Limited Time Offer: Save 10% on all 2021 and 2022 Premium Study Packages with promo code: BLOG10    Select your Premium Package »

Sustainable (Persistent) Earnings

Sustainable (Persistent) Earnings

Sustainable (persistent) earnings are earnings that are expected to recur in the future. Non-recurring earnings are not sustainable and thus are low-quality earnings. More persistent earnings are more practical inputs for equity valuation models involving earnings forecasts. One way to measure earnings persistence is to use a regression model such as:

$$\text{Earnings}_{t+1}=\alpha+\beta_{1} \text{Earnings}_{t}+\epsilon$$

A higher coefficient (\(\beta_1\)) indicates more persistent earnings relative to a low coefficient.

Earnings are composed of a cash component and an accruals component. The accruals component is discussed in details in the following section:

Accruals Component

The accrual basis of accounting requires recognizing revenues when they are earned and not when they are received in cash. Similarly, and recognition of expenses occur when incurred and not when paid.

Decomposing earnings into its two major components, cash and accruals, further enhances the quality of earnings as input for forecasting future earnings. The accruals component is less persistent than the cash component. In the following regression model,

$$ \beta_1 > \beta_2\ $$

Where \(\beta1\) is the coefficient of cash flow, whereas \(\beta_2\) is the coefficient of accruals implying that the cash flow component of earnings is more persistent than the accruals component:

$$\text{Earnings}_{t+1}=\alpha+\beta_{1} \text{Cash flow}_{t}+\beta_2 \text{Accruals}_{t}+\epsilon$$

It is crucial to note that non-discretionary accruals occur as part of normal transactions in the period. In contrast, discretionary accruals result from non-normal transactions or non-normal accounting choices and are sometimes used to distort earnings.

One approach to identifying abnormal accruals is first to model companies’ normal accruals and then to determine outliers. Discretionary and non-discretionary accruals are separated by modeling (using regression) total accruals as a function of a set of factors that usually give rise to normal accruals. The factors may include the growth of credit sales and the amount of depreciable assets. The residuals from such a model would be an indicator of discretionary accruals.

Finally, a stronger signal of questionable earnings quality is when a company reports positive net income but negative operating cash flows. The following example demonstrates a hypothetical company’s fraudulent reporting:

$$ \textbf{Example of Fraudulent Reporting Showing Positive Net Income but Negative Cash from Operating Activities} $$

$$\small{\begin{array}{l|r|r} \textbf{Three months ended 31 March (\$ millions)} & \textbf{2018} & \textbf{2017}\\ \hline\text{Net income} & 178 & 91\\ \hline\text{Net cash used in operating activities} & -711 & -704\\  \end{array}}$$

The quarterly data for the above company shows a positive net income but negative cash from operating activities in quarters that were shown to have been misreported.

$$\small{\begin{array}{l|r|r|r} \textbf{Year ended 31 December (\$ millions)} & \textbf{2017} & \textbf{2016} & \textbf{2015}\\ \hline\text{Net income} & 732 & 646 & 703\\ \hline\text{Net cash used in operating activities} & 4,532 & 981 & 1,640\\  \end{array}}$$

From the above company’s annual information, the net cash flow from operating activities is more than double that of net income in 2015, almost a half higher than the net income in 2016 and almost six times net income in 2017. An analyst can, therefore, raise a significant red flag about the earnings quality of this company. A company’s considerable accruals may reflect potential manipulation and, consequently, low-quality earnings. However, it is not automatically the case these companies will have such a profile. The investors should, therefore, explore and understand the existence of such differences.

In conclusion, albeit accrual measures can serve as indicators of earnings quality, they cannot be used exclusively or applied mechanically. Comparing cash-basis measures such as cash provided by operating activities, with net income, may provide a false sense of confidence about the net income. Net income is calculated using subjective estimates, such as the expected life of long-term assets, which can be easily distorted. It suggests that an analyst should also consider investing activities in examining the quality of earnings.

Question

An analyst estimates the following regression model to examine a company’s earnings persistence.

$$\text{Earnings}_{t+1}=\alpha+\beta_{1} \text{Cash flow}_{t}+\beta_2 \text{Accruals}_{t}+\epsilon$$

Solely based on the regression model, earnings persistence for the company is most likely to be highest if:

A. \(\beta_1\) is greater than \(\beta_2\).

B. \(\beta_2\) is greater than \(\beta_1\).

C. \(\beta_1\) is less than 0.

Solution

The correct answer is A.

Research shows that the cash component is more persistent than the accruals component when earnings are broken down into the two components.

A higher beta coefficient (\(\beta_1\)) on the cash flow variable than the beta coefficient (\(\beta_2\)) on the accruals variable shows that the cash flow component of earnings is more persistent than the accruals component. This result provides evidence of earnings persistence.

B and C are incorrect: If the beta coefficient (\(\beta_2\)) on the accruals variable is higher than (\(\beta_1\)) on the cash flow variable, it shows that the cash flow component is less persistent than the accruals component. This indicates low earnings persistence.

Reading 13: Evaluating Quality of Financial Reports 

LOS 13 (e) Describe the concept of sustainable (persistent) earnings.

Featured Study with Us
CFA® Exam and FRM® Exam Prep Platform offered by AnalystPrep

Study Platform

Learn with Us

    Subscribe to our newsletter and keep up with the latest and greatest tips for success
    Online Tutoring
    Our videos feature professional educators presenting in-depth explanations of all topics introduced in the curriculum.

    Video Lessons



    Daniel Glyn
    Daniel Glyn
    2021-03-24
    I have finished my FRM1 thanks to AnalystPrep. And now using AnalystPrep for my FRM2 preparation. Professor Forjan is brilliant. He gives such good explanations and analogies. And more than anything makes learning fun. A big thank you to Analystprep and Professor Forjan. 5 stars all the way!
    michael walshe
    michael walshe
    2021-03-18
    Professor James' videos are excellent for understanding the underlying theories behind financial engineering / financial analysis. The AnalystPrep videos were better than any of the others that I searched through on YouTube for providing a clear explanation of some concepts, such as Portfolio theory, CAPM, and Arbitrage Pricing theory. Watching these cleared up many of the unclarities I had in my head. Highly recommended.
    Nyka Smith
    Nyka Smith
    2021-02-18
    Every concept is very well explained by Nilay Arun. kudos to you man!
    Badr Moubile
    Badr Moubile
    2021-02-13
    Very helpfull!
    Agustin Olcese
    Agustin Olcese
    2021-01-27
    Excellent explantions, very clear!
    Jaak Jay
    Jaak Jay
    2021-01-14
    Awesome content, kudos to Prof.James Frojan
    sindhushree reddy
    sindhushree reddy
    2021-01-07
    Crisp and short ppt of Frm chapters and great explanation with examples.