Quality of Earning

Quality of Earnings

Users need good information about a company's earnings to make decisions; however, not all income statements provide this. We understand that there are limitations to income statement. When analyzing earnings information, two aspects must be considered:

1. Content, which includes

a. the integrity of the information, including whether it reflects the underlying business fundamentals, and

b. the sustainability of the earnings.

2. Presentation, which means a clear, concise manner that makes it easy to use and understandable.

The nature of the content and the way it is presented are sometimes referred to as the Quality of Earnings.

From an accountant's perspective, the emphasis is on ensuring that the information is unbiased, reflects reality, and is transparent and understandable. From a capital market perspective, these factors are also important, but an additional focus is on whether the earnings are sustainable. With its current business model, can the company continue to generate or sustain these earnings in the future? Note that the accountants acknowledge this additional perspective by segregating earnings on the income statement between those that are expected to continue and those that are not. For instance, the income statement shows income from continuing operations separately from income from discontinued operations. Even though the underlying business might be accurately reflected and understandable in the financial statements, the quality of earnings might be judged to low because the earnings are not sustainable.

As suggested, earnings numbers may be judged to be of a higher quality or, conversely, a lower quality. Higher quality earnings are more reliable with a low possibility of potential misstatement, and are more representative of the underlying business and economic reality.

Companies with higher quality earnings are attributed higher values by the markets, all other things being equal. Earnings that cannot be...