Saturday, November 12, 2011

Quality of Earnings: Chapter 11

Investors rely heavily on the financials that companies release. But managements have significant leeway when it comes to creating its results. In this book, Thornton O'Glove tells investors how to judge the quality of a company's earnings, in order to both protect against fraud and find value.

Because managements using GAAP have considerable leeway to apply judgements, they can make their earnings results say almost anything. O'Glove illustrates an example between two typical, identical companies whereby one company uses conservative accounting methods while the other uses liberal accounting methods. The liberal accounting method results in EPS more than twice that of the conservative method.

There are many who believe that the market sees through such accounting gimmickry. For example, proponents of the Efficient Market Hypothesis would argue that such information is already built into the stock prices of firms. Based on O'Glove's experience identifying companies that have changed to more liberal accounting policies, he disagrees.

O'Glove describes several examples where companies have gone from using conservative to liberal accounting. In many cases, this was done by changing depreciation lengths/methods (e.g. from 7 years to 10 years, and/or from switching from accelerated to straight-line), increasing salvage value estimates, or playing with pension assumptions (e.g. increasing future expected asset returns).

In many of O'Glove's examples, companies had earnings growth only because of such changes in accounting policies. Nevertheless, their P/E ratios and stock prices increased as investors cheered the higher earnings.

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