What is the quality of earnings in accounting?

April 28, 2012

Learn about quality of earnings in accounting.

1. Definition of the quality of earnings

There is no single definition of the quality of earnings, as well as there is no single measure of this concept.

According to the Statement of Financial Accounting Concepts No.1, the earnings quality is defined as follows:

Higher quality earnings provide more information about the features of a firmís financial performance that are relevant to a specific decision made by a specific decision-maker.

In general, the earnings quality can be looked at as the quality of information. High quality information is precise (accurate), relevant, comparable, unbiased, and timely. The concept of the quality of information is especially applicable in the context of capital markets. For example, from the precision perspective, the quality of earnings is high when earnings precisely reflect the underlying (i.e., true) operating risk and environment, business performance, and reporting quality of an entity.

High quality information is important in making good judgments and decisions. Itís important for many participants in the financial reporting process: investors (e.g., where and how much to invest, what is the investment risk), regulators (e.g., what is the quality of financial reporting standards), auditors (e.g., what is the quality of financial statements and audit performed), lenders (e.g., what is the credit quality of an entity), etc. Itís used in many investment decision and valuation models.

As we can see, earnings quality is of interest not only to investors but also to regulators, standard setters, credit rating agencies, analysts, accounting researchers, and many other participants in the financial reporting process. As the result, there are numerous benchmarks and views used to measure the quality of earnings.

Earnings quality can be viewed from such perspectives as (not an exhaustive list):

  • Analyst expertise
  • Auditor independence
  • Balance sheet
  • Decision usefulness
  • Earnings management
  • Financial analysis/reporting
  • International
  • Measurement

For instance, from the decision usefulness perspective, the quality of earnings is how precisely the earnings reflect the changes in the wealth of a company. From the financial analysis perspective, the earnings quality is how precisely the earnings measure the value of the company and how accurately they (earnings) represent the firmís current and future performance.

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