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Not all profits are made equal.
For most investors and analysts, the Income Statement is the first port of call. That’s why it is home to all manner of financial shenanigans and accounting trickery.
Yes, company A and company B both generated net income of £100, but how did they generate that net income figure? The importance of this question is why we have the concept of earnings quality.
High-quality earnings are persistent, recurring earnings that are generated from the core operations of a company. And it is this idea of ‘core’ where the fun and games begin.
The classification of earnings is subjective, and so there is scope to inflate core earnings by shifting non-core (such as one-off gains from the sale of property) into core earnings.
Core operating expenses can also be classified as non-core (by reclassifying normal expenses to special items or by shifting operating expenses to discontinued operations), inflating the headline earnings figure that way. Similarly, special attention should be given to income-decreasing special items - particularly if the company is reporting unusually high operating earnings.
Unfortunately, these actions are much easier to spot after the fact than before, but it still helps to understand some of the ways in which management can spin the earnings figure.
The notion of how persistent a company’s earnings are is tied up with the Matching principle of accounting, or the accruals method.
If a sale is made in one period and cash is collected the next, the difference between reported net income and cash collected constitutes an accrual. This sensible principle can lead to all sorts of interesting accounting.
When earnings are split into their cash and accrual components, research has shown that the cash part is more persistent than the accruals part. This ‘accruals anomaly’ was first documented in the catchily-titled academic study Do Stock Prices Fully Reflect Information in Accruals and Cash Flows about Future Earnings? (Sloan, 1996). We cover the topic in more detail here.
Although sizeable accruals (roughly, net income minus operating cash flow) can indicate manipulated or low-quality earnings, this is not the profile of all frauds. In fact, smart fraudulent companies will go out of their way to avoid this profile.
As shown in this article, it is possible to manipulate the cash flow from operations figure by, for example, improperly capitalising (instead of expensing) certain costs. Because capital expenditures are shown as investing cash outflows rather than operating cash outflows, this inflates cash flow from operations.
In a study of 227 enforcement cases brought between 1997 and 2002, the SEC found that the most common accounting misrepresentation occurred in the area of revenue recognition (SEC 2003). Revenue is the largest single figure on the income statement and therefore generally has the largest impact on earnings. Any analysis of earnings quality requires an analysis of revenue.
Unfortunately, there is no single characteristic that perfectly captures the quality of earnings.
This is why the Earnings Manipulation Risk Indicatory (aka. Beneish M-Score) that we put on every company’s StockReport is so handy. As far as earnings quality checklists go, we could do a lot worse than to investigate the areas of accounting that go into this regression analysis:
Or just pay attention to the M-Score itself, of course... Some other qualitative areas to investigate or be aware of include:
Changes in accounting policies (especially revenue recognition)
Changes in accounting assumptions (eg. increased proportion of capitalised R&D)
Historic confirmations of poor-quality earnings (enforcement actions, restatements, etc.)
Level of disclosure and transparency in financial reports and footnotes
The amount of adjustments that go into pro forma earnings
About Jack Brumby
I'm looking for compounding investments.
I started off in Leisure - a part of the market I still love, but an area where stocks can appear "cheap" for years without going anywhere. It made me realise that valuation is only one part of the puzzle.
Now I sift through a much broader universe of stocks in search of small, high quality operators with large addressable markets, strong and maintainable margins, and clear share price catalysts.
CFA charterholder.
Disclaimer - This is not financial advice. Our content is intended to be used and must be used for information and education purposes only. Please read our disclaimer and terms and conditions to understand our obligations.
Hi John,
Its just a checklist with a formula attached, if you like a quick shorthand to trigger further investigation. These are tools and are not fool proof.
Patisserie wasn't flagged as risky probably because the accounts were a work of fiction. In respect to Beeks, if you can satisfy yourself that the red flags are explainable then that's fine, if not then they probably remain as red flags and therfore potential risk.
Hi John,
Mike said it as well as I ever could I think... The M-Score isn't foolproof but it is handy for bringing certain things to attention that might be worth investigating or just being aware of. A failing M-Score isn't a guarantee of earnings manipulation. The test is a probabilistic model, so it cannot detect companies that manipulate their earnings with 100% accuracy, but it does attempt to quantify the probability.
Re. Pat Val - a management team that is committed to fraud can manipulate their accounts to artificially pass known tests such as the M-Score. Presumably, this happened here. This doesn't completely discredit the M-Score, but as noted above, it is not foolproof.
Re. Beeks - I'm not sure. I know one of the checks ("is sales growth not excessive") penalises growth companies as this has historically been where a lot of earnings manipulation occurred. It is worth bearing in mind that the M-Score is automatically wary of high growth companies.
And re. treating all businesses equally - good point and the short answer is no it doesn't. Financial institutions were excluded from Beneish's study so it might be less effective here. It also does not account for varying industry characteristics (eg. different levels of gross profitability between, say, car manufacturers and software providers).
As Mike says, the M-Score probably works best as a tool to identify areas worth investigating in more detail.
Good article.
I also look at quality of assets, as well as quality of earnings, especially 2 items: inventory (applicable only to manufacturers and resellers) and intangibles.
Inventory (goods manufactured but not yet sold) is an asset on the balance sheet, but an increase in inventory can hide problems because it might be significantly over-valued - for example if the company's products are becoming obsolete. Generally a company needs to keep some inventory to fulfil future sales. But if inventory is increasing faster than sales, look out. Some of that "inventory" might end up as landfill.
Next, ask what the balance sheet looks like if you eliminate "goodwill". Goodwill generally arises when company A buys company B for a price higher than company B's tangible assets, which of course is normal. But if merging B's operations with A's does not yield the expected benefits, the "goodwill" is completely worthless. Normally it is amortised over several years, but if the expected reductions in costs don't show up within 2 years, they probably never will.
Looking at these 2 items can sometimes tell you that a company is basically worthless, whatever its "bottom lines" may be.
Hi Nick,
You read my mind! Just published this on balance sheet quality
https://www.stockopedia.com/content/balance-sheet-quality-and-three-simple-safety-rules-479626/
I think it covers your points but any comments are welcome
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Thanks Jack for another very insightful and educational post. I have no financial or accounting background so I really appreciate these articles even though I still find myself at the edge of my capacity to understand some of the concepts - your quick and easy cash flow checklist was neither for myself, although I really appreciate the attempt to demystify. I wonder, does the Beneish M-Score treat all business types equally? Would it reveal potential fraud equally for a manufacturer as for a software company or IT services business? I note that one of my holdings, Beeks Financial Cloud (LON:BKS) has an M-score of -0.51 and HIGH risk of earnings manipulation but I don't have the knowledge to assess if there are innocent reasons for the score connected to the type of business it is. Any insights would be very useful. I note also that Patisserie Holdings (LON:CAKE) had a healthy M-score and LOW risk rating as recently as September just before it was suspended. How was the company able to conceal such a massive fraud without any indication within its M-score?