High-quality earnings are characterized by two elements:
- Sustainable: high-quality earnings tend to persist in the future.
- Adequate: high-quality earnings cover the company’s cost of capital.
Sustainable earnings are ones that can be expected to continue. They would not be comprised of many non-reoccurring items. Classification of non-recurring items can be subjective and can lead to low quality earnings figures. For example, classifying normal operating expenses as expenses from discontinued operations can lead to overstating the persistence of earnings.
One way to gauge earnings persistence is to use a regression model such as:
earnings(t+1) = α + β1 earnings(t) + ε
In this model, a higher value of β1 indicates higher persistence of earnings.
Under the accrual basis of accounting, revenues are recognized when earned and expenses are recognized when incurred, regardless of the timing of cash flow. Because accruals can be subjective, separating accruals out of cash flow increases the quality of the earnings.
It is important to recognize that some accruals occur as part of normal business. Such accruals are called as non-discretionary accruals. Discretionary accruals result from non-normal transactions or non-normal accounting choices, and are sometimes used to manipulate earnings.
Finally, a major red flag about earnings quality is raised when a company reports positive net income while reporting negative operating cash flow.