What is the quality of earnings in accounting?

2. Earnings quality determinants and outcomes

As mentioned earlier, there are multiple views and benchmarked used to measure the quality of earnings. Similarly, many attributes can be used to measure earnings quality and its outcomes. Both the determinants and consequences are proxies of the earnings quality. In other words, they can be used to estimate the quality of earnings.

Earnings quality proxies have unique features: unique combination of quality determinants and consequences. According to the accounting research literature, earnings quality proxies might include the following:

  • Properties of earnings: earnings persistence and smoothness, timely loss recognition (TLR), accounting conservatism, magnitude of accruals, target beating, etc.  
  • Investor responsiveness to earnings: accounting methods, auditor quality.
  • External indicators of earnings misstatements: restatements, internal control deficiencies.

For example, one of the external indicators of earnings quality is restatements of financial statements. The determinants of restatements include, to name a few, audit committees with financial expertise and executive compensation portfolios that are sensitive to stock price. Restatements affect (i.e., consequences) company value, company management (e.g., turnover), and company litigation risk.

The determinants of earnings quality might include the following, according to the accounting research literature:

  • Firm characteristics: performance, size, growth, investment, debt, etc.
  • Firm financial reporting practices:  financial statement classification, interim reporting, accounting methods used, etc.
  • Firm governance and internal controls: internal controls, characteristics of the Board of Directors (BOD), managerial ownership and compensation, etc.        
  • Audit: auditor industry expertise, hours spent auditing, etc.
  • External factors: politics, tax regulation, capital requirements, etc.
  • Capital market incentives: earnings-based targets, raising capital, etc.    

The quality of earnings may affect (i.e., outcomes) the following:

  • Analyst forecasts
  • Audit opinion
  • Executive compensation and labor market
  • Firm cost of debt and equity capital
  • Firm real activities (i.e., real operating activities)
  • Litigation risk
  • Market valuation

All in all, there are many dimensions of earnings quality

So what are the outcomes of earnings quality for companies? In general, higher quality of earnings often helps companies to receive higher stock prices, higher credit limits, lower interest rates, etc.

Because there are so many dimensions of earnings quality, market participants use various factors to estimate this quality. For instance, analysts might consider the following factors when evaluating the quality of earnings (not an exhaustive list):

  • Earnings characteristics: earnings trend, major source of net income, conversion of sales into cash
  • Firm characteristics: market share, brand awareness and loyalty, labor relations
  • Financial ratios: debt-to-equity, total liabilities to total assets, rate of return on investment, earnings per share, price-earnings ratio, dividend payout ratio, net profit as a percentage of sales, percentage of expenses to sales, sales growth rate, etc.
  • Audit opinion
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