Earnings Quality

Generally, earnings quality is the degree to which earnings (also known as net income) accurately reflect the economic performance of an enterprise for the particular period of time to which the earnings apply. Earnings quality (also known as quality of earnings) is also a measure of the usefulness of the earnings number. It is reasonable to assume that a more accurate report of a firm's performance would be more useful than a less accurate report. Earnings that can be sustained—expected in the future—are more useful, and hence of higher quality, than those that appear transitory. The real debate is about the specific factors that influence earnings quality and how we can measure earnings quality.

Measures of earnings quality may include (1) the number of estimates embedded in the earnings calculation, (2) the choices in accounting methods, (3) significant changes in discretionary expenditures, (4) the relationship between cash from operations and earnings, and (5) the adequacy of disclosure and degree of transparency in the financial statements.

The calculation of earnings is fraught with estimates. For example, the useful lives of assets and the assets' salvage values must be estimated to calculate depreciation expense. All else equal, a firm with more long-term assets would have lower earnings quality than a firm with few long-term assets because the former would have many opportunities to influence the level of depreciation expense with these estimates. Management judgments create opportunities for errors. In general, more estimates involved in the calculation of earnings suggest lower earnings quality.

Firms must choose the appropriate method of accounting for certain transactions, and these choices can influence the quality of earnings. For example, under U.S. generally accepted accounting principles, a firm may use FIFO (first-in, first-out) or LIFO (last-in, first-out) for the calculation of cost of sales. If the cost of the inventory has been rising, LIFO may result in higher earnings quality because the more recent costs will be matched with the period's sales. That means the resulting earnings amount may be more useful in predicting the future than earnings calculated using FIFO costs, which match old inventory costs with the period's sales. On the other hand, a firm's earnings quality could be reduced if the firm liquidated old LIFO layers, which would result in the inclusion of illusory profits in the earnings calculation. This example shows how difficult it is to measure the quality of a firm's earnings, even on a single dimension like the cost of sales.

A reduction in expenditures on research and development (R&D) or on maintenance could have a positive effect on the size of earnings, but in some cases it could mean a reduction in earnings quality. Any reduction in discretionary expenditures should be investigated to see whether the firm is increasing its efficiency (which would increase earnings quality) or simply trying to keep earnings high while sacrificing maintenance and R&D.

Because earnings are calculated using accrual-basis accounting, we know that earnings are not the same as cash. However, even with accruals and deferrals for such items as credit sales or credit purchases, eventually firms are interested in generating cash from the operations of the firm. Some people view earnings as higher quality when there is a strong relationship over time between elements in the calculation of earnings and elements in the calculation of cash from operations. Suppose, for example, that a firm's net sales revenue was always larger than its cash collected from customers. This may signal a pattern of underestimating uncollectible accounts, which reduces earnings [Page 547]quality. Overall, a positive correlation between earnings and cash from operations is often seen as an indication of higher earnings quality.

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