What Is Earnings Quality?

Hawkins (1998) believes that companies with high earnings quality have the following characteristics: a consistent and stable accounting policy, which is prudent in confirming the company's financial position and net income; the income is derived from recurring transactions related to the company's basic business The sales reflected in accounting can be quickly converted into cash; the level and growth of net income do not depend on changes in tax laws; the level of corporate debt is appropriate, and the company does not use its capital structure for earnings manipulation; Stable and predictable trends that reflect future levels of returns. At the same time, he pointed out that the quality of earnings does not only involve a factor of income. The characteristics of financial activities and operating activities will affect the order of the quality of income, such as: operating leverage, financial leverage, liquidity, industry factors, and the economic environment. , Tax policy, accounting policy, user purpose, etc. are also important factors that determine the quality of the company's earnings.

Earnings quality

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Hawkins (1998) believes that companies with high earnings quality have the following characteristics: a consistent and stable accounting policy, which is prudent in confirming the company's financial position and net income; the income is derived from recurring transactions related to the company's basic business The sales reflected in accounting can be quickly converted into cash; the level and growth of net income do not depend on changes in tax laws; the level of corporate debt is appropriate, and the company does not use its capital structure for earnings manipulation; Stable and predictable trends that reflect future levels of returns. At the same time, he pointed out that the quality of earnings does not only involve an element of income. The characteristics of financial activities and operating activities will affect

Dechow and Schrand (2004) believe that high-quality earnings need to meet the following three conditions: the first reflects current operating conditions; the second is a good predictor of future operating conditions; and the third is a true reflection of the company's intrinsic value. Therefore, when the surplus is of high quality, it will be: more sustainable and stable; more relevant to the realization of future cash flows; more relevant to the company's stock price or market value. They also pointed out that continuity and stability only make sense if the company's surplus truly reflects the value of the company. If continuity and stability are considered in isolation, the forecasting effect of the earnings cannot be guaranteed.

Both of the above definitions emphasize the quality, sustainability, predictability, stability and value of accrued profits in earnings

In the conceptual frameworks of the US General Accounting Standards (GAAP) and International Accounting Standards (IFRS), correlation and reliability are the most basic quality characteristics of accounting information. Earnings, as the basic elements of accounting statements, should of course meet these qualitative characteristics, but as a study specifically for earnings, scholars have defined more targeted attributes for it, such as: Francis et al. (2004) believes that earnings have the following Attributes:

Quality of accrued profits

Because the manipulability of accruals reduces the relevance of earnings information, securities analysis generally believes that the more cash-secured accrued profits, the better the quality. Operating cash flow is superior to net income figures in measuring business performance because net income figures include many accrued, deferred, amortized, and estimated items, and these items are significantly more manipulable and subjective Operating cash flow.

2. Persistence

The better the sustainability, the better the quality, because the ongoing surplus will happen again. Generally, the slope of the current earnings is used as the criterion for the persistence of the earnings in the current earnings and later earnings regression models. The larger the slope, the better the continuity. However, it should be noted that the continuity of different items in the income statement is different.

3. Predictability

Predictability is the ability of earnings to predict themselves. Sustainability is one of the relevant components of the FASB's conceptual framework. Predictable earnings are considered high-quality by standard makers and are also considered by analysts to be an important part of value assessment.

4. Value relevance

This attribute is derived from the viewpoint that earnings should explain the ability to return on investment. Earnings with stronger explanatory power are considered to be of higher quality. There should be a positive correlation between earnings quality and stock returns. Companies with better earnings quality have higher earnings reflection coefficients, and stock prices will have a positive reflection.

5. Stationarity

The smaller the fluctuation, the more stable the surplus. Stable returns are considered high quality because business people use their private information about future income to smooth out short-term fluctuations in earnings and report a more useful piece of information. ^[1]