Quality of Earnings
The term quality of earnings refers to the degree to which earnings reported on the company's income statement are a direct result of sustainable and ongoing business operations. Factors lowering the quality of earnings include inflation and other economic conditions, one-time events, and liberal accounting practices.
While a company's income statement is a very important document to investors and creditors, it does have limitations. Of particular importance is the quality of earnings reported by companies. Flexibility is oftentimes found in written accounting standards, allowing accountants to establish what might be deemed liberal or conservative practices. When taken to extremes, earnings can be grossly overstated and are said to be of low quality.
When assessing the overall quality of earnings, the analyst, auditor, or investor will examine the company's accounting practices, as well as other factors, to determine the long-term sustainability of those earnings. Factors lowering the quality of earnings typically serve to understate expenses or overstate revenues in the near term. Examples include:
- Accounting Practices: liberal or manipulative policies with respect to accruals, depreciation expense, and recording of revenues.
- Economy: affects associated with inflation or currency exchange rates.
- One-Time or External Events: includes unusual gains or losses, changes in accounting practices, special charges, extraordinary items, and prior period adjustments.
In addition to the above, there can be non-quantifiable indicators as to the quality of the company's earnings. For example, management's opinion, completeness of disclosures, and notes to financial statements oftentimes provide insights into the sustainability of earnings.