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.
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