The quality of earnings refers to the amount of earnings attributable to higher sales or lower costs, rather than artificial profits created by accounting anomalies or tricks such as inflation of inventories or changing depreciation or inventory methodology. Quality of earnings is considered poor during times of high inflation. Also, earnings that are calculated conservatively are considered to have higher quality than those calculated by aggressive accounting policies. Quality of earnings can also be eroded by managers who undertake shady accounting practices in order to hide poor sales or increased business risk. Financial analysts often carefully assess the quality of earnings and do not simply take financial statements at their face value.
One measure of fundamental analysis that analyst like to track is net income. It provides an overview of how well the company is doing from an earnings perspective. If net income is higher than it was the previous year and/or beats analyst estimates, it represents a win for the company, but how reliable are these earnings? Due to myriad accounting conventions, companies can manipulate earnings to serve their own needs. Some companies seek to manipulate earnings down to pay lower taxes, while others find ways to artificially inflate earnings, especially in times of earnings decline. Companies that manipulate earnings are said to have poor or low earnings quality; conversely, companies that do not manipulate earnings have a high quality of earnings.
There are many ways to gauge the quality of earnings. Starting with the top of the income statement, which can be found in a company's annual report, analysts can work their way down. For instance, companies with high or growing sales may also have high growth in credit sales. Such changes in credit sales, or accounts receivable, can be found on the cash flow statement. Analysts don't like sales growth due to a loosening of credit terms and prefer increased sales to arise organically. Working down the income statement, analysts then may look for variations between operating cash flow and net income. A company that has a high net income and yet also has negative cash flows from operations may be achieving those apparent earnings through artificial means. One-time adjustments to net income, also known as nonrecurring expenses, are also a potential red flag - it is not unusual for companies to make supposedly one-time adjustments for several quarters and years in a row.
It should also be noted that companies can manipulate popular earnings measures such as earnings per share and price-to-earnings ratio by buying back shares of stock, which reduces the number of shares outstanding. In this way, a company with declining net income may be able to post earnings-per-share growth. Because earnings go up, the price-to-earnings ratio goes down as well, signaling that the stock is undervalued or on sale. In actuality, the company simply repurchased shares. It is particularly concerning when companies take on additional debt to finance stock repurchases. Several accounting scandals, such as with Enron and Worldcom, have been the product of poor earnings quality that misled investors.