Quality of earnings (also called earnings quality) refers to the portion of a company’s income gained directly from its core operating activities. Quality of earnings (QoE) represents the company’s actual earnings without any irregularities, accounting tricks or one-time events. When such earnings have been taken into account, income from lower expenditure or higher sales becomes clear.
Apart from the factors mentioned above, the quality of earnings can also be affected by external factors. For instance, during periods of hyperinflation, a company’s earnings quality is considered poor.
Conservatively calculated earnings are considered more dependable than aggressively calculated earnings. Therefore, unethical accounting practices that hide low-quality sales or other business uncertainties can affect the quality of earnings.
There are generally accepted accounting principles (GAAP) that companies can adopt to guide accounting best practices. The closer a company’s practice adheres to the generally accepted accounting principles, the higher its quality of earnings is likely to be.
Financial scandals such as WorldCom and Enron arose due to poor earnings quality that misinformed investors.
- A company’s quality of earnings can only be evident when accounting tricks, irregularities, and one-time events are removed.
- Quality of earnings is the proportion of a company’s income attributed to lower costs or greater sales.
- Adhering to generally accepted accounting principles (GAAP) prevents QoE distortion due to aggressive accounting practices.
A Closer Look at Quality of Earnings
Net income is a primary indicator of the quality of earnings. Analysts track net income because it indicates the strength of a company’s earnings. If the company’s net income grows each quarter and exceeds analyst’s predictions, that is considered a win.
Unfortunately, earnings alone are not a reliable measure. Companies can artificially increase or decrease their earnings to suit their whims. Some businesses can under report earnings to avoid taxes. Others can manipulate their earnings upward to look attractive to analysts, investors and shareholders.
Companies with manipulated earnings have a low quality of earnings. Those who don’t have a high quality of earnings. It is generally believed that successful companies are less likely to manipulate their earnings. However, even successful companies can manipulate their earnings downward to avoid taxes.
The best measure of earnings quality is the company’s adherence to GAAP. The basic features of GAAP are:
- Relevance: This metric is timely and can be used for prediction.
- Reliability: This metric accurately represents the transaction, can be verified, and is free from bias.
How do Quality of Earnings Work?
Analysts can determine a company’s quality of earnings by examining a company’s annual report. To evaluate the quality of earnings, analysts study the income statements thoroughly. They look at the sales, cash flow and net income. If a company’s net income is high, but their cash flow is negative, then the income isn’t coming from sales, and the quality of earnings is low.
Another thing analysts look for is adjustments to net income. For instance, a company might artificially lower expenses by deferring or refinancing its debts into a future payment. Doing this would create a temporary income increase. Such an approach undermines the quality of earnings and discourages long-term investors.
Practical Examples of Earnings Manipulation
A company can manipulate its earnings in several ways. For example, a company can manipulate the earnings per share and price to earnings by buying back their own shares. Doing this can create earnings per share growth despite a decrease in net income.
Increased earnings per share create a lower price-to-earnings ratio. A lower price-to-earnings ratio usually suggests a stock is undervalued and would make a good investment. However, if this is artificially created by the company repurchasing its shares, it isn’t very meaningful.
A company can also adopt extreme measures to look profitable. For example, they can borrow money to buy back their shares, creating artificial scarcity and increasing the price. This practice is a red flag and a sign of poor earnings quality.