Analysts sometimes speak of the quality of a firm’s earnings, or the quality of its balance sheet. In general, quality financial statements are those that accurately reflect reality; they lack accounting tricks and one-time changes designed to make the firm appear stronger than it really is. Financial statements reflect reality when accounting income is a good approximation to economic income. The Balance Sheet A quality balance sheet typically shows conservative use of debt or leverage, which keeps the potential of financial distress due to debt service quite low. Limited use of debt also implies the firm has unused borrowing capacity; should an attractive investment opportunity arise, it can draw upon that unused capacity to invest wisely for the shareholders’ benefit. A quality balance sheet shows assets whose market values exceed their book values. In general, inflation and historical cost accounting should keep book values below market values. Beyond these accounting effects, a capable management team and the existence of intangible assets, such as goodwill, trademarks, or patents, will make the market values of firm’s assets exceed their book values. Situations that might reduce assets’ market values below their book values include: use of outdated, technologically inferior assets; unwanted out-of-fashion inventory; and the presence of nonperforming assets on the firm’s books (as when a bank writes off a nonperforming loan). The presence of off-balance sheet liabilities also harms the quality of a balance sheet by hiding economically important information. Such liabilities may include joint ventures and loan commitments or guarantees to subsidiaries. The Income Statement High quality earnings are recurring earnings that arise from sales to the firm’s regular stream of customers. One-time and nonrecurring effects, such as accounting changes, mergers, and asset sales, should be ignored when examining earnings. Also, costs must not appear artificially low as a result of unusual and short-lived input price reductions. Unexpected exchange rate fluctuations that work in the firm’s favor to raise revenues or reduce costs also should be viewed as nonrecurring. Quality earnings are revealed by conservative accounting principles that do not overstate revenues or understate costs. The quality of the income statement rises as its statement of earnings more closely approximates cash. Suppose that a firm sells furniture on credit, allowing customers to make monthly payments. A high-quality income statement should recognize this revenue using the installment principle (i.e., the statement of sales revenue should reflect only the cash collected from sales each month during the year). A low-quality sheet would recognize 100 percent of the revenue from a sale at the time of sale, even though payments may stretch well into the following year. The footnotes to the income statement would tell the analyst which method was used.