Using Accounting Analysis To Measure Earnings Quality
  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

Earnings Quality: Introduction

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

  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


RELATED TERMS
  1. Short-Term Debt

    An account shown in the current liabilities portion of a company's ...
  2. Audit

    An unbiased examination and evaluation of the financial statements ...
  3. IRR Rule

    A measure for evaluating whether to proceed with a project or ...
  4. Profit and Loss Statement (P&L)

    A financial statement that summarizes the revenues, costs and ...
  5. Discounted Payback Period

    A capital budgeting procedure used to determine the profitability ...
  6. Contribution Margin

    A cost accounting concept that allows a company to determine ...
RELATED FAQS
  1. What is finance?

    "Finance" is a broad term that describes two related activities: the study of how money is managed and the actual process ... Read Full Answer >>
  2. What items are considered liquid assets?

    A liquid asset is cash on hand or an asset that can be readily converted to cash. An asset that can readily be converted ... Read Full Answer >>
  3. What is the 'Rule of 72'?

    The 'Rule of 72' is a simplified way to determine how long an investment will take to double, given a fixed annual rate of ... Read Full Answer >>
  4. What is the formula for calculating EBITDA?

    When analyzing financial fitness, corporate accountants and investors alike closely examine a company's financial statements ... Read Full Answer >>
  5. How do I calculate the P/E ratio of a company?

    The price-earnings ratio (P/E ratio) is a valuation measure that compares the level of stock prices to the level of corporate ... Read Full Answer >>
  6. What is a stock split? Why do stocks split?

    All publicly-traded companies have a set number of shares that are outstanding on the stock market. A stock split is a decision ... Read Full Answer >>
Hot Definitions
  1. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
  2. Super Bowl Indicator

    An indicator based on the belief that a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in ...
  3. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
  4. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
  5. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, many new (smaller-scale) Ponzi schemers became exposed. Ponzimonium ...
  6. Quarterly Earnings Report

    A quarterly filing made by public companies to report their performance. Included in earnings reports are items such as net ...
Trading Center