Quality of Earnings

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More and more often you see the phrase quality of earnings in the business and financial press. Reported net income is put to a quality test, or a litmus test as it were. This term does not have a precise definition that I'm aware of, but clearly most persons who use this term refer to the quality of the accounting methods used by a business to record its profit.

Conservative accounting methods are generally viewed as high-quality, and aggressive accounting methods are viewed with more caution by stock analysts and professional investment managers. They like to see some margin for safety, or some cushion for a rainy day in a company's accounting numbers. They know that many estimates and choices have to be made in financial accounting, and they would just as soon a business err on the low side rather than the high side.

Professional investors and investment managers are especially alert for accounting methods that appear to record revenue (or other sources of income) too early, or that fail to record losses or expenses that should be recognized. Even though the financial statements are audited, the professionals go over them with a fine-tooth comb to get a better feel for how trustworthy are the reported earnings of a business.

And, they pay a lot of attention to cash flow from profit (operating activities) because this is one number managers cannot manipulate—the business either got the cash flow or it didn't. Accounting methods determine profit, but not cash flow. If reported profit is backed up with steady cash flow, stock analysts rate the quality of earnings very high.

To think that financial reports issued by businesses are pure as driven snow is naive. People are people, after all; we're not all angels. As my father-in-law puts it, "There's a little larceny in everyone's heart." Just because a few cops accept bribes doesn't mean all police are on the take. Clearly the large majority of businesses prepare honest financial statements. But there are some crooks in business, and they are not above preparing false financial statements as part of their schemes.

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