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

By Tim Keefe,CFA (Contact Author | Biography)

Along with the time-series plots above, which illustrated scenarios where a firm experiences a large jump for two operating-assets accruals, investigation into the financing of these asset accruals will provide insights as to the quality of earnings. In addition, determining how efficiently the firm is employing these assets will be helpful. Recall that a large jump in these two asset accruals may be a harbinger of poor earnings quality or a large jump in economic performance of the firm.

The Importance of Accounts Payable

By looking at the growth in accounts payable, it can be determined which of the two operating scenarios is more likely. As with the previous two graphs, time zero on the x-axis indicates the most recent period. This is the time period where the accrual misestimation/manipulation catches up to management.

1. Accounts Payable / Average Total Assets

Figure 14
Source: Source: "Earnings Quality and Stock Returns", The Journal of Business, May 2006

Accounts payable is a current operating accrual liability, as opposed to accounts receivable and inventory, which are current operating accrual assets. Because accounts payable is an accrual liability, increases in accounts payable reduce total accruals. Further, because it is a liability with a contract that states the fixed terms of payment (amount due, due date and interest) it is not open to much accounting discretion. Because management does not have much accounting flexibility regarding accounts payable, analysis of this accrual by itself is not very enlightening. But if we use accounts payable, which typically is the dominant operating liability, as a proxy for the "healthy" financing of related current assets, the analysis can bring forth some relevant details about a firm's underlying economic condition.

The key to this analysis is the growth in Accounts Payable / Total Average Assets relative to the growth in Accounts Receivable / Total Average Assets, and Inventory / Total Average Assets. If growth in the accounts payable metric is significantly slower than the large jump in accrued asset growth, it signals weakness in the operating business and a higher probability that the large jump in the current asset accruals is a harbinger of poor earnings.

Financing Using Operating Liabilities
The reason financing operating assets with operating liabilities is better than financing operating assets with non-operating liabilities is twofold. A company that is financing an inventory glut, versus a healthy inventory expansion, will have little cash from sales to extinguish payables. The firm may eventually extinguish payables by taking on debt or selling financial assets or stock. Further, trade creditors are motivated to continuously verify the quality of the debtor's operating assets that are available to satisfy their claims. The inability to rapidly increase accounts payable in the face of rapidly increasing operating accrual assets may be a reflection of suppliers' negative assessment of the quality of these assets and may be a sign that the company is carrying these assets at greater than their true value.

So if a firm is experiencing rapid growth in accruals, it doesn't mean that management is necessarily manipulating earnings. This rapid accrual growth could very well be justified by rapid growth in the business. By looking into the financing of the firm's operating assets, the analyst can get an idea of the quality of the assets on the balance sheet, and therefore an idea regarding the soundness of the firm's growth.

Earnings Quality: Measuring The Discretionary Portion Of Accruals

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