The professional investor knows that reported earnings numbers are often the product of deliberate choices between various accounting treatments and business options. In order to assess true earning power, the analyst must make some determination of the quality of earnings.
The quality of a reported earnings figure can be lowered if management recognizes revenues or expenditures either prematurely or belatedly, or chooses a liberal accounting treatment over a more conservative one. The analyst should be particularly wary of changes in accounting policy, taking note of any termination of auditor contracts resulting from disagreements over proposed accounting changes.
But earnings quality is affected by business, as well as by accounting, decisions. Management can manipulate the level of reported net income by raising or lowering discretionary expenses — e.g., increasing income by failing to replace obsolete fixed assets or by neglecting necessary repairs or, in certain cases, by cutting advertising costs. If the company is deferring such outlays merely to increase current earnings, it is degrading earnings quality.
Development costs can also be discretionary, and are particularly worthy of analysis since they often represent the key to a company’s future success or failure. Finally, outlays for the development of human resources — the costs of training operating, sales and managerial talent — can have long-term significance.