Earnings Quality Using the Long-Run Equilibrium Relation Between Income and Cash Flows

Abstract

In this study, we provide evidence confirming the existence of a long-run equilibrium relationship between comprehensive income and cash flows and that short-run deviations from the long-run equilibrium are regularly corrected. Therefore, we introduce an alternative approach to evaluating the quality of earnings, according to which, the quality of earnings is a function of the magnitudes of these short-run deviations and the speed with which they are corrected. We also develop an earnings quality measure, the Income Quality Index (IQI), to serve that purpose. Finally, we illustrate the application and advantages of this approach to earnings quality.