The quality of earnings refers to the proportion of income attributable to the core operating activities of a business. Thus, if a business reports an increase in profits due to improved sales or cost reductions, the quality of earnings is considered to be high. Conversely, an organization can have low-quality earnings if changes in its earnings relate to other issues, such as:
- Aggressive use of accounting rules
- Elimination of LIFO inventory layers
- Sale of assets for a gain
A key characteristic of high-quality earnings is that the earnings are readily repeatable over a series of reporting periods, rather than being earnings that are only reported as the result of a one-time event. In addition, an organization should routinely provide detailed reports regarding the sources of its earnings, and any changes in the future trends of these sources. Another characteristic is that the reporting entity engages in conservative accounting practices, so that all relevant expenses are appropriately recognized in the correct period, and revenues are not artificially inflated.
Investors like to see high-quality earnings, since these results tend to be repeated in future periods and provide more cash flows for investors. Thus, entities that have high-quality earnings are also more likely to have high stock prices.