Answer
Quality of Earnings of a company is of extreme importance to analysts. A Company that has a high quality of earnings provides full and transparent information that will not confuse or mislead users of the financial statements.
Quality of earnings has taken increased importance because recent accounting scandals it has been revealed that some companies involve themselves too much in managing their income / Balance sheet.
The following are the factors affecting quality of earnings:
(A) Alternative Accounting Methods
(B) Pro forma income
(C) Improper Recognition
(D) Price-Earnings Ratio
Work Step by Step
(A) As per the Generally accepted accounting principles, accounting methods once accepted, should not be changed, unless there is very much necessity for the same. For example if a company has adopted FIFO system of Inventory valuation, it should not be changed to LIFO or other method in the next years. If this is changed it will lead to higher / lower profits in that year. This will also effect to the current ratio and other ratios also. This will also apply to change in methods of Depreciation, and amortization. Although these differences in accounting methods might be detectable from reading the notes to the financial statements, adjusting the financial data to compensate for the different methods is often difficult.
(B) Companies, whose stock are traded in the share market are required to present their income statement following GAAP. Recently, some companies have started reporting a second measure of income, called pro forma income. In this pro forma income, the companies do not include items that the company thinks are unusual or non recurring. This gives a big difference in the net income of the company as per GAPP and as per pro forma income.
(C) Since there is always a pressure from stock exchange, to increase the income, some companies have manipulated their earnings. One example of such is to sale the goods offering deep discounts. In this case the customer is encouraged to purchase huge stock, when he doesn't need it. This results in good profit in this year but a great loss in the next / subsequent years.
(D) Price earnings ratio is the indicator of the relation of earnings per share to Market price of the share. The financial statement, if have been manipulated, the investor / share holder will perceive that and this will be reflected in lower market price of the shares.
