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Earnings Quality 
Source: Encyclopedia of Banking & Finance (9h Edition) by Charles J Woelfel
(We recommend this as work of authority.)      

Realistic earnings.  Accounting principles, methods, and policies can incluence the quality of a company's reported earnings.  Such factors should be considered when evaluating the financial statements of companies.  Generally, accounting principles, methods, and policies that result in the slowest reporting of income are considered the most conservative.  When a firm has conservative accounting procedures, its earnings are of high quality.

A company's accounting policies should be compared with industry standards.  If the policies are more liberal, earnings quality is generally considered to be lower.  Consider the following generalities when evaluating the quality of a company's earnings:

1.  A low price/earnings ratio (market price per share divided by earnings per
     share) generally means lower-quality earnings.

2.  FIFO (first in, first out) inventory procedures match the oldest costs against
     revenue.  FIFO is generally considered to be more liberal than other inventory
     procedures.

3.  The completed contract method (revenue recognized when the contract is
     completed) of accounting for construction firms that have long-term contracts is generally considered to be more conservative than the percentage of
     completion method (revenue recognized during the construction period).

4.  Accelerated depreciation methods that recognize a large amount of
     depreciation in the early years of the asset are conservative.  These include the sum-of-the-years' digits and the declining balance method.  The straight-line
     method of depreciation is generally considered to be among the least
     conservative depreciation methods.  Also, the shorter the depreciation periods,  the lower the income and the more conservative the statements.

5.  In the accounting for pensions, the higher the assumed discount rate used to
     compute the actuarial present value of the accumulated benefit obligation and
     the projected benefit obligation, the lower the present value of the liability and
     the lower the immediate pension cost will be.  If the rate is too low, then the
     projected benefit obligation is too low and vice versa.

An understanding of nature and scope of generally accepted accounting principles will help in evaluating a firm's accounting policies.  Major accounting principles and policies are disclosed within the financial statements and presented in the notes to the financial statements.  Notes are considered an integral part of financial statements.  Many accounting policies used in financial statements are disclosed in a Summary of Accounting Policies, which immediately precedes the first note or is the first note to the statements.

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