Earnings quality, in accounting

Accountancy

Accountancy is the process of communicating financial information about a business entity to users such as shareholders and managers. The communication is generally in the form of financial statements that show in money terms the economic resources under the control of management; the art lies in...

, refers to the overall reasonableness of reported earnings

Earnings

Earnings are the net benefits of a Corporation's operation. Earnings is also the amount on which corporate tax is due. For an analysis of specific aspects of corporate operations several more specific terms are used as EBIT -- earnings before interest and taxes, EBITDA - earnings before...

. It is an assessment criterion for how "repeatable, controllable and bankable" a firm's earnings

Earnings

Earnings are the net benefits of a Corporation's operation. Earnings is also the amount on which corporate tax is due. For an analysis of specific aspects of corporate operations several more specific terms are used as EBIT -- earnings before interest and taxes, EBITDA - earnings before...

 are, amongst other factors. It recognizes the fact that the economic impact of a given transaction

Financial transaction

A financial transaction is an event or condition under the contract between a buyer and a seller to exchange an asset for payment. It involves a change in the status of the finances of two or more businesses or individuals.-History:...

 will vary across firms as a function of their fundamental business characteristics

Fundamental analysis

Fundamental analysis of a business involves analyzing its financial statements and health, its management and competitive advantages, and its competitors and markets. When applied to futures and forex, it focuses on the overall state of the economy, interest rates, production, earnings, and...

, and has variously been defined as the degree to which earnings reflect underlying economic effects, are better estimates of cash flows, are conservative, or are predictable.

Rationale

The concept of earnings quality has roots in the judgmental nature of accounting, which can be seen in the fact the different parties may interpret the economics underlying a transaction differently, and different firms may have different business characteristics.

Interpretation of underlying economics

The interpretation of the economics underlying a transaction and even the wording of the accounting standards can vary between firms. This, along with the fact that a firm's financial statement

Financial statement

A financial statement is a formal record of the financial activities of a business, person, or other entity. In British English—including United Kingdom company law—a financial statement is often referred to as an account, although the term financial statement is also used, particularly by...

s are the responsibility of the firm's management, allows management to structure transactions to achieve desired accounting results, by choosing an interpretation of the economics underlying ther transactions that may be different from another party's. This use of judgment by management thus increases the chances that the earnings presented in a firm's financial statements may have been manipulated

Creative accounting

Creative accounting and earnings management are euphemisms referring to accounting practices that may follow the letter of the rules of standard accounting practices, but certainly deviate from the spirit of those rules...

.

Differing business characteristics

Furthermore, the fact that firms have different fundamental business characteristics increases the possibility of error in or manipulation of presented earnings. For example, companies that operate in different industries may use a given machine for entirely different purposes or wear out a given machine at dramatically different rates, which makes it appropriate to allow management to choose between alternative depreciation methods and useful lives

Depreciation

Depreciation refers to two very different but related concepts:# the decrease in value of assets , and# the allocation of the cost of assets to periods in which the assets are used ....

 to be applied to the use of the machine. This discretion, however, increases the possibility for firms to make both honest mistakes, such as the accidental use of a wrong useful life, or to manipulate earnings

Creative accounting

Creative accounting and earnings management are euphemisms referring to accounting practices that may follow the letter of the rules of standard accounting practices, but certainly deviate from the spirit of those rules...

.

Earnings quality and ways to lower it

The above factors lead to investors needing to assess the extent to which a firm's reported earnings are free from mistake or manipulation, i.e. the quality of the firm's earnings.

Other ways accounting choices can lower a firm's earnings quality include

• Recording revenue too soon or of questionable quality,
• Recording fictitious revenue,
• Boosting income with one-time gains,
• Shifting current expense to a different period,
• Failing to record or improperly reducing liabilities,
• Shifting current revenue to a later period, and
• Shifting future expenses to the current period as a special charge

Assessing earnings quality

While the criteria for earnings to be considered high-quality differs between authors, sustainability of earnings may be the underlying concept.

Conservative accounting policies

Earnings quality has usually been associated with the use of conservative

Conservatism

Conservatism is a political and social philosophy that promotes the maintenance of traditional institutions and supports, at the most, minimal and gradual change in society. Some conservatives seek to preserve things as they are, emphasizing stability and continuity, while others oppose modernism...

 accounting policies. It has, however, been noted that conservatism in the current financial periods may allow aggressiveness in future financial periods. For example, choosing an "accelerated" depreciation method, or one that allocates a large amount of depreciation expense at the beginning of an asset's useful life, allows the firm to present abnormally high expenses for a given financial period and abnormally low expenses for future financial periods: conservatism, followed by aggressiveness. In other words, conservative decisions by management in a single period should not be used as sole proof of earnings quality.

Other factors

An assessment of earnings quality would therefore be based on other factors, such as

1. A correlation between reported earnings and underlying economic activity,
2. The permanence and sustainability of reported earnings,
3. The relationship between reported earnings and market valuation,
4. The extent and impact of discretionary accruals,
5. The transparency and completeness of disclosures,
6. The impact of low reported earnings on corporate image,
7. The company's handling of "bad news," and
8. The degree to which earnings are good estimates of cash flows.

Sustainability of earnings

One author claims, simply, that earnings are considered to be of high quality when they are sustainable.

Methods of assessment as conflicting

Different definitions of earnings quality, and hence the different methods of assessment, sometimes lead to contradictions between methods. For example, using only the criteria of correlation between reported earnings and underlying economic activity, accelerated depreciation may give rise to higher-quality earnings than straight-line depreciation, while the converse is true if one uses only the criteria of predictability of earnings.