Book: Quality of Earnings
Author: Thorton L. O’Glove
This is a decent book which can help you build a useful list of items to check the earnings quality of a company is good. Note that earnings quality that the book talks about goes beyond earnings management and outright fraud (not that those are not important by themselves). I like this book more than your average book on earnings management not only because it gives you more markers to look for but also because I believe that the tips given in this book are more useful because it’s almost impossible to catch earnings management in action if the auditor is giving the book its blessing. Which takes us to the first tip in the book –
Auditor: O’Glove points out that auditors cannot be trusted to do an analyst’s job because the auditor is hired by the company itself. Auditors gives three kinds of opinions: (a)clean, (b) “subject to” meaning that the auditor was unable to audit certain areas because of some areas of judgement, and (c) “except for” meaning that certain areas couldn’t be audited at all, something SEC will not all for public companies.
Shareholder Letter: This is the “To The Shareholder” section of the annual report, which doesn’t have a specific format, and can offer interesting tidbits, especially on how the CEO thinks about certain issues which (s)he hasn’t been explicitly asked about. This will have a discussion about successful and failed strategies, and when compared with previous letters and results, and the selection and omission of the items that the management chooses can tell us a lot about how honest and transparent the company is being. O’Glove admits that 9/10 times the exercise will not unearth anything but once in a while it’ll pay big dividends. One interesting example that O’Glove highlights is the front cover of Apple’s shareholders’ report of 1985 showed Steve Jobs missing from the picture taken of the Sr. Management team, a tip of the hat of things to come. It is useful to find companies that have honest people and even better, good forecasters.
It is also useful to see if the language of the management differs from what they talk about in the SEC filings (differential disclosure).
Non-operating / Non-recurring Revenue: It is very useful to see how much of the revenue and earnings of the company is under company’s “control” i.e. based on management estimates. Financial companies have a lot more leeway in this area compared to other operating companies.
Reading this chapter, I think it is useful to categorize revenue under 4 categories:
- Core Operating: what the the company is earning from its operations (i.e. from its workforce)
- Acquisitions: revenues that the company paid for (i.e. from actions of it its Board)
- One-time revenues/earnings: from one-time sales etc. (i.e. from actions of the CEO’s office)
- Accounting / tax-driven: from interpretation of rules (i.e. actions taken by the CFO’s office)
Shareholder vs. Tax Reporting: If one is a 1% shareholder of the company, one can get the Form 1120 (according to section #6103), which shows company’s tax books, which are often markedly different from the company’s accounting books. Most people cannot get the Form 1120, but they can get an idea by looking for things like investment tax credits practice (deferred vs. flow-through accounting).
Another interesting tidbit that O’Glove talks about is the exploration of land in the O&G business where once the land is explored and an assessed value has been placed, the company has to pay tax on this value, so O&G companies prefer not to know the exact assessed value if they can help it.
Accounts Receivables and Inventories: Considerable increase in A/R and inventories can project significant downward earnings surprises, esp. in industries with rapid changes in products and tastes–e.g. fashion, seasonal goods and high-tech. The best way to see these changes may not be as DSO/DPO etc. but rather as increases in A/R and inventory compared to increases in sales.