Lesson 1 of 7 · 14 min
Reporting quality, earnings quality and the quality spectrum
Reporting quality asks whether the reports tell the truth about the business; earnings quality asks whether the business itself is producing sustainable, adequate profits, and the two combine into a spectrum running from useful reports of good results down to pure fiction.
In short
- Financial reporting quality is about the information: is it relevant, complete, neutral and free from error, so that it faithfully shows what happened?
- Earnings (results) quality is about the economics: are earnings, cash flow and balance sheet items sustainable and do they earn an adequate return? The term covers cash flow and balance sheet quality too.
- You can only judge earnings quality if reporting quality reaches some basic level. Good reporting of poor results is perfectly possible.
- The quality spectrum, from best to worst: GAAP, decision-useful, sustainable and adequate returns → GAAP and decision-useful but not sustainable → within GAAP but biased choices → within GAAP but earnings management → non-compliant accounting → fictitious transactions.
- Earnings management can be real (changing actual decisions, such as cutting R&D) or accounting (changing estimates or methods).
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