By Tim Keefe,CFA (Contact Author | Biography)

The anecdote in the introduction does not portray the accounting situation with complete accuracy; there are rules that management must use when reporting operating performance. But even with rules, it is still difficult to determine how much, if any, manipulation has taken place. In fact, there is enough accounting noise in the data that shaping an idea about a firm's earnings quality is certainly not a science. Further still, analyzing earnings quality won't necessarily get you a definite answer as to whether the company's books are being managed. Because of the subjectivity involved in this analysis, it is imperative that you understand the nexus of this accounting challenge. (For related reading, see Show And Tell: The Importance Of Transparency.)


Accounting could be one of the driest subjects in this world. Accountant types may not be dull people, but for most people the subject of accounting certainly is boring. Unfortunately, this dryness makes accounting analysis a skill set that is neglected by many in practice. Fortunately, this neglect may be part of the reason that there are superior stock market returns to be earned by analyzing how a company applies accounting rules to its business. These superior returns are obtained through strategies that sell short stocks in companies where earnings quality is believed to be low and buy stocks in companies where earnings quality is believed to be high. The idea behind these strategies is that when earnings quality is believed to be low, earnings are less stable and more likely to be overstated than when earnings quality is perceived to be high. (For more on this strategy, see What Is Warren Buffett's Investing Style?)

Eventually, the past earnings overstatement will level out, which results in lower earnings (and thus security prices) down the road. This information can be summarized as follows:


Earnings Quality

Stability of Earnings

Likelihood of Earnings Overstatement

Direction of Eventual Earnings Readjustment

Future Earnings
Low Low High Down Low
High High Low Up High
Figure 1


Understanding a firm's accounting doesn't mean you have to pass the CPA exam and then manage the company's audit, but you should understand the objectives and theoretical concepts behind the setting of accounting standards. Once you have this understanding, you will then begin to see that the issue of earnings quality arises because of the cost/benefit tradeoff between cash accounting and accrual accounting. In turn, you will better understand what accounting analysis attempts to root out from the financial statements and other company disclosures. Again, this analysis is not a science; there is not an equation where you can just input X and always get Y. If you want to understand how 1+1=3, then you had better start at the beginning: the accounting concepts.


Next: Earnings Quality: Defining "Good Quality" »



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