Measures of Earnings Quality

  • Conceptually, earnings quality refers to the accuracy of the income statement reported by a company in predicting future financial performance.
  • The term earnings quality can be extended more broadly by stating financial reporting quality. As the management of a company makes more aggressive assumptions, the quality of its financial statements tends to deteriorate.
  • High quality financial reporting is commonly associated with the application of conservative assumptions by management.
  • When looking at earnings quality, a financial analyst or investor is trying to determine if the company in question is applying aggressive or conservative assumptions.

  • Conservative Accounting examples:

    • Accelerated depreciation methods,
    • High allowances for doubtful accounts, and
    • Large unearned revenue balances.This conservatism should wash out over time, as lower current period earnings lead to higher future period earnings.
  • Mean Reversion in Earnings: extremely high earnings levels are typically not persistent and tend to revert to normal levels.

  • Within the context of simple economic theory, if a new and highly profitable market or industry is established, the first to enter may enjoy high profits. However, over time these profits will attract new entrants and drive down profitability, in the absence of barriers to market entry.

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