Reporting quality, earnings quality and the quality spectrum

Two different questions about quality

Financial reporting quality concerns the information in the reports, including the notes. High-quality reporting gives decision-useful information: it is relevant (it could change a user's decision, which includes the idea of materiality) and it is a faithful representation (complete, neutral and free from error). Enhancing characteristics such as comparability, verifiability, timeliness and understandability make it more useful still.

Earnings quality, also called results quality, concerns the economic activity behind the numbers. High-quality earnings come from activities the company can keep doing, and they earn an adequate return: one above the cost of the investment and at least equal to the expected return. Analysts use 'earnings quality' broadly, so it also covers the quality of cash flow and balance sheet items.

The two are linked. If reporting quality is very low, there is nothing reliable to analyse, so earnings quality cannot be judged at all. Above that minimum, better reporting makes it easier to judge earnings quality and to forecast.

Good reports of bad results, and bad reports of good results

Reporting can be high quality even when the business is not. A company that makes a loss, earns less than its cost of capital, or depends on a one-off gain or a favourable currency swing can still describe all of that clearly and correctly. That is high reporting quality combined with low earnings quality.

The reverse also happens. A healthy company may produce poor reports because its internal systems are weak, or because it deliberately makes its results look worse (for example to avoid political attention or to store profit for later). Most often, though, poor reporting goes with poor results: managers use aggressive choices to hide weak performance.

Think of a doctor's report. Reporting quality is whether the test results are measured and written down correctly; earnings quality is whether the patient is actually healthy. An accurate report can still show a sick patient.

The quality spectrum, level by level

Combining both dimensions gives a ladder for ranking reports. The top rung has both kinds of quality. As you go down, reporting quality falls, and near the bottom the two ideas blur together, because once the numbers are unreliable you cannot say anything about the underlying earnings.

Biased choices stay inside the rules but tilt the picture, either upward (aggressive) or downward (conservative), or flatten it (earnings smoothing). Bias can also lie in presentation: hiding bad news in a footnote or giving prominence to flattering figures.

Earnings management means deliberately making choices to influence reported earnings. The line between biased choices and earnings management is mostly one of intent, which is hard to prove, so in practice the two are often discussed together. Real earnings management changes what the company actually does, such as postponing research or advertising spending into the next period. Accounting earnings management changes how results are measured, such as lowering estimates of returns, bad debts or impairments.

Below that, reports depart from GAAP: for example, losses taken straight to equity instead of profit, expenses capitalised that should be expensed, or debt kept off the balance sheet. Comparisons with prior periods and peers break down, so earnings quality cannot be assessed. At the very bottom, reports describe fictitious transactions: invented sales, fake inventory or non-existent bank balances, used to mislead investors or to hide theft of company assets.