What is Earnings Quality?

With an overwhelming amount of short-term remuneration linked to share price targets, investors need to be aware of the financial alchemy available to management. Companies have various tools in which they’re able to paint an image of financial health, stability of earnings, or revenue growth.

Although earnings management isn’t a new theory, companies can often go years without fault. However, if there’s one thing the market doesn’t like, it’s negative surprises. We have put together three simple reference points when assessing earnings quality.

The three areas below can be utilised as a quick measure against earnings management.

1. Divergence Between Earnings & Operating Cash Flow

While the order in which financial statements are presented may vary between companies, usually the statement of cash flows is presented last. However, the importance of cash flows cannot be overstated. As management has greater flexibility with the income statement, a point of reference for earnings quality is to check the ratio between earnings and operating cash flow (highlighted below).

Statement of Profit or Loss - Extract

Consolidated Statement of Cash Flows - Extract

A great excess of earnings over operating cash flow may indicate aggressive accounting and calls for further investigation. It is important to note that this check isn’t always compatible with certain financial companies, such as banking or insurance businesses.

2. Acquisition Accounting

When a business makes an acquisition, it will allocate the purchase price to the fair value of identifiable assets/liabilities of the acquiree. Companies frequently pay a premium over the identifiable amount, which is then allocated to goodwill. A simplified demonstration of how this will look is outlined below.

The acquirer will write off (through depreciation) identifiable assets over time. However, with the amount allocated to goodwill, management has discretion over when to impair the asset. In other words, the former will result in a consistently lower income amount, and the latter allows for a one-off impairment loss. Meaning management can inflate income by previously over-allocating to goodwill.

3. Non-Recurring Disclosure

Over time, management will often disclose certain information they believe to be indicative or linked to performance. This information may be generic, such as segment growth, or items with greater detail, such as average revenue per user or cost of acquisition per user.

Often companies will present this data in a recurring format to allow for easy comparisons across periods. A glean across multiple reports should reveal whether data points have been altered. Again, this may raise suspicion about the quality of earnings.

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