Using Accounting Analysis To Measure Earnings Quality
AAA
  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

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
Earnings Quality: Introduction
RELATED TERMS
  1. Inherent Risk

    The risk posed by an error or omission in a financial statement ...
  2. Deferred Tax Asset

    A deferred tax asset is an asset on a company's balance sheet ...
  3. Expanded Accounting Equation

    The expanded accounting equation is derived from the accounting ...
  4. Earnings Per Share - EPS

    The portion of a company's profit allocated to each outstanding ...
  5. Return On Investment - ROI

    A performance measure used to evaluate the efficiency of an investment ...
  6. Working Capital

    This ratio indicates whether a company has enough short term ...
  1. What are the differences between gains & losses and revenue & expenses?

    Learn how to distinguish between gains, losses, revenues and expenses. Take a look at how accountants record each category ...
  2. When should I use depreciation expense instead of accumulated depreciation?

    Distinguish differences between depreciation expense, which is reported on the income statement, and accumulated depreciation ...
  3. What are the differences between operating expenses and cost of goods sold (COGS)?

    Discover the differences between operating expenses and cost of goods sold, how each are calculated and why they are considered ...
  4. What are the differences between gross profit and gross margin?

    Learn how gross profit and gross margin are calculated and how each is used in fundamental analysis. Generally, these numbers ...
comments powered by Disqus
Related Tutorials
  1. Industry Handbook
    Investing Basics

    Industry Handbook

  2. Investing For Safety and Income Tutorial
    Bonds & Fixed Income

    Investing For Safety and Income Tutorial

  3. Discounted Cash Flow Analysis
    Fundamental Analysis

    Discounted Cash Flow Analysis

  4. American Depositary Receipt Basics
    Economics

    American Depositary Receipt Basics

  5. Ratio Analysis Tutorial
    Fundamental Analysis

    Ratio Analysis Tutorial

Trading Center