1. Earnings Quality: Introduction
  2. Earnings Quality: Understanding Accounting Standards
  3. Earnings Quality: Defining "Good Quality"
  4. Earnings Quality: Why Aren't All Earnings Equal?
  5. Earnings Quality: Reviewing Non-Accrual Items
  6. Earnings Quality: Measuring Accruals
  7. Earnings Quality: Adjusting Accruals For Proper Comparisons
  8. Earnings Quality: Analyzing Specific Accrual Accounts
  9. Earnings Quality: Investigating The Financing Of Accruals
  10. Earnings Quality: Measuring The Discretionary Portion Of Accruals
  11. Earnings Quality: Conclusion

By Tim Keefe,CFA (Contact Author | Biography)

The following classic Wall Street joke plays to a risk that many investors don't know how to measure:
A company is going through the interview process in order to hire a chief financial officer. In the last interview session, each of three finalists is given the company's financial data and asked, "What are the net earnings?" Two applicants diligently compute the net earnings. Neither of them gets the job. The candidate who lands the position answers the question by replying, "What do you want them to be?"

Determining how much "What do you want them to be?" (manipulation) there is in a company's reported earnings number is the point of this tutorial. We'll show you how to use accounting analysis to better estimate the degree of quality in reported earnings. Specifically, we'll detail some methods for analyzing the integrity of accrual accounts, which are key tools used in the manipulation of reported earnings. Hopefully, the end result will be to reduce your uncertainty as to whether a firm's accounting captures its true economic condition, which is the goal of financial accounting.

Keep in mind that when determining earnings quality, accounting analysis still relies on subjective input. You will need to incorporate opinions regarding the magnitude of accounting accruals: the macro and micro business environment, governance, insider trading, auditors' opinions, and fees and management incentives to manipulate financial statement results. Further, accounting analysis should not be thought of as a standalone methodology for determining the investment merits of a security. This accounting scrutiny fits into a larger framework of analysis, which includes strategic analysis, financial ratio analysis and valuation analysis; all are tools available to the fundamentalist.

For background reading, see Common Clues Of Financial Statement Manipulation.

Earnings Quality: Understanding Accounting Standards

Related Articles
  1. Investing

    Financial Statement Manipulation An Ever-Present Problem For Investors

    The SEC has taken steps to eliminate this type of corporate fraud, but it remains a real risk for investors.
  2. Investing

    How Financial Statements Are Manipulated

    Financial statement manipulation is an ongoing problem, and investors who buy stocks or bonds should be aware of its signs and implications.
  3. Investing

    Look For These Red Flags In The Income Statement

    Companies can overstate their revenues and understate their losses to boost investor confidence. Learn how to spot the these red flags in income statements.
  4. Investing

    How To Decipher Accrual Accounting

    Accrual accounting is an important method of measuring the performance and position of a company. Learn more on how its used.
  5. Personal Finance

    Accountant: Job Description & Average Salary

    Discover what the job description of an accountant entails, along with education and training, salary and skills necessary for success.
Frequently Asked Questions
  1. What are the Differences Among a Real Estate Agent, a broker and a Realtor?

    Learn how agents, realtors, and brokers are often considered the same, but in reality, these real estate positions have different ...
  2. What is the difference between amortization and depreciation?

    Because very few assets last forever, one of the main principles of accrual accounting requires that an asset's cost be proportionally ...
  3. Which is better, a fixed or variable rate loan?

    A variable interest rate loan is a loan in which the interest rate charged on the outstanding balance varies as market interest ...
  4. What is the 1003 mortgage application form?

    Learn about the 1003 mortgage application form, what information it requires and why this form is the industry standard for ...
Trading Center