Revealing the truth about Quality of Earnings

Last Updated on March 4, 2020

What is the first thought that strikes our mind when we come across names such as Enron and Satyam Computers? The only thing we remember about these two completely different companies is their involvement in accounting frauds. Why is it that most of the so called intelligent Wall Street investment experts and the retail investors failed to smell the rat? The only possible reason could be utter negligence to the quality of the earnings posted by such tainted companies.

Now, let’s try to understand what is meant by “Quality of earnings” and how the firms can manipulate the numbers to positively surprise the markets positively. Why go so far into the history to find a case? Recently (in 2008), Jet Airways changed its depreciation accounting method to artificially boost its profits.

It is rightly said that don’t judge a book by its cover.  As retail investors, it is very important that we do not take the profits or sales figures at their face value. We need to lift the corporate veil to appreciate the performance of the company and accordingly decide upon whether it’s worth investing. You may be wondering what may be the reasons for the management to indulge in such activities. The reasons are many; but amongst those, the crucial is the performance pay (to the management of the company) which is linked to company’s profits.

So, what does the phrase ‘quality of earnings’ actually mean? The Quality of earnings is nothing but the degree of closeness of reported accounting earnings to the actual (economic) benefit to the company.

Another way of looking at the same thing is consistency and sustainability of earnings of a company. Quality of the earnings does not necessarily mean conservatism. In fact, conservatism in current period, will lead to aggressive accounting in future reporting period. For instance, in ‘accelerated’ depreciation method, huge depreciation expense is charged at the beginning of useful life; thus, showing higher expenses in the given period with low expenses in the future period.

Let’s see certain pointers that investors can look at, to assess a company’s Quality of Earnings.

Be cautious of increasing credit sales

As an investor, one should be cautious if the sales and profit figures are way above expectations and major chunk of the sales are credit sales. Increase in debtors for a single year might not be bad, especially if the entire industry is facing a similar problem. But if the company’s debtors continue to increase year after year, then certainly investors should start doubting the quality of its earning.

 Increasing credit sales indicates a substantial probability that the company may not be able to recover the cash from its customers. In other cases, some companies inflate their top line and corresponding profits by fictitious sale receipts. The best way would be to analyse these ratios in comparison to its direct competitors and then gain a perspective about them within the industry.

Look for CFO vs. Net Profit

If the net profit numbers are increasing at a healthy rate and cash flows from operations are stagnant or are growing at a much slower rate, then it is advisable not to invest in such company as there is a likelihood of unsustainable credit sales.

Change in depreciation method

One of the simplest ways, in which companies can manipulate the account, is changing the depreciation method and decreasing the operating expenditure. This boosts both operating and net profit. In the case of Jet Airways, the same method was adopted. Depreciation is nothing but the yearly allocation of capital expenditure on fixed assets.

To make things clearer, let’s consider an example of a simple tea shop. Here, the cost of preparing a cup of tea is not only the cost of ingredients (cost of milk, sugar, ginger, cardamom etc.), but also the cost of equipment like a tea pot, kettle and a stove. Now, of course, one cannot assign the entire equipment cost to one cup of tea! The cost of the equipment used to make tea has to be spread across the number of days. These costs, which are allocated over the life of equipment’s, are termed depreciation in financial jargon.

Depreciation can be reduced by changing depreciation method from accelerated to straight line method (SLM), by increasing the expected life or scrap value. In case of accelerated depreciation, the depreciation for initial years is higher as compared to the later years. In the US, it is a common practice to use simple depreciation for financial reporting and accelerated depreciation for tax purposes. By using accelerated depreciation for tax purposes, the company will report higher depreciation, leading to lower income and consequently lower taxes. Naturally, if a company changes its depreciation policy from accelerated to SLM, it will show higher profits as depreciation expense is comparatively lower.

Classifying capital lease as operating lease

Another method of mis-representation is accounting capital leases as operating ones. It provides many benefits to management, as we will see later. But, before jumping on to its advantages, let’s try and understand what exactly is a capital or an operating lease. To put it simply, an operating lease is a rented asset similar to a housing lease wherein the tenant pays the rent for the duration of his occupancy but the ownership of the property stays with the landlord. In case of capital lease, the asset is bought out by the company and the financing for the asset is provided by the same party which sells it to the company similar to a housing loan wherein the property is in the name of person who has taken the loan.

Companies prefer using operating lease over capital lease as it results in lower asset base. One of the major advantages is that the lower asset base results in higher asset turnover ratios and lower leverage ratios (e.g. Debt to equity ratio). The very purpose of analyzing asset turnover ratios is gauging the efficiency with which the assets of the company are being utilized. By showing capital lease as an operating lease, companies try to portray a rosy picture of their financials.

Last but not the least….

In case of Enron scandal, there was huge divergence between reported profit and the cash available from operations. This scandal taught us a very important lesson, that is, ‘all that glitters is not gold’. Though we have covered only three ways of manipulations, in reality there are plenty of them.

There would be another Enron or Satyam in the making and we never know when they will be exposed.  Thus, it becomes all the more important to gauge the quality of a firm’s earnings before actually putting one’s hard earned money into the stocks of the firm.

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