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What is Earnings Quality?

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  • Written By: Malcolm Tatum
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  • Last Modified Date: 11 November 2016
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"Earnings quality" is a term that is used to describe how earnings are recognized within an accounting process. Defining the quality of earnings is important to the process of understanding exactly how any revenue generated came about, which in turn can sometimes yield ideas on how to build on those methods. Depending on the outcome of this assessment of the earnings, the value of the company’s stock may be justified, or considered to be undervalued or overvalued.

While there are different ways of going about determining earnings quality, one basic approach calls for defining any given earnings source as high-quality or low-quality. High-quality earnings result from a strong and consistent cash flow, often coupled with accounting standards that are considered somewhat conservative. Low-quality earnings would typically relate to some sort of artificial factor, such as attempts at creative accounting or the impact of a sudden increase in inflation on the cost of finished goods offered for sale. While artificial factors such as shifts in the general economy will have some impact on the bottom lines of most companies, the goal is to determine if that effect is sufficient to offset the otherwise strong cash flow that is a sign of a healthy company.

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The distinction in earnings quality is very important, since identifying each source of earnings as high- or low-quality makes it easier to determine if the current value of the company’s stocks have adequate support. For example, if the earnings quality of a business is primarily based on strong cash flow, then there is a good chance that the shares issued have adequate backing and that the current price per share is justified. At the same time, if the apparent profitability of a company is due more to the fact that it makes use of accounting ethics that are legal but somewhat questionable, effectively generating the illusion of higher profits, then there is a good chance the stock price associated with the company shares is not reasonable, and the shares are overvalued.

Part of the process of selecting investments wisely is to ascertain the earnings quality associated with a given company before actually buying any of its outstanding shares. While there are exceptions, companies that tend to have low cash flows and are somewhat creative in how profit figures are determined will not constitute a secure investment. For this reason, many investors will consider a business with a steady cash flow and an accounting process that provides full disclosure to be a better investment opportunity.

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MrMoody
Post 3

@allenJo - I think low cash flows are common when a business is in startup mode. So that alone won’t tell you anything about the earnings quality assessment.

How do you know if a company is creative in its accounting? Well there are a few ways. I’ve heard of this concept called “earnings management” which companies use to embellish their books.

Maybe they tell you that revenue is up, for example, but they don’t tell you that profit margins have been squeezed thin because of increased competitive pressures. That’s one possibility I suppose. But nowadays most companies have to be pretty up front about this kind of stuff, so I think it’s hard to get away with it personally.

allenJo
Post 2

@everetra - Well the quality of earnings assessment is easy based on cash flow according to this article. Whether that indicates that the accounting involved is “creative” or not, I don’t know.

I can tell you that I once worked for a company that was hemorrhaging cash each month. They were up front about their cash flow problems. I actually knew when “D Day” was, based on their cash on hand and their quarterly statements. They weren’t necessarily creative (they were honest) but the quality of their earnings was below par in my opinion.

Eventually they filed for bankruptcy. Sometimes the writing is indeed on the wall.

everetra
Post 1

I dislike the term creative accounting – or more specifically, I dislike the concept. It’s an oxymoron. Creative and accounting are two words that should not go together.

Accounting is about hard numbers, facts and figures. There should be little room for imagination. So if a company is employing creative accounting it’s best to steer as far away as possible. Creative accounting is sure to impact the earnings quality analysis.

The question is, how do you determine if the company is being creative or not? You really have to drill down into the numbers, at a very granular level, to see what they’re doing. This is the domain of analysts in my opinion. I guess I’ll have to trust their buy and sell recommendations.

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