Quality of Earnings

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  • #227254
    Kellie Farber
    Participant

    Regarding Question ID: ICMA 19.P2.070 (Topic: Inflation)

    What is the definition of “Quality of Earnings” here? I don’t quite understand how choosing the inventory method that leads to the lowest income level would result in a higher quality of earnings. I would think that choosing FIFO, which would lead to greater income in a period of rising prices would lead to higher quality of earnings. The definition I found is: <b>Quality of earnings</b> is the percentage of income that is due to higher sales or lower costs. Any insight would be helpful.

    Thank you.

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  • #227264
    Lynn Roden
    HOCK international

    Hello Kellie,

    Higher income is not higher quality earnings than lower, more conservative income.

    Earnings quality is defined and explained in your HOCK CMA Part 2, Vol. 1 textbook. According to that explanation, “increased earnings due to increased sales and improved cost controls are of a higher quality than artificial profits created by inflation of inventory or other asset prices.”

    In a period of rising prices, the use of LIFO will result in a more conservative and more realistic profit figure than will the use of FIFO, for example, because LIFO is based on inventory costs that more closely represent the current cost to replace the sold inventory. Those earnings based on LIFO would therefore be of higher quality than earnings based on FIFO costs of inventory purchased possibly months ago at a much lower cost than the company would have to pay to purchase the same inventory currently.

    Please read the explanation in your HOCK textbook in the topic “Earnings Quality” on page 140 of the current edition for more information.

    Lynn

    • This reply was modified 6 months, 3 weeks ago by Lynn Roden.
    • This reply was modified 6 months, 3 weeks ago by Lynn Roden.
    • This reply was modified 6 months, 3 weeks ago by Lynn Roden.
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