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Subject 3. Indicators of Earnings Quality PDF Download
High earnings quality must be persistent and sustainable.

  • It is not how much money a company is making that counts, it's how it makes its money.
  • It's how repeatable a firm's earnings are.Companies that generate lots of sustainable cash from their operations have good earnings quality.

Various alternatives have been used as indicators of earnings quality.

Recurring Earnings

Net income includes the impact of non-recurring items, which are transitory or random in nature. Therefore, net income is not the best indicator of future income. Recurring pre-tax income from continuing operations represents the company's sustainable income, and therefore should be the primary focus of analysis.

Segregating the results of recurring operations from those of non-recurring items facilitates the forecasting of future earnings and cash flows. Generally, analysts should exclude items that are non-recurring in nature when predicting a company's future earnings and cash flows. However, this does not mean that every non-recurring item in the income statement should be ignored. Management tends to label many items in the income statement as "non-recurring", especially for those that reduce reported income. For the purpose of analysis, an important issue is to assess whether non-recurring items are really "non-recurring", regardless of their accounting labels.

Earnings Persistence and Related Measures of Accruals

Accounting earnings consists of two underlying components. A cash component provides both relevant and reliable information. An accrual component provides relevant information, but for which reliability has potentially been compromised. Because the accrual component is expected to be less reliable than the cash component, the accrual component of earnings is less persistent than the cash component of earnings.

Researchers can decompose earnings into its components and examine whether the components have different implications for future earnings. For example, Sloan (1996) examines two components of earnings:
Earningss+1 = α + β1CFt + β2Accrualst + εt

It can be shown that β2 < β1, which implies that the cash flow component of earnings is more persistent than the accrual component.

Mean Reversion in Earnings

Earnings tend to be mean reverting. That is, unusually positive changes in earnings tend to be followed by negative changes, while unusually negative changes tend to be followed by positive changes in earnings. This suggests that earnings eventually move back towards the mean or average.

Firms with more accruals have less persistent earnings, and therefore experience mean reversion in earnings performance muck quicker.

Beating Benchmarks

Earnings quality should be questioned if a company consistently reports earnings that exactly meet or only narrowly beat benchmarks.

External Indicators of Poor-Quality Earnings

Examples are after-the-fact confirmations of poor-quality earnings, such as enforcement actions and restatements. They are relatively less useful to an analyst.

User Contributed Comments 2

User Comment
bodduna When aggregate accruals are the dominant component of a company's earnings, mean reversion tends to occur more quickly and so earnings with a high accrual component can be considered lower quality.
davidt87 It's more that the the accrual component is less consistent - due to the inherent uncertainty in creating an accrual or due to purposeful manipulation. So firms with high levels of accruals have less consistent (more volatile) earnings. That's why their earnings are considered low quality.

On a separate note, earnings in general are found to be mean reverting, and it makes sense that firms with more volatile earnings will experience mean reversion at a faster rate
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