Quality of earnings
Quality of earnings describe how much investor or company earns in real, excluding the impact of inflation or inventories. High quality earnings is associated with growing sales or decreasing costs - sources of real earnings. Often it is related to the amount of employees' pay. The more money a company makes, the more it can offer its employees. Very often when an employee is appreciated, this translates into his quality of work, commitment and, consequently, raising the level of the entire company. Low quality of earnings is related to sources such as: inflation, creative accounting, etc. Companies can manipulate their earnings to give the impression of a certain state of the company. They can artificially increase earnings, shift between periods, pay lower taxes, etc. This is known as low earnings Many companies talk about a sustained increase in income, which causes an increase in earnings response rates. The more profit the company brings, the more stable its position, the earnings are more lasting, the operational efficiency in the future stronger [1].
What affects the quality of earnings?
We can distinguish two stages of the process that affects the quality of earnings. The first analytical work consists in disseminating information. The second empirical work - combines the management of earnings and the use of information. The whole process gives us predictions about the effect of linking information with earnings. With the disclosure of information and the dissemination of their liquidity in the market increases. Usually large companies can afford it. Which analysts have among their employees. They are studying the information policy. However, it is not always good to disseminate information about a company because it goes to competitive companies.Thanks to analytical models, we learn that along with the increase in information asymmetry, opportunistic gains increase.It is possible to examine the entire discretionary period by means of a relationship of limitation of the accruals [2]. In addition, the increase in the quality of earnings may be caused by other factors: revenue and expenses, quality, management, employees, advertising [3].
How to measure quality of earnings?
Popular earnings measures, like earnings per share can be manipulated. Therefore, deepened analysis is required. High sales should be compared with credit sales and accounts receivable (cash flow). High net income should be compared with cash flow from operations. High non-recurring expenses should be checked as they can be a signal of manipulations. When the financial situation is stable for a long time, there are no sudden and unexpected signals, changes in expenses and costs, then we can assume that everything functions properly. Stability and continuity in financial analysis is equated with the lack of in-depth analysis [4].
| Quality of earnings — recommended articles |
| Liquidity management — Optimal capital structure — Degree of financial leverage — Capital gearing — Debt management ratio — Average collection period — Average payment period — Payables turnover — Bank efficiency ratio |
References
- Lobo, G., & Zhou, J. (2012). Disclosure Quality and Earnings Management. "Asia-Pacific Journal of Accounting and Economics" p. 2-10
- Penman, S. H., & Zhang, X. J. (2002). Accounting conservatism, the quality of earnings, and stock returns. "The accounting review" 77(2), 237-264.
- Ghosh, A., & Gu, Z., & Jain, P. (2005). Sustained Earnings and Revenue Growth, Earnings Quality, and Earnings Response Coefficients. "Review of Accounting Studies Ghosh" p. 3-9
Footnotes
Author: Mariola Goc
