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Earnings Quality: Understanding Accounting Standards
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:
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.
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" »
Table of Contents
- Earnings Quality: Introduction
- Earnings Quality: Understanding Accounting Standards
- Earnings Quality: Defining "Good Quality"
- Earnings Quality: Why Aren't All Earnings Equal?
- Earnings Quality: Reviewing Non-Accrual Items
- Earnings Quality: Measuring Accruals
- Earnings Quality: Adjusting Accruals For Proper Comparisons
- Earnings Quality: Analyzing Specific Accrual Accounts
- Earnings Quality: Investigating The Financing Of Accruals
- Earnings Quality: Measuring The Discretionary Portion Of Accruals
- Earnings Quality: Conclusion
by
Tim Keefe
Timothy Keefe, CFA, is an experienced investment professional with more than 15 years in the financial industry. Keefe traded equities and then fixed income for a national broker/dealer, counseled high-net-worth clients at a large asset management firm, held research positions at the level of director for an investment banking firm as well as for a consulting firm and established an earnings quality information service specifically for the individual investor. Keefe earned both a master's and bachelor's degrees in finance from the University of Illinois, Urbana.
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