What is the quality of income?
August 29, 2012
Do you normally just look at the net income of a company? Do you analyze the company's cash flows from operations? See how the two are connected in this article discussing the quality of income.
Quality of income is how accurately the net income reflects the operating performance of an entity.
Quality of income is related to the concept of earnings quality. The quality of earnings usually indicates how precisely the earnings measure the value of an entity and reflect the entity’s current and future performance. To learn more about the quality of earnings as well as its determinants and outcomes, please refer to article What is the quality of earnings in accounting?
When analyzing an entity, it is important to assess the quality of its income as the entity can use different accounting procedures to report higher or lower income.
In other words, the entity can engage in creative accounting: use accounting procedures to make reported information more attractive to the users of accounting information such as investors, creditors, government, regulation authorities, etc. Important to note, creative accounting is not illegal. Rather, creative accounting is a misleadingly optimistic form of accounting when management can use its judgment in recording accounting transactions subject to ambiguous regulation or no regulation.
In general, management might engage in earnings management – that is, use its discretion (judgment) in structuring transactions as well as in preparing financial reports – to alter financial reports to influence contractual obligations or mislead some stakeholders about the underlying condition of the entity.
Income smoothing is one of the aspects of earnings management.
For example, a company might have an incentive to engage in income smoothing activities in order to attract more investors: many investors pay attention to the amount of income as well as its trend in their decision making process. Companies reporting high levels of fluctuations in their income are often perceived by investors as the companies taking more risks in comparison to those reporting smooth earnings. As the result, to signal the strength of earnings, stability, and growth, management might have an incentive to smooth company’s income trend (i.e., decrease fluctuation or variation in the income trend).