The Quality of Earnings

By Sean Stevenson – Latest Revision January 3rd, 2021

Understanding the quality of earnings is integral for investors. 

For enterprising business leaders too, the uses and contrast of this term are integral to promoting intelligent discussion about the fiscal health of an enterprise.

In this article, I will tell you everything you need to know about the quality of earnings.  This includes:

  • The definition and categories of the term
  • What High-Quality of Earnings Looks Like
  • What Low-Quality of Earnings Looks Like
  • Why The Quality of Earnings are Important
  • GAAP Standards
  • The Use The Quality of Earnings To Gauge a Company
  • Why Focusing On Business Integrity and Overall Quality Matters

Definition - What Is The Quality of Earnings?

The quality of earnings is defined as the core profits that come from the typical operating activities of a business.  This typical amount is then compared to any improvement in overall profitability.  If the company’s business reports indicate a higher-than-normal profit due to a confirmed increase in sales or a reduction in expenditure, then the quality of earnings is high.  This is often reflected in:

  • Honest and open-ended fiscal reporting
  • Full disclosure of all assets and capital
  • Steady growth levels that are repeatable 
  • Easily traced profitability with no anomalous or “one-time” reporting
  • Verifiable and relevant financial reporting in good standing with GAAP standards

In the opposite scenario, the company might act in a way that is perceived as fiscally devious.  The reason for this is to falsify financial data to entice prospective investors.  Often, companies that employ such malpractice are not very profitable.  That is to say, the offending company may use short-term tactics to give the temporary appearance of increased sales, price-to-earnings ratios, or general profitability.  This may take the form of:

  • Questionable accounting practices
  • Selling of assets for short-term gains
  • Increased and hidden risk due to realistic insolvency
  • Inflation
  • Company repurchasing of outstanding shares

As a general rule, any use of dishonest accounting practices to give the appearance of bolstered profitability will inevitably reduce the quality of earnings. 

The use of honest, regulatory, and time-tested principles in accounting, will provide a high-quality of earnings report.

What High-Quality of Earnings Looks Like

High-quality earnings are a repeatable process.  They consistently and accurately represent the core profitability process of an enduring enterprise. 

Over the course of several reporting periods, a healthy company will produce consistent growth that can be accurately measured over time.  Further, these high-quality earnings reports will consistently feature exact sources of profitability as a matter of public reference.  Any shift in policy too, will be detailed to include changing asset allocations or alterations made to the structure of the organizational pipeline. 

Accounting practices for high-quality earnings are typically conservative in nature.  Any relevant expenses are detailed for the correct fiscal period in which they occurred.  Moreover, details on income are not dubious, nor inflated artificially. 

What Low-Quality of Earnings Looks Like

Conversely, a key component of the quality of earnings is that they are not anomalous.  Any sudden shift in a company’s policy to make short-term gains, is often a tell-tale sign of low-quality of earnings. 

In other words, a one-time event in profitability, should be treated as a low-quality earnings report.  In such a scenario an investor must tread carefully.  If they had any interest in transacting with said company, it may be advisable to reevaluate their prospective investment opportunity.

Visualized Examples Of The Quality of Earnings

The Quality of Earnings
The Quality of Earnings

High-Quality of Earnings

Example: 

  • Your business uses valid accounting practices and principles
  • You operate in accordance with regulatory law 
  • You provide honest earnings reports every quarter, leaving no stones unturned

Low-Quality of Earnings

Example: 

  • Your business uses deceptive malpractice in its accounting
  • Your business is ambivalent towards fiscal legality 
  • You use short-term solutions to appear financially viable as an investment vehicle and are (in reality) not very profitable

Case-Study

Jim Burton decides he would like to invest in one of two companies.  However, upon reviewing the first company’s earnings report, he finds consistent anomalies that have contributed to its apparent rise. 

Upon further investigation, he realizes that the company in question has been liquidating important assets to stimulate it earnings report artificially.  With this in mind, Jim realizes that the first company is not worthy of his time, nor his investment.

Upon review of the second option, Jim finds a company that is forthright in its accounting practices.  They give detailed reports to their shareholders and are well-known in their industry.

Given that this second company is experiencing steady growth, and adheres to such stalwart accounting practices, Jim is more optimistic about its future.  

Jim will therefore choose to invest in the second option, as the quality of earnings is high.

Key Takeaways

  • Quality of earnings is best described as the percentage of a company’s increased income that is due to higher sales or reduced cost
  • Any high-quality earnings report will be linked to a business that has strong fundamentals, and is likely experiencing healthy growth
  • A high-quality earnings report is based on sound accounting principles, without the need for artificial and dishonest business accounting to compensate for lackluster profits
  • A low quality earnings report is rooted in deceptive accounting practices, and often a “one-time” stimulation towards increased earnings that is not repeatable
  • Spotting financial anomalies, accounting malpractice, or one-time events that alter overall numbers, is the only way to ensuring the due diligence of an investment
  • For the purposes of personal investing, it is advisable to be wary of companies that produce a low-quality earnings report

Why Are The Quality of Earnings Important?

The quality of earnings is integral for investors.  They allow for a metric of closer inspection, to consider the reliability of a company’s financial reports. 

From a company’s perspective, any gain in net income that appears higher than the previous quarter is a boon to their efforts.  Beating the estimates of analysts is an accounting convention.  It often sees manipulative tactics being used to ensure corporate interests.  Moreover, some companies even manipulate their earnings report downwards as a tax-avoidance measure.

These aggressive accounting practices that delude the reality of a business scenario will often be noticed upon closer inspection.  This gives an investor a chance to reconsider their options.  Being able to avoid a potentially toxic company -and investment- is always the product of meticulous due diligence on the part of a potential stakeholder.

Extreme examples of financial scandals such as Worldcom or Enron, represent the importance of understanding the quality of earnings present in any company’s financial report.

In Review:  In general, any company that deceptively manipulates its earnings upwards or downwards is said to have a low-quality of earnings!  Conversely, any company that does not use fraudulent accounting is said to have a higher quality of earnings in comparison.

GAAP Standards

GAAP, otherwise known as generally accepted accounting principles, are a set of accounting rules that provide guidelines for both business and corporate accounting.  This makes navigating the complexities, details, and legalities of a comprehensive set of approved accounting methods more manageable.

It is fortunate for investors that there are standard accounting principles which allow for companies in good standing to display their high-quality attributes.

U.S and Canadian law states that publicly traded companies on indices and stock exchanges must follow GAAP guidelines.  Of these guidelines, there are 10 core concepts:

  • Principle of Consistency:  Consistent standards are applied throughout the financial reporting process
  • Principle of Regularity:  GAAP-compliant accountants strictly adhere to established financial rules and regulations
  • Principle of Permanence of Methods: Consistent procedures are used during preparation of all financial reports related to business activities
  • Principle of Sincerity:  GAAP-compliant accountants must remain committed to impartiality and accuracy at all times
  • Principle of Prudence:  Speculation must never influence the reporting of fiscal data
  • Principle of Non-Compensation:  Any and all aspects of an organization’s performance -whether positive or negative- are fully reported and without any prospect of debt compensation
  • Principle of Continuity:  All asset valuations are based on the assumption that the organization’s operations will continue
  • Principle of Periodicity:  Reporting of all revenues are divided by standard accounting time-periods without exception, such as fiscal quarters or years
  • Principle of Materiality:  Financial reports fully disclose the organization’s monetary situation
  • Principle of Utmost Good Faith:  All involved parties are believed to be acting in full accordance with law, regulation, and in utmost honesty

As noted, any company with a high-quality of earnings will have nothing to hide from investors.  Hence, they will use these GAAP standards and regulations to their full effect. 

The fundamentals behind GAAP standards are based on reliability and relevance in accounting.  This is to say:

Reliability:  The accounted metric in question is free of any error or bias whatsoever.  It accurately represents a verifiable business transaction.

Relevance:  The accounted metric has predictive power in that it is timely in nature.  It can enhance understanding about prior predictions made.  It also has value for making new predictions.  This allows for confirmation or contradiction of previous biases also.

Using The Quality of Earnings To Gauge a Company

While there are many ways to use the quality of earnings to study a company’s annual report, most analysts usually being with the top of the income statement.  Assessing each column carefully, taking meticulous notes, and working your way down, is a sure-fire way of ensuring accurate analysis.

Always be sure to check for variations between cash flow and net income.  Any company which enjoys a net income while suffering from negative cash flows, is likely to be making its money outside of its core business structure.  This should represent a concern for a current or prospective investor, as it is a sign of low-quality of earnings.

Any one-time event that positively adjusts net income (also called nonrecurring income or expenses) should also raise alarm.  This could represent short-term refinancing or other shady tactics that may compromise the company’s interests in the future.  A long-term investor would view this as a hazard to their portfolio.

Example of Manipulating Popular Earnings Ratios

By repurchasing shares of its own stock, a company can manipulate its earnings per share and its price-to-earnings ratio.  In effect, they are reducing the number of shares available on the market.  This allows the company to manipulate financial data to appear more attractive than it is in reality.

If a company were to take on additional debt in order to finance the repurchasing of its own stock, this should raise a red flag.  Such a company would be putting itself at further risk of insolvency. 

Moreover, clear malpractice is occurring, and any investor would be well-advised to stay away from such a toxic investment.

Why Focusing On Business Integrity and Overall Quality Matters

Despite many legal and regulatory measures in place today, fraudulent accounting practices still occur in surprising numbers.  It is an unfortunate reality of our capitalistic financial system, that it is impossible for our government agencies and watchdogs to be omniscient.  There are simply too many publicly listed companies.

While the efforts of public servants are always to be appreciated, it is your own due diligence that  you must come to rely on for effective investment practices.

Stalwart business integrity and high-quality of earnings still exist in droves within our marketplace.  However, to uphold and benefit from these positive facets in our day-to-day lives requires awareness.

Whenever you are exercising your rights in business or in choosing your investments, always consider the higher quality of earnings as your first option. 

Not only will you be reinforcing the traits that allow for high-quality organizations to exist, you will wisely investing your capital also.

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