CFA Level II Exam · Evaluating Quality of Financial Reports

Earnings Quality and Sustainable Earnings Explained

Updated 7 October 2026 · Fact-checked

High-quality earnings are earnings that are sustainable and that provide an adequate return on the company's capital. Sustainable earnings come mainly from recurring, core operations and are likely to repeat. To assess them, separate recurring from non-recurring items, strip out the one-offs, and check that the profits reflect real economic performance.

Understand Earnings Quality and Sustainable Earnings

Start with a simple idea. Earnings quality asks two questions: will these earnings repeat, and do they reflect real performance? Under the CFA framework, high-quality earnings are both sustainable and generate an adequate level of return on invested capital. Both conditions matter. Earnings can be stable but too low to cover the cost of capital. They can also be high this year but impossible to repeat.

There are two separate ideas to keep apart. Reporting quality is about how well the financial reports describe the company's performance and position. Earnings quality is about the level and sustainability of the results themselves. High-quality earnings need high-quality reporting, because you cannot judge sustainability from misleading numbers. But good reporting can still describe poor earnings. A company can report honestly that its earnings are low and fading.

The key tool is the split between recurring and non-recurring items. Recurring items come from ongoing, core operations and are expected to continue. Non-recurring items are unusual or infrequent, such as gains on asset sales, restructuring charges, impairments, litigation settlements and results of discontinued operations. When you forecast or value a company, you want earnings built from recurring items. These are the basis for a sustainable earnings figure, sometimes called core or persistent earnings.

You should also look at where earnings come from. Earnings driven by operating cash flow, genuine sales growth and stable margins tend to persist. Earnings boosted by aggressive accounting choices, large accruals, or one-time gains tend to reverse. A very high earnings level is not automatically good: if it is out of line with the industry or with past results, ask why, because unusually high earnings often mean-revert.

Finally, classification is a judgement. Management may label recurring costs as one-off ('restructuring every year') to make core earnings look better. A cost that appears every year is, in substance, recurring. Your job is to decide by substance, not by the label.

Key formulas to remember

Definition of high-quality earnings: High-quality earnings = sustainable earnings + adequate return on invested capital; Both parts are needed. Sustainable but low returns, or high but unsustainable earnings, are lower quality.
Sustainable (core) earnings, adjusted: Core earnings = Reported net income − non-recurring gains + non-recurring losses (each after tax); Adjust after tax. Remove one-off gains and add back one-off charges, if they are truly non-recurring.
Accruals ratio (balance sheet approach): Aggregate accruals = Change in net operating assets; Accruals ratio = Aggregate accruals ÷ Average net operating assets; A higher ratio suggests more of earnings comes from accruals rather than cash, which is a warning sign for persistence.
Cash flow comparison: Accruals = Net income − Cash flow from operations; Cash-flow-based accruals ratio = (Net income − Cash flow from operations) ÷ Average net operating assets; Persistently large positive accruals relative to average net operating assets point to lower earnings quality.

How to solve Earnings Quality and Sustainable Earnings questions

Use this method for any item-set question on earnings quality, whether it asks for an adjusted figure or a judgement.

1Read the question first so you know whether you must compute an adjustment or judge quality.
2Find the income statement items and notes in the vignette. List every unusual item: gains, impairments, restructuring, discontinued operations, changes in estimates.
3Decide for each item whether it is recurring or non-recurring by substance. Ask if it happened in prior years and is likely to happen again.
4Adjust net income: subtract non-recurring gains and add back non-recurring losses, and apply the tax effect if the vignette gives a tax rate.
5Compare earnings with operating cash flow and look at accruals. Large gaps between income and cash suggest lower quality.
6Check the level: are margins or returns well above or below peers or history? Judge whether the level can be sustained and whether it covers the cost of capital.
7Match your conclusion to the answer options. Pick the one that follows from the data, not from the label management used.

Quickest way: Strip, compare, judge

When to use it: Use when time is short and the question needs either a core earnings number or a quality conclusion.

Underline unusual items in the vignette.
Remove one-off gains and add back one-off losses, after tax.
Compare adjusted income with cash flow from operations.
Choose the answer that favours persistent, cash-backed earnings as higher quality.

Common mistakes in Earnings Quality and Sustainable Earnings

Treating all unusual items as non-recurring
Management labels such as 'one-time' or 'special' look convincing.
Fix: Check whether similar charges appear in several years. If they repeat, treat them as recurring.
Adjusting for the pre-tax amount only
Students forget the item sits in net income, which is after tax.
Fix: Multiply the item by (1 − tax rate) before adjusting net income, unless the amount is already given after tax.
Removing a one-off loss but leaving a one-off gain
Students focus on bad news and miss the gain on asset sale.
Fix: Scan every line for gains and losses. Adjust both directions.
Assuming high earnings means high quality
Strong profits feel like good performance.
Fix: Quality needs sustainability and adequate returns. Check cash backing and whether the level is out of line with peers.
Confusing reporting quality with earnings quality
The two terms sound alike and are covered in the same chapter.
Fix: Remember that reporting quality is about how well results are disclosed, while earnings quality is about the level and sustainability of the results.

Worked examples

Example 1

Vignette: Altavia Corp reported net income of €84 million. The notes show a pre-tax gain of €20 million on sale of a warehouse and a pre-tax restructuring charge of €8 million. The company has not sold property or restructured in the past five years. The tax rate is 25%. Questions: (1) What is Altavia's core net income? (2) Is the sale gain a recurring item? (3) If operating cash flow is €60 million, what does it suggest?

Show the solution

Gain after tax: 20 × (1 − 0.25) = €15 million. Remove it.
Charge after tax: 8 × (1 − 0.25) = €6 million. Add it back.
Core net income = 84 − 15 + 6 = €75 million.
The company has not sold property in five years, so the gain is non-recurring.
Reported net income minus operating cash flow is 84 − 60 = €24 million. The €15 million after-tax gain inflates net income but brings no operating cash, because the sale proceeds are investing cash flow and the gain is removed in the reconciliation of net income to operating cash flow. So the gain widens the gap between net income and operating cash flow. Core net income removes this effect.
Compare core net income with operating cash flow: 75 − 60 = €15 million. This is about 20% of core net income (15 ÷ 75), so it is worth investigating.
The remaining €15 million gap is partly due to the restructuring charge. If the charge was paid in cash, it reduced operating cash flow, but we added it back to get core income. That widens the gap between core income and operating cash flow. Check the notes for how much of the charge was paid in cash.

Answer: (1) €75 million. (2) Non-recurring; exclude it. (3) Net income of €84 million exceeds operating cash flow of €60 million by €24 million. The €15 million after-tax gain on the warehouse sale inflates net income but brings no operating cash, so it widens this gap. Core net income of €75 million still exceeds operating cash flow by €15 million. Part of that remaining gap may be the restructuring charge, which reduced operating cash flow if paid in cash but was added back to core income. The remaining gap is moderate and calls for a check of the accruals, not an automatic conclusion of weak quality.

Example 2

Vignette: Brennick Ltd reports net income of $50 million each of the last three years. Operating cash flow was $52 million, $49 million and $51 million. Each year includes a 'special restructuring charge' of about $6 million pre-tax. The tax rate is 30%. Return on invested capital is 7% and the cost of capital is 9%. Questions: (1) How should the restructuring charge be treated? (2) What is core net income? (3) Assess earnings quality.

Show the solution

The charge appears every year, so in substance it is recurring despite the label. Do not add it back.
Core net income stays at $50 million.
Net income is close to operating cash flow every year, so accruals are small and earnings are stable and cash backed, which supports sustainability.
ROIC of 7% is below the 9% cost of capital, so the return is not adequate.

Answer: (1) Treat it as recurring. (2) Core net income is $50 million. (3) Earnings are sustainable and cash backed but return is below the cost of capital, so overall quality is only moderate.

Exam tips

Always ask whether an item repeats. The vignette often gives prior-year history to test this.
Apply the tax rate to each adjustment unless the figure is already after tax.
Remember that quality has two parts: sustainability and adequate return. Check both before choosing an answer.
Compare net income with operating cash flow. Distractors often ignore the cash flow data in the exhibit.
Do not accept management labels. The correct answer usually follows the economic substance.

Earnings Quality and Sustainable Earnings in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Earnings Quality and Sustainable Earnings: frequently asked questions

What are the main indicators of earnings quality?

Look for earnings that are sustainable, cash backed and produce an adequate return on capital. Key indicators include the share of recurring items, the gap between net income and operating cash flow, and stability of margins. Large one-time gains or high accruals are warning signs.

How do I tell recurring from non-recurring items?

Ask if the item arises from core operations and whether it is likely to happen again. Check prior years in the vignette. A charge labelled one-off that appears every year should be treated as recurring.

Does high quality earnings mean high earnings?

No. High quality means the earnings are sustainable and provide an adequate return on invested capital. Very high earnings can be low quality if they come from one-offs or aggressive accruals and are likely to reverse.

Is earnings quality the same as reporting quality?

No. Reporting quality is about how well the reports describe performance and position. Earnings quality is about the level and sustainability of the earnings themselves. High-quality earnings require high-quality reporting, but good reporting can describe poor earnings.