5.13 Earnings Quality and Predictability

Financial Reporting Quality is an area that has attracted both academic and practitioner attention.  The quality of financial reports affects both the accuracy of the financial statements as well as how relevant they are for predicting future cash flows.  This has led to a large body of research that attempts to understand accrual accounting and its impact upon financial reporting quality. 

There are two major drivers of accounting income, cash flows from operations and accounting accruals.  From a prediction perspective cash flows from operations should have a more persistent impact upon earnings than accruals because over time accruals reverse. For example, an accelerated depreciation method that is aggressive early in the life of an asset becomes conservative later in the asset’s life.   In addition accounting accruals have also been associated with managing earnings to meet earnings’ targets.  This is because it is easier for management to manage accruals than it is to manage cash flows – although both of course are subject to management.

This hypothesized difference between cash flows and accruals, in terms of a sustainable earnings impact, is supported empirically.  For example, a higher proportion of accruals relative to cash earnings is associated with lower earnings performance in the subsequent period (Sloan 1996).  As a result, the differential implications resulting from cash flows and accruals raise questions regarding the relationship between the use of accruals and earnings quality.  Earnings are assessed to be of higher quality if they are sustainable and thus analyzing accrual ratios provide important insights into these issues.  In turn, this has additional implications for understanding situations where the efficiency of business ratios and price ratios appear to be misaligned.

In this section we introduce three accrual ratios.  These ratios are designed to provide an analyst with insight into earnings quality. 

Earnings’ Quality Scaled by Average Net Operating Assets

Earnings quality is a relative measure and as thus is interpreted relative to some benchmark.  A useful comparison is to use decile cutoffs relative to some defined benchmark set of stocks.  In this way an analyst can judge whether or not a company is out of line wth it’s peer group.  Valuation Tutor’s “decile analysis” lets you do this relative to whatever subset of stocks you choose or relative to all stocks in the dataset that covers the major stock indexes and more.  We will illustrate interpretation in the example that follows this section.

The first two earnings’ quality measures are the traditional measures which measure the relative importance of accruals to current earnings by applying a common size analysis where the scaling variable is net operating assets.  These measures are developed by starting from aggregate accruals:

To express in a comparable ratio form requires an additional concept, referred to as Net Operating Assets.  This term is the difference between operating assets and liabilities.  This technique for constructing an accounting accrual related ratio meets several needs. 

First, operating assets subtracts out cash and near cash in a consistent manner with the subtraction of cash earnings from Aggregate Accruals.  Second, in the liabilities part financing decision effects are subtracted.  Thus Net Operating Assets sharpens the measurement of the impact of accounting accruals upon the numbers resulting from the investment decision.

Formally this is defined as:

We next define two accruals ratios designed to provide a measure of financial reporting quality:

Operationally these defined relative to two successive Consolidated Balance Sheets as follows:

The Aggregate Accruals can be defined from the Consolidated Statement of Cash Flows as follows:

Earnings’ Quality Scaled by Net Income

In a recent refinement by Hafzalla, Lundholm and Winkel (2010) proposed a refined measure that is constructed relative to total earnings not assets.  In this paper the simple accrual formula was:

This relates the non-cash earnings to earnings to provide what is argued to be a more sensitive measure of the relative importance of earnings management.

Valuation Tutor lets you explore these issues further by comparing the measures relative to a benchmark.  In a section below we will illustrate this by using the “Calculate All” feature to see how the different measures of earnings quality result in different decile memberships.  That is, by ranking each measure we can identify 10-subsets (ranging from relative large reliance upon accruals to relatively small reliance upon accruals) from the total population of stocks in the Valuation Tutor dataset which contains over 1500 stocks to see whether or not the three measures result in different decile memberships.

Earnings Quality and Non-Controlling Interests:  A Note

We first illustrate earnings’ quality with a hands-on example of a company that we expect to have high quality earnings, and this is Wal-Mart.  It will serve to illustrate the computation of net operating assets post FAS 160 which requires that “non-controlling interests” are part of equity in a consolidated reporting entity.  This change brings US GAAP in line with IFRS accounting standards.