Quality of Earnings

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Quality of Earnings

Companies have a higher quality of earnings if increased profits are due to increased revenues or lower costs rather than due to statistical changes such as changes in accounting methods.

Let’s say ABC Company depreciates its $10,000 asset with a straight line method over 10 years for a deduction of $1,000 a year while DEF Company depreciates its $10,000 asset with a straight line method over 5 years for a deduction of $2,000 a year. ABC had sales of $4000 minus depreciation of $1000 for a profit of $3000. DEF had sales of $5000 minus depreciation of $2000 for a profit of $3000. DEF has a higher quality of earnings because in their case the net income is due more to actual revenue received by the company rather than by which depreciation method they chose to use.

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