What is Earnings Quality?

Management may use discretion when selecting and applying accounting methods. This discretion reflects the fact that the economic impact of a given transaction will vary across firms as a function of their fundamental business characteristics. For example, companies that operate in distinct industries may use a specific machine, such as a generator, for two entirely different purposes. Additionally, firms within the same industry may use and wear out the same generator at dramatically different rates. Accordingly, it is appropriate to permit alternative depreciation methods and depreciable lives to reflect these inherent differences.

However, with this discretion comes the possibility for both honest mistakes (a poor estimation of product returns, for example) and intentional earnings manipulation (changing the estimate in order to “make the number.”) Therefore, the investor should separately assess the quality of the reported financial results.

Earnings quality is in the eye of the beholder. It has variously been defined as :

• Earnings that reflect underlying economic effects.
• Earnings that are better estimates of cash flows.
• Earnings that are more conservative (lower).
• Earnings that are predictable.

These definitions are often in conflict. Consider accelerated depreciation methods. They reduce earnings in the early years (are more conservative) but increase earnings in future years (at which point they are less conservative.) Straight line depreciation will more closely reflect cash flows and will be more predictable, but accelerated methods are probably more reflective of the underlying economic effects.

Many of these potential impacts on the income statement were discussed above in the context of the line item they affect. Analysts can estimate the effect of changing discretionary options by adjusting the reported financial statements.

For more information, see all articles on: Accounting, Adjusting Reported Financial Statements, Corporate Governance, Financial Statement Analysis, Fundamental Analysis, Security Selection

See also:
  • Earnings Measures and Stock Return Momentum
  • Standardized Unexpected Earnings (SUE)
  • Scaled Earnings Surprise
  • Using Revenue and the Balance Sheet to Derive Cash Collected From Customers
  • Normalizing Price to Earnings Ratio for Business Cycle Effects
  • Technical Analysis Explained : The Successful Investor's Guide to Spotting Investment Trends and Turning Points

    The Intelligent Investor: The Classic Text on Value Investing

    Financial Statement Analysis: A Practitioner's Guide, 3rd Edition

    Managing Investment Portfolios: A Dynamic Process (CFA Institute Investment Series)

    One Response to “What is Earnings Quality?”

    1. DBD: Diebold Takeout Offer Making Me Look Stupid (DBD, rated SELL) | Best Stock Offers Says:

      [...] Diebold (DBD) at about $33 per share and said investors should probably look elsewhere due to earnings quality concerns and what I considered to be unsustainable cash flows. That looked good until this morning, [...]

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