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Earnings Quality

In simple words, earnings quality means to show the income statement without any cheating or mistake. Good quality of earning report will not show fictitious revenue, decreasing the expenses by shifting it to other period. It also does not inflate profit by adding increase the share prices. If company has added the inflation in its
stock prices but cash from operation is very low, its earnings quality level will be very low. For bringing the quality in the earning reports, accountant will not follow the creative accounting. He will follow all the updated accounting standards. If company management manipulates the income statement for attracting the investors, it will decrease the quality of earnings. Later, goodwill of company will decrease due to this.

Steps to Measure Earning Quality

1. For auditor and investors, measurement of earning quality is very necessary for taking decisions. To measure the quality of earning is not so easy. You have to study your income statement very deeply. First of all you have to check income side. In income side, you will see the sales. Check whether sales price is affecting from inflation or not. High inflated price of sale will low the quality of earning. Compare it with the average of the price over the period.

2. Second effect will of accruals.

Seeking Alpha has written useful thoughts relating to earning quality
The EQ score ranges from 1 to 100, 1 being the best EQ score resulting from the lowest accruals, and 100 being the worst EQ score indicating the highest accruals. Because high EQ score companies (bad Earnings Quality) are more likely to have negative earnings surprises, you may want to avoid these firms.

3. From quality of earning ratio, we can also measure the earnings quality. Following is the formula of quality of earning ratio:

Cash from Operation / Net Income X 100

This ratio creates the relationship between cash income and total business income. Higher of this ratio will show the higher of quality of earning because more earning money will receive without any risk For example, A firm has 70% quality earning ratio and second firm has 30% quality earning ratio. It means, out of 100, A firm has 70 in cash form but B firm has just 30 cash profit out of total profit of 100.

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Accounting Education: Earnings Quality
Earnings Quality
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Accounting Education
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