Indicators of Earning Quality

High-quality earnings are characterized by sustainability and adequacy. Sustainability of high-quality earnings means that they tend to persist in the future, whereas adequacy implies that high-quality earnings cover the company’s cost of capital. High-quality earnings assume high-quality reporting. Furthermore, high-quality earnings increase the value of the company more than low-quality earnings. Low-quality earnings are as a result of:

• Earnings that are insufficient to cover the company’s cost of capital.
• Earnings derived from non-recurring one-off activities.
• Earnings whose reported information does not provide a useful indication of the company’s performance.

In the previous section, we tackled earning sustainability (persistence) as one of the indicators of earnings quality. Other indicators include recurring earnings, beating benchmarks, and external indicators of poor quality earnings.

Recurring Earnings

Recurring earnings are earnings (returns), which are expected to occur again in the future. Operating income is a typical example of recurring earnings. On the other hand, non-recurring earnings include one-off asset sales, one-off litigation sales, and one-off tax settlements. Recall from the previous section that non-recurring earnings are not sustainable and thus are low-quality earnings.

Fraudulent companies may use non-recurring items in their reporting to create an illusion of reliable performance. Classification of items as non-recurring is a subjective decision. Therefore, classification decisions can provide an opportunity to inflate the amount potentially identified as repeatable earnings. Many companies voluntarily disclose additional information to differentiate between recurring and non-recurring items. An analyst should, therefore, review the disclosed information to ensure that excluded items are truly non-recurring.

Mean Reversion in Earnings

Extreme levels of earnings, both high and low, tend to revert to normal levels over time. This phenomenon is known as “mean reversion in earnings,” which is a typical characteristic of competitive markets. In other words, whether a company is experiencing unusually high or low earnings, the net effect over time is that a return to the average should be forecasted. This is evidence of a sustainable company.

Beating Benchmarks

Precisely meeting or only narrowly beating consensus estimates has been proposed as an indicator of earnings manipulation and, consequently, low-quality earnings. While this is a foolproof metric, a company that consistently reports earnings that exactly meet or only narrowly beat benchmarks can raise questions about its earnings quality.

External Indicators of Poor-Quality Earnings

External indicators of poor-quality earnings include enforcement actions by regulatory authorities and restatements. External indicators are relatively less useful as they cannot be used to forecast deficiencies before such deficiencies are publicly known.

Question

An analyst is reviewing research notes for a particular company that reflects the company’s performance trends during the last four years.

Note 1: “Accounts payable has increased, whereas accounts receivable and inventory have substantially decreased.”

 

Note 2: “The operating income has been substantially lower than the operating cash flow.”

Which of the analyst’s notes about the company is most likely an accounting warning sign of a probable reporting problem?

   A. Only Note 1.

   B. Only Note 2.

   C. Both Note 1 and Note 2.

Solution

The correct answer is A.

Only Note 1 provides a warning sign. Increases in accounts payable with massive decreases in accounts receivable and inventory are an accounting warning sign that management may be inflating cash flow from operations.

B and C are incorrect. Operating income being higher than operating cash flow is a warning sign of a potential reporting problem. However, in this case, the company’s operating income is lower than its cash flow. Therefore, Note 2 does not automatically provide a warning sign.

Reading 15: Evaluating Quality of Financial Reports 

LOS 15 (f) Describe indicators of earnings quality.