Quality of earnings is an accounting and investment term used to describe the earnings that a business reports through its income and cash flow statement. When investors look at earnings reports, they want to make sure that earnings are reliable -- that they are continual and stable. However, companies can use many different accounting procedures to pad their net earnings, inflating them by recording expenses in different ways, which can affect the quality of earnings.
Discretionary Expenses
Discretionary expenses are those expenses that are not required in order to run core business operations. This does not mean that these expenses are nonrecurring or unusual. Most businesses have regular discretionary expenses they consider part of their overall model. Research and development expenses are a good example. While a company does not need to spend money on R&D, many set aside a certain number of funds each period for use in this department.
Maintaining Discretionary Expenses
A business has the chance to make no changes to discretionary expenses when entering a period. In this case, changes will be relatively few based on such expenses, related more to budgeting and costs than earnings manipulating. As a result, the earnings will reflect business success during the period more accurately and quality of earnings will be high.
Cutting Back
Other companies may choose to cut back discretionary spending in several areas when entering a period. This inflates net earnings, since the money that was once allocated to departments like research and development now shows up as extra revenue. Sales may not have changed, but earnings are artificially changed. As a result, the quality of earnings is decreased even if the value rises because investors can no longer trust the income reports.
Considerations
Quality of earnings is a complex concept and can be affected by many more things than just discretionary expenses, so investors should not look at discretionary changes alone when making quality-of-earnings considerations. Often, a look at several years is necessary to see if discretionary expenses actually change to bolster revenue in times of low sales or if it is just a reactionary change to some other variable.
