{"id":10985,"date":"2021-02-11T04:15:23","date_gmt":"2021-02-11T04:15:23","guid":{"rendered":"https:\/\/analystprep.com\/study-notes\/?p=10985"},"modified":"2025-12-03T16:45:49","modified_gmt":"2025-12-03T16:45:49","slug":"indicators-earning-quality","status":"publish","type":"post","link":"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/indicators-earning-quality\/","title":{"rendered":"Indicators of Earning Quality"},"content":{"rendered":"<script type=\"application\/ld+json\">\r\n{\r\n  \"@context\": \"https:\/\/schema.org\",\r\n  \"@type\": \"QAPage\",\r\n  \"mainEntity\": {\r\n    \"@type\": \"Question\",\r\n    \"name\": \"Which of the analyst\u2019s notes is most likely an accounting warning sign of a probable reporting problem?\",\r\n    \"text\": \"An analyst is reviewing research notes for a particular company that reflects the company\u2019s performance trends during the last four years.\\n\\nNote 1: \\\"Accounts payable has increased, whereas accounts receivable and inventory have substantially decreased.\\\"\\n\\nNote 2: \\\"The operating income has been substantially lower than the operating cash flow.\\\"\\n\\nWhich of the analyst\u2019s notes about the company is most likely an accounting warning sign of a probable reporting problem?\\n\\nA) Only Note 1.\\nB) Only Note 2.\\nC) Both Note 1 and Note 2.\",\r\n    \"answerCount\": 3,\r\n    \"acceptedAnswer\": {\r\n      \"@type\": \"Answer\",\r\n      \"text\": \"A) Only Note 1.\"\r\n    },\r\n    \"suggestedAnswer\": [\r\n      {\r\n        \"@type\": \"Answer\",\r\n        \"text\": \"B) Only Note 2.\"\r\n      },\r\n      {\r\n        \"@type\": \"Answer\",\r\n        \"text\": \"C) Both Note 1 and Note 2.\"\r\n      }\r\n    ]\r\n  }\r\n}\r\n<\/script>\r\n\r\n<p><iframe loading=\"lazy\" src=\"\/\/www.youtube.com\/embed\/dVSE9osby10\" width=\"611\" height=\"343\" allowfullscreen=\"allowfullscreen\"><\/iframe><\/p>\r\n\r\n<p>High-quality earnings are characterized by <b>sustainability <\/b>and <b>adequacy. <\/b>Sustainability of high-quality earnings means that they tend to persist in the future, whereas adequacy implies that high-quality earnings cover the company\u2019s 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:<\/p>\r\n<ul>\r\n\t<li>Earnings that are insufficient to cover the company\u2019s cost of capital.<\/li>\r\n\t<li>Earnings derived from non-recurring one-off activities.<\/li>\r\n\t<li>Earnings whose reported information does not provide a useful indication of the company\u2019s performance.<\/li>\r\n<\/ul>\r\n<p>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.<\/p>\r\n<h2>Recurring Earnings<\/h2>\r\n<p>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.<\/p>\r\n<p>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.<\/p>\r\n<h2>Mean Reversion in Earnings<\/h2>\r\n<p>Extreme levels of earnings, both high and low, tend to revert to normal levels over time. This phenomenon is known as \u201cmean reversion in earnings,\u201d 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.<\/p>\r\n<h2>Beating Benchmarks<\/h2>\r\n<p>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.<\/p>\r\n<h2>External Indicators of Poor-Quality Earnings<\/h2>\r\n<p>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.<\/p>\r\n<blockquote>\r\n<h2>Question<\/h2>\r\n<p>An analyst is reviewing research notes for a particular company that reflects the company\u2019s performance trends during the last four years.<\/p>\r\n<p><em>Note 1<\/em>: \u201cAccounts payable has increased, whereas accounts receivable and inventory have substantially decreased.\u201d<\/p>\r\n<p>&nbsp;<\/p>\r\n<p><em>Note 2<\/em>: \u201cThe operating income has been substantially lower than the operating cash flow.\u201d<\/p>\r\n<p>Which of the analyst\u2019s notes about the company is <i>most likely<\/i> an accounting warning sign of a probable reporting problem?<\/p>\r\n<p>\u00a0 \u00a0A. Only Note 1.<\/p>\r\n<p>\u00a0 \u00a0B. Only Note 2.<\/p>\r\n<p>\u00a0 \u00a0C. Both Note 1 and Note 2.<\/p>\r\n<h4>Solution<\/h4>\r\n<p><strong>The correct answer is A.<\/strong><\/p>\r\n<p>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.<\/p>\r\n<p><strong>B and C are incorrect.<\/strong>\u00a0Operating income being higher than operating cash flow is a warning sign of a potential reporting problem. However, in this case, the company\u2019s operating income is lower than its cash flow. Therefore, Note 2 does not automatically provide a warning sign.<\/p>\r\n<\/blockquote>\r\n<p>Reading 15: Evaluating Quality of Financial Reports\u00a0<\/p>\r\n<p><em>LOS 15 (f) Describe indicators of earnings quality.<\/em><\/p>","protected":false},"excerpt":{"rendered":"<p>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\u2019s cost of capital. High-quality earnings assume high-quality reporting. Furthermore, high-quality&#8230;<\/p>\n","protected":false},"author":5,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[102,312],"tags":[216,313,170],"class_list":["post-10985","post","type-post","status-publish","format-standard","hentry","category-cfa-level-2","category-financial-reporting-and-analysis-fra","tag-cfa-level-2","tag-financial-reporting-and-analysis-fra","tag-indicators-of-earning-quality","blog-post","no-post-thumbnail","animate"],"acf":[],"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v27.4 - https:\/\/yoast.com\/product\/yoast-seo-wordpress\/ -->\n<title>Indicators of Earning Quality - CFA, FRM, and Actuarial Exams Study Notes<\/title>\n<meta name=\"description\" content=\"Learn about indicators of earnings quality such as sustainability, adequacy, recurring earnings, mean reversion, and external indicators.\" \/>\n<meta name=\"robots\" content=\"index, follow, max-snippet:-1, max-image-preview:large, max-video-preview:-1\" \/>\n<link rel=\"canonical\" href=\"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/indicators-earning-quality\/\" \/>\n<meta property=\"og:locale\" content=\"en_US\" \/>\n<meta property=\"og:type\" content=\"article\" \/>\n<meta property=\"og:title\" content=\"Indicators of Earning Quality - 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