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Evaluating The Quality Of A Company's Earnings

Investors have been inundated with daily news publications that report the many accounting irregularities of companies, fraudulent activity by some corporate officers, and aggressive accounting practices used to inflate earnings numbers.  Examining the earnings reports that firms submit to the government, known as 10-Q’s and 10-K’s, can mitigate some of this confusion.  One area to scrutinize is when a company recognizes revenue.  In most countries, including the United States, revenue from a sale cannot be recognized on the income statement until goods are actually shipped to the end customer or services have been rendered.  Some companies boost their revenue by recognizing sales at the time its products were shipped to the distributor (or reseller), not the end user.  Other companies recognize the full value of long-term contracts before all the services have been performed.  Furthermore, a company could ship more products than the customer has ordered in the current period.  This allows the company to realize a sale now at the expense of the next quarter.  This practice is referred to as “stuffing the channel.” 

Other ways companies can artificially inflate earnings involves the company’s pension funds.  Some companies use aggressive expected rate of return estimates for their plan assets.  The better plan assets are estimated to perform, the less the company has to pay retirees out of its own pocket.  The danger with this practice is that earnings can be damaged in the later years if the company’s plan assets do not meet the aggressive return estimates.  Also, raising the discount rate of future obligations lowers the estimated future obligations, or what must be paid to employees upon retirement.  Lastly, lowering the expected rate of future salary increases, decreases the amount it must pay employees after they reach retirement.  Other common abuses include excessive use of stock options as a form of compensation, creating off-balance-sheet partnerships or special purpose entities to hide liabilities, and recording investment and interest income as revenue.

Our advice to investors who attempt to assess the “quality of earnings” for a company is to “follow the cash.”  Cash flow statements are more difficult to manipulate than the earnings statement or balance sheet.  Examine the cash flow statement by looking at the relationship between cash flow from operations and net income.  If the net income number from the earnings statement can be validated by a similarly high operating cash flow figure, the company probably has quality earnings.  On the other hand, if earnings have continued to grow while cash flow from operations has stayed flat or declined, it is possible that the firm is using some accounting technique to make its earnings statement look better.  Security analysis, of course, does not end with a cash flow analysis, but it remains a sound approach to “filter out“ any accounting trickery.

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