Earnings quality is an assessment criterion for describing how repeatable, controllable, and bankable an entity's earnings are. High-quality earnings increase an entity's value more than low-quality earnings. In addition, high-quality earnings assume high reporting quality, while low-quality earnings indicate that reported information is not useful or accurate in indicating the entity's performance.

A variety of quantitive and non-quantitative alternatives can be used as indicators to determine the quality of earnings for an entity:

The combination of the above alternatives represents a powerful analysis tool to piece together a view of the quality of earnings for an entity.

Earnings that contain a high proportion of non-recurring earnings, i.e., earnings that aren't expected to occur in the future again, are less likely to be sustainable and are considered lower quality.

Typically, when analyzing an entity’s current and prior earnings to determine future earnings, one focuses on earnings that are expected to recur in the future. Earnings from discontinued operations, tax settlements, once-off impairments, and gains from asset sales are once-off and must be excluded from recurring earnings.

It's important to note that classifying earnings as non-recurring has an element of subjectiveness attached to it. When reviewing financial statements, one must determine what is included in non-recurring earnings (and, by extension, core earnings) and ensure that category changes are adequately explained.

Benchmarking is a useful supplementary tool for earnings quality analysis. Benchmarking analysis can be compared across profit and loss (including earnings), balance sheet, and ratios. Meeting or exceeding industry benchmarks is not always an indicator of high-quality earnings but is a useful litmus test.

One can compare how earnings are achieved vs. the industry to determine if the financials stack up - and, by extension, determine the quality of earnings.

For example, for entities in the same industry, one would expect similar margins and cost structures - a large deviation may indicate an underlying reporting issue, which may indicate low-quality earnings. In terms of listed entities, an entity that consistently beats earnings can raise questions about its earnings quality.

Benchmarking should be used in conjunction with other analysis tools instead of being a hard-and-fast rule.

For large and listed entities, auditors are often a requirement. Although it's common for entities to change their auditor(s), auditors are typically expected to serve for a time before a change, e.g., a 5-year period. Entities that change auditors often or change auditors near the release of official trading statements or financial information (such as financial statements) may indicate reporting issues and, by extension, low-quality earnings.

Similarly to a change of auditors, entities that change senior financial officers, CFOs or senior members of audit/risk committees near the release of official financial information (such as financial statements) may indicate reporting issues and by extension, low-quality earnings.

An example of this red flag is OneSmart International Group, a Chinese online education and daycare company. In July 2019, its CFO departed (SEC filing here), while in January 2020, an independent audit committee member resigned (SEC filing here). OneSmart's share price is down 50% over the past year.

The restatement of financial statements does not necessarily indicate low earnings quality but should be investigated thoroughly to determine the impact on current and future earnings. Restating financial statements may be due to one of several reasons, including the correction of errors, an effort to address non-compliance (either on an accounting standard basis or required by a listed exchange), or to correct fraudulent financial reporting. Entities try to avoid restatements as it's a subtle admission that they cannot create reliable financial reports and information.

Investigations conducted by regulatory or tax authorities, as well as any associated fines or penalties, may indicate low-quality earnings. This is caused by the fact that the entity either conducted operations that breached certain regulatory guidelines or misrepresented financial information. Fines and penalties can have an immediate financial impact on earnings and unintended long-term consequences in the form of reputation damage and enhanced scrutiny.

Earnings can be viewed as a combination of accrual and cash components. To recap, accrual basis accounting reflects revenue in the period it is earned and expenses in the period they are incurred. Conversely, cash-based accounting reflects revenue in the period in which the cash is collected and expenses in the period funds are disbursed. Accrual-based accounting is the most common reporting type. Earnings that are underpinned by cash components that are received are more desired and expected to remain more persistent in the future. Earnings underpinned by less cash are subject to estimates and debtors' books with a risk of non-collections.

Take care,
Syft