Reporting quality and earnings quality are two sides of the same coin used to judge a company as a potential investment. Analysts need to first make an assessment of the reporting quality of the company before they can begin to rely on and interpret the reported financial information to make judgments about the earnings quality of the company.
If reporting quality is low enough on the spectrum and enough red flags are raised in an assessment of earnings quality, prudent investors should not hesitate to say “I wouldn’t touch that company with a 10-foot pole”. Studious investors doing their homework might have got out of the likes of Enron, Nortel Networks, Valeant Pharmaceuticals and GE (to name only a few) early to avoid the impending corporate disasters that were so clear in hindsight.
First up, reporting quality is concerned with the presentation and information provided in the financial statements. The financial statements should provide decision-useful information which can then be used to assess the quality of earnings and make investment decisions. In order for financial information to be useful to investors, it needs to be both reliable and relevant which are primary qualities of financial information.
Reliability: Financial information needs to be faithfully represented and follow either U.S. generally accepted accounting principles (GAAP) or international financial reporting standards (IFRS). High quality financial reporting should also be free from material errors and bias.
Where there is scope in financial reporting and estimate choices, accounting choices should be conservative in order to understate financial performance rather than aggressive choices aimed to increase reported financial performance in the current period. As past accounting choices and estimates become clearer with future information, conservative choices will potentially lead to better future financial performance while aggressive policies will lead to worse future performance as profits recognised early in prior periods will need to be reversed.
Relevant: For reporting to be relevant it needs to be decision-useful for investors through being an understandable representation of the economics of the business. Relevance also means that financial reporting needs to be provided on a timely basis ideally before the security and exchange commission (SEC) deadline of filing 35 days after quarter-end and 60 days after year-end for companies with a public float over $75 million.
Additional transparency should also be disclosed in the notes to the financial statements that would allow analysts to understand management’s estimates and assumptions used in applying accounting standards and which make their way into the face of the financial statements. Companies with the highest quality reporting will go above and beyond the required disclosure of business segments and geographic exposure which are required to be broken out if they account for over 10% of revenue, profits, or assets.
Side Note: Looking through the notes of the financial statements can shed a lot of light on the reporting quality of financial information and its conservative or aggressive underpinning relative to industry peers. Some notable examples would be looking at the weighted average capitalization rate used by REITs to fair value their property investments, the rate of expected credit losses (ECL) provisions which financial service companies are currently marking their loan asset portfolio down by, and the useful life being applied to depreciable assets for asset-heavy businesses such as manufacturers.
High quality financial reporting enables an investor or lender to evaluate a business as a potential investment while low quality financial reporting hampers decision making and adds extra risks. As such, high quality financial reporting increases the business valuation while low quality financial reporting will decrease valuation due to the added risks of making a misinformed decision.
Indicators of Reporting Quality
- Lower cash flow from operations as seen from the cash flow statement than net income suggests that aggressive accrual policies are moving expenses out to later periods.
- Decreasing asset turnover would suggest that assets are not generating the same return they once were and could indicate their useful life estimate is too high and thus depreciation expenses are too low and an asset write-down might be needed.
- Decreasing receivables turnover which would indicate that revenues are being recognized prematurely or in the worst case are completely fictitious. Declining receivables turnover could also indicate that the allowance for doubtful accounts is insufficient.
- Decreasing inventory turnover could suggest that inventory is not in demand and is becoming obsolete. This would indicate that inventory is being carried above its fair value and a write-down will be needed.
After first making an assessment of financial reporting quality, investors can then look at earnings quality (also referred to as results quality) which has to do with the sustainability of net income and the sources of cash flows. A company might have beautifully professionally presented high-quality financial reporting but a low quality of earnings which do not provide an adequate return of capital. The quality of earnings can be established after a rigorous analysis of whether returns on investment are adequate given the business’s cost of capital and if they can be sustained into the future. Investors need to do their homework to back out one-time items and adjust for aggressive accounting policy choices among numerous other anomalies that could arise.
Indicators of Earnings Quality
- Recurring and sustainable earnings are what investors are most concerned with as valuations are based on forecasted future cash flows. While under accounting standards earnings from discontinued operations need to be broken out separately for parts of the business that are being sold, other one-time items can sneak their way into net income from continuing operations. Investors need to keep an eye out for earnings (and their associated cash flows) coming from one-time gains on asset sales, insurance proceeds, litigation settlements, tax settlements, etc. These items are of the lowest quality and need to be backed out to look at recurring and sustainable operations.
- Investors also need be keep an eye out for EPS manipulation through a decrease in shares outstanding that is financed unsustainably by debt. Management and the media might be quick to highlight EPS growth when in fact total net income is flat or declining. Share buybacks can be great, but when being financed unsustainably by growing debt they are just masking a declining business.
High quality financial reporting allows investors to make an informed assessment of the earnings quality of the company. That being said, high financial reporting quality alone is not enough to make an investment decision and investors need to do their homework to assess earnings quality and judge whether returns are adequate and sustainable. It is a buyer beware world out there and reported financial information should not always be taken at face value.