnings reduces the quality of earnings.
Impact of the Quality of Earnings on Stock Prices
Investors like to see high-quality earnings, since 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.
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The Interpretation of Financial Statements
Characteristics of High-Quality Earnings
A key characteristic of high-quality earnings is that the earnings are readily repeatable over a series of reporting periods, rather than being earnings that are only reported as the result of a one-time event. In addition, an organization should routinely provide detailed reports regarding the sources of its earnings, and any changes in the future trends of these sources. Another characteristic is that the reporting entity engages in conservative accounting practices, so that all relevant expenses are appropriately recognized in the correct period, and revenues are not artificially inflated.
The Impact of Inflation on the Quality of Earnings
A modest level of inflation has no impact on the quality of earnings, since it is relatively immaterial. When the inflation in a country stays low - two percent or less - it is typically ignored when considering the quality of earnings. However, this is not the case for more robust levels of inflation, where rapid increases in prices can lead to reported results that are far higher than the year before, simply because prices have been increased to keep pace with increases in costs. In this situation, a business can provide disclosures about what its revenues and profits would have been without the effects of inflation; doing so would contribute to a much higher quality of earnings.
Example of Earnings Manipulation
An easy way for a business to manipulate its reported earnings is to lower its capitalization limit, so that more expenditures are classified as fixed assets. This means that expenses are deferred to later periods, when they are recognized through depreciation. This results in a bloated fixed asset register, but can deliver an increase in profits over the short term.