By Brian Nelson, CFA
Let’s first become acquainted with why assessing earnings quality is important. According to the Research Foundation of the CFA Institute:
Understanding the quality of earnings is an essential part of processing and interpreting information. A high-quality earnings number will (1) reflect current operating performance, (2) be a good indicator of future operating performance, (3) and fairly annuitize the intrinsic value of the company.
At Valuentum, there are five basic areas that we evaluate to assess the quality of a firm’s earnings:
a) is the company’s earnings growth driven by higher-quality revenue expansion or lower-quality cost-cutting measures (can the trajectory of earnings be sustained with continued revenue increases because cost-cutting, by definition, is a finite activity?);
b) has the company benefited from one-time items and/or an abnormally low tax rate to bolster net income (is the company shifting items from one period to the next?)
c) has the company engaged in aggressive share buybacks to bolster earnings per share (is management incentivized based on return on invested capital or accounting earnings per share, the latter not always in the best interests of shareholders?);
d) does the company convert 100%+ of its net income into cash flow from operations (are the earnings it generates truly cash earnings or are they more an accounting measure?);
e) was there a large re-classification of costs and/or segments that muddied the performance (is the company trying to hide something?).
There are other items to consider in evaluating the quality of earnings—including assessing depreciation methods and other more fraudulent activity that can impact reported net income such as creating fictitious revenue and/or failing to record expenses—but for the most part, the five reasons outlined above cover the topic quite well in practice.
Never did we ever think we’d be using Big Blue ( ) as an example of poor earnings quality, but let's discuss the firm's historical results to get a feel for how poor earnings quality can translate into disappointing share-price performance. Shares of IBM once traded for more than $200 each prior to the collapse in the middle of last decade. Let's get started with the analysis. In IBM’s fourth-quarter 2013 income statement shown below, we have encircled three items that stood out to us at the time.
IBM's earnings quality began to deteriorate significantly in 2013. IBM
The first is revenue growth. IBM’s fourth-quarter 2013 revenue dropped 5.5%, a pace that exceeded that of the 4.6% drop for the year, indicating an acceleration of the revenue decline. Without a solid backdrop of revenue growth, earnings-per-share expansion will have to come either from lower quality cost-cutting, one-time items, or share buybacks. Interestingly, IBM didn’t cut operating costs faster than the revenue declines in the period, as SG&A and RD&E as a percentage of revenue expanded, to 21.6% (up 140 basis points) and 5.7% (up 30 basis points), respectively. Clearly, revenue and costs had been moving in the wrong direction at IBM.
However, IBM still reported a 6% increase in net income and a 240 basis point improvement in its net income margin for the quarter (see bottom two lines of the image above). Let’s examine how it did so by looking at the two other encircled items on its income statement. ‘Other (income) and expense’ advanced by $66 million—the measure is an offset to expenses, which is why it is a negative. Second, IBM’s tax rate (‘Effective tax rate’) tumbled significantly. Big Blue’s net income was more than $1 billion higher than it otherwise would have been (the ‘Provision for income taxes’ declined more than 60%).
The quality of earnings expansion, however, was muddied even further. IBM bought back more than 50 million shares of stock (a reduction in share count to 1,072.5 million from 1,124.7 million), which further boosted headline earnings per share. On a diluted basis, IBM recorded ~11% earnings-per-share growth in the quarter, but there wasn’t anything fundamental in the quarter that should have driven such strong bottom-line expansion. Said differently, the buybacks contributed as an artificial means to hide weakening underlying fundamentals at the company.
IBM's buybacks were artificially boosting EPS. IBM
Another important consideration in assessing earnings quality is to ascertain whether cash flow from operations is increasing at a pace (or is at a level that is) consistent with net income expansion. If it isn’t, then the earnings the firm is posting on the income statement are more accounting-based than cash-flow based. For IBM, net cash from operations per GAAP is slightly higher than accounting earnings on the income statement (in the quarter and on an annual basis), so the possibility of any serious financial shenanigans at Big Blue was remote, in our view.
On an annual basis, however, the decline in net cash from operating activities ($18.79 billion versus $22.49 billion) was much steeper than the fall in net income for the year ($16.5 billion versus $16.6 billion). Free cash flow trends weren’t that great either. As a percentage of net income, free cash flow fell to 91.1% in 2013 from 110% in 2012. The pace of the free cash flow decline was much steeper than that of net income on an annual basis.
It's paramount to pay attention to operating cash flow trends relative to net income. IBM
The steeper drop in cash flow (both operating cash flow and free cash flow) relative to the fall in net income shouldn’t be that surprising. A look at the breakdown in incentive compensation in IBM’s 2013 proxy statement, for example, revealed more of a focus on operating net income (60% weighting in executives’ annual incentive program) and operating earnings per share (an 80% weighting in executives’ performance share unit program) than anything else. [Please see page 34 of 2013 proxy statement and/or image below.] As shareholders (owners of the company), they often get what they incentivize management to do.
Incentives play an important role in outcomes. IBM had been incentivized more on driving operating earnings per share than on driving economic-value-added, ROIC dynamics. Such a focus on accounting EPS eventually led to low-quality earnings growth and eventually IBM's share-price weakness. IBM
Incentives based heavily on accounting EPS tend to do more harm than good, in our view. In this case, a strong case could be made that IBM's management "fell asleep at the wheel" by depending more on share buybacks to target operating earnings per share goals, instead of concentrating on tangible operating improvements to drive higher-quality ROIC.
After years of scraping by on poor earnings quality, IBM finally threw in the towel and ended up in late 2014 dropping its long-held operating earnings-per-share target for 2015 of $20 per share. The company's share buyback "buffer" was simply not enough to offset underlying business weakness and poor earnings quality--a situation that was not remedied by a management team, which was too busy focused on accounting EPS and not on economic-value-added dynamics. The stock suffered as a result.
As a matter of better corporate governance, we’d like to see a greater focus on return on invested capital (ROIC) and economic profit (EVA) than accounting measures. In addition to adding other ESG considerations to incentive programs, we think long-term performance will benefit from such a heightened focus.
IBM didn’t engage in any large re-classifications to complicate year-over-year comparisons, but the firm’s quarterly results as outlined in this case study had flown in the face of what we and the Research Center for the CFA Institute characterize as high-quality earnings. The fourth quarter of 2013 at IBM was not (1) reflective of current operating performance, (2) a good indicator of future operating performance, and (3) helpful in assessing the intrinsic value of the company.
As we look across our coverage universe today, perhaps Meta Platforms ( ) may have become the new torch bearer of poor earnings quality as the social media giant deals with low earnings quality supported by aggressive layoffs in the wake of revenue pressure.
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I thought that everything related to accuracy, reliability, of the reported information was linked to "Quality of reporting", and not "Quality of earnings". Now this Kaplan guys are telling me that it is "Quality of earnings analysis".
Even in the curriculum i've found this definition:
So i guess they're playing on words. "Quality of earnings", relates to the sustainability of earnings, as we've been told since Level 1. But "Quality of earnings analysis ", also includes scrutinizing if there is any balance sheet management (which means giving inaccurate financial information).
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By SVG Staff Wednesday, August 28, 2024 - 9:00 am Print This Story | Subscribe
A new $1.4 billion multipurpose sports venue was looking to incorporate advanced connectivity, audiovisual, and security technologies to draw larger event crowds, and Wesco helped the stadium create an immersive fan experience while saving time and money.
In a world of 4K UHD televisions and ever-growing in-home conveniences, event venues are challenged with getting people out of their homes and through the doors at live events. One venue looking for innovative ways to get more people in its seats was the new $1.4 billion multipurpose venue that would be home to an NFL team and a professional soccer club. The venue would also host a variety of events year round, including concerts and NCAA football games.
Among the reasons event attendance is declining is simply that fans can watch the event from home and for a much lower price. Not only has this led venues to seek out ways to create one-of-a kind experiences that cannot be replicated at home, but it has also led them to find solutions to the challenges of attending a live event, such as traffic and long restroom lines, and incorporate more of the comforts and conveniences of home into the venue.
Driven by the demand and expectation for enhanced fan experiences and by the potential revenue that analytics have proven such experiences can generate, the end user wanted to incorporate technologies that would appeal to fans, including advanced Wi-Fi and cellular networks to keep them connected, an engaging audiovisual system, and advanced security measures to provide a safe and pleasant environment.
A project of this size and scope is inherently challenging. However, it is made even more complex when being constructed in a busy urban environment with little space for staging and storage. Additionally, cities impose strict safety, delivery, and noise regulations, requiring more oversight and planning than would be necessary in a rural construction project. The stadium needed a partner who not only understood and had experience with these challenges but could also ensure the project complied with city-mandated regulations.
After initial discussions about the project, the local Wesco team began building relationships with local engineering teams and learning the logistical landscape of the area, so when the project was awarded, they were ready to hit the ground running. Wesco worked in tandem with the IT general contractor to win the project by offering an all-inclusive fiber-based solution that offered both time and cost savings. Wesco’s ability to supply the complete bill of materials enabled the contractor to provide a single-source solution with advanced supply chain capabilities, putting them ahead of the competition.
Wesco leveraged its supplier relationships to source products and build a proof of concept network that would simulate the stadium environment demonstrating to the customer how the solution would work. Furthermore, Wesco provided recommendations for expert wireless contractors in the area to test the design and made product and infrastructure recommendations to help the stadium become LEED certified.
With products from industry-leading manufacturers, Wesco supplied the complete stadium infrastructure and connectivity network materials, including:
Logistics were key to project success. Wesco provided a project coordinator to be an inventory management and logistics liaison between the IT contractor and numerous subcontractors. The stadium’s urban location meant that job site storage was a challenge, so Wesco staged and managed inventory out of its local warehouse to feed the job. With approximately 900 different products being delivered to the job site, it would be easy to lose or misplace material, therefore delaying construction and racking up costs as installation crews wait for items to be found or reordered. Wesco provided kitting, labeling, serial number capture, and regular product reporting to simplify installation, keep track of material, and ensure it would be delivered to its intended location within the stadium. These efforts, along with maintaining open communication with all parties involved, helped ensure a successful deployment and kept the project on track.
The stadium was completed on schedule, just in time for NFL season kick-off. With advanced networking capabilities, a audio/visual system, and even an app that could tell fans the quickest traffic routes and where the shortest restroom and concession queues were, the stadium offered an enhanced fan experience that draws people out of their homes and into the stadium. These technologies are having a positive impact on revenue streams and profitability from sales, merchandising, advertising and more. The new stadium saw a 3% increase in average attendance over the previous year in the old stadium.
By partnering with Wesco, the contractor saved time and costs associated with sourcing, inventory management, and logistics. Wesco provided immeasurable value for the contractor by recommending and sourcing products for the various applications and obtaining samples for the proof of concept network. Wesco also assisted with research on what local resources were available to help manage fan data traffic that comes from each game. Additionally, Wesco introduced the contractor to the local police department to ensure they could seamlessly integrate their security system into the stadium’s system.
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Assessing the impact of straw burning on pm 2.5 using explainable machine learning: a case study in heilongjiang province, china.
2. materials and methods, 2.1. fengyun-3 series global active fire products, 2.2. land cover, 2.3. auxiliary data, 2.3.1. climate-related variables, 2.3.2. dem and aod data, 2.3.3. chinahighpm 2.5, 2.4. feature selection, 2.5. random forest model, 2.6. interpretable analysis, 2.7. data preparation for temporal and spatial models, 3. results and discussion, 3.1. comparison with modis fire points, 3.2. spatial distribution of fire points, 3.3. temporal patterns and variations, 3.4. monthly variations in crop fire points, 3.5. correlation and collinearity analyses of input features, 3.6. accuracy of the temporal and spatial models, 3.7. impacts of straw burning and other influencing factors on pm 2.5, 4. discussion, 5. conclusions, author contributions, institutional review board statement, informed consent statement, data availability statement, conflicts of interest.
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Xu, Z.; Liu, B.; Wang, W.; Zhang, Z.; Qiu, W. Assessing the Impact of Straw Burning on PM 2.5 Using Explainable Machine Learning: A Case Study in Heilongjiang Province, China. Sustainability 2024 , 16 , 7315. https://doi.org/10.3390/su16177315
Xu Z, Liu B, Wang W, Zhang Z, Qiu W. Assessing the Impact of Straw Burning on PM 2.5 Using Explainable Machine Learning: A Case Study in Heilongjiang Province, China. Sustainability . 2024; 16(17):7315. https://doi.org/10.3390/su16177315
Xu, Zehua, Baiyin Liu, Wei Wang, Zhimiao Zhang, and Wenting Qiu. 2024. "Assessing the Impact of Straw Burning on PM 2.5 Using Explainable Machine Learning: A Case Study in Heilongjiang Province, China" Sustainability 16, no. 17: 7315. https://doi.org/10.3390/su16177315
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IMAGES
COMMENTS
1. A quality of earnings study is not an audit. Clients frequently ask why there is a need to perform a quality of earnings study when the subject company is already audited. There are several differences between an audit and a quality of earnings study. Such differences include the following: In a quality of earnings, the focus is on the ...
Case Study: Fashion Retail. Let's show the adjustments in action by walking through a case study example for a fashion retailer. The acquisition target is Fashion X, a small retailer with 10 stores across the region. ... Here are the key insights drawn from the case data that impact quality of earnings. 1. One-off store setup costs.
It is a matter of importance in the financial reporting and regulatory communities, and it impacts the confidence of investors in global financial markets. For this reason, the American Institute of CPAs in the U.S. engaged authors and experts to assemble this collection of case studies, to put the reader in the seat of executives making ...
Quality of earnings report refer to assessing the part of profit that can be attributed to the core business operations. It is considered high is the profits rise due to cost reduction and rise in sales. ... Consider our " Accounting for Financial Analyst " course, featuring in-depth case studies of McDonald's and Colgate, and over 16 ...
Quality Of Earnings: The quality of earnings refers to the amount of earnings attributable to higher sales or lower costs rather than artificial profits created by accounting anomalies such as ...
merit, research studies, International Management Accounting Practice Statements (IMAPS) and guides for practitioners. Periodically, a member body makes available its own work for distribution to a broader audience through FMAC in an effort to share that work. Such is the case with this collection of case studies on earnings quality.
Sample Quality of Earnings Report: A Comprehensive Analysis of Financial Performance. FEB 16, 2023. This downloadable is an example of Amplēo's final deliverable for a quality of earnings report. You will find that the report is broken up into 7 different sections: Background, Overview, and Key Findings. Quality of Earnings.
Quality of earnings is an assessment of a company's earnings that accurately removes distortions or anomalies such as one-time events that may skew the true bottom line of a business's financial performance. Quality of earnings refers to an evaluation of a company's financial performance to identify items such as: Nonrecurring transactions.
A quality of earnings report is a routine step in the due diligence process for private acquisitions. The report assesses how a company accumulates its revenues - such as cash or non-cash, recurring or nonrecurring. Net income is not necessarily a 100% accurate indication of financial performance for a business.
In every period, the firm's manager privately learns the firm's earnings and issues a report about the firm's equity, rt, to the market. The manager can manipulate the report, but he bears personal costs of doing so. In particular, we assume that the manager's biasing costs in a given period are: c. ð rt 2.
A quality of earnings report is a financial analysis that evaluates the quality and reliability of a company's earnings and profitability. It aims to provide a comprehensive understanding of a company's financial performance and earnings potential by reviewing key financial metrics such as revenue, operating expenses, and cash flow.
What is Quality of Earnings?1 The terms "quality of earnings" and "earnings quality" have no single, agreed-upon meaning. Both terms are used when making accounting choices; considering the business cycle, including timing of transactions; and discussing earnings management [see page 2]. Accounting Choices • Some use "quality of ...
Download. We study a dynamic model of earnings quality and earnings management in which firms take into account both long- and short-term considerations when reporting earnings. In addition to providing predictions about time series properties of earnings quality and reporting bias, the model offers a distinction between two components of ...
SOLUTIONS. VIP's dataroom deliverable facilitated a high efficient quality of earnings review in spite of a breadth of strategic initiatives. Our thorough process resulted in a single additional $500,000 adjustment recommended in the quality of earnings.
The contractor in question engaged an accounting firm to perform a Quality of Earnings (QoE) engagement to support the adjusted EBITDA. The contractor maintained the books in QuickBooks and engaged an outside accountant for CFO services. ... Case Study: Normalization Adjustments and the COVID-19 Pandemic. Understanding the Need for Quality of ...
Purpose. Although the academic research on the quality of earnings has been improved by presenting different approaches of measurement, there is no agreed‐upon generally accepted approach to measure the earning quality. Aims to present results of an empirical study measuring the quality of earnings on companies listed in NYSE.
In September 1998, Arthur Levitt, then Chairman of the Securities and Exchange Commission (SEC), presented an address at New York University, "The Numbers Game." In that speech, he called attention to an escalating problem with the quality of financial reporting in filings with the SEC. The topic received a great deal of attention over the next several years, both at the SEC and in the ...
This case examines issues related to accounting method choice, earnings management, and earnings quality. Specifically, the case examines a company (PhotoWorks, Inc.) that chose the less conservative approach of capitalizing and then amortizing a certain type of advertising expenditure rather than expensing the costs as incurred.
High-quality earnings reflect an adequate level of return on investment and are derived from activities that a company will likely be able to sustain in the future. Thus, high-quality earnings increase the value of a company more than low-quality earnings. When reported earnings are described as being high quality, it means that the company's ...
Evaluating the Quality of Earnings. This course will be an overview of: The impact of presentation and biased accounting The steps to take to evaluate financial reporting quality Quantitative tools to assess earnings quality Instruments to control earnings management and low-quality financial reporting. $29.00. Add to Cart.
Quality of Earnings - A Case Study - Free download as PDF File (.pdf), Text File (.txt) or read online for free.
How a lack of a focus on return on invested capital and economic profit and an emphasis on accounting measures and earnings per share in IBM's executive incentive programs brought down Big Blue. In this case study, let's discuss the five basic areas that we at Valuentum evaluate to assess the quality of a firm's earnings.
High-quality earnings increase the value of the company more than low quality earnings, and the term "high-quality earnings" assumes that reporting quality is high . A variety of alternatives have been used as indicators of earnings quality: recurring earnings, earnings persistence and related measures of accruals, beating benchmarks, and ...
A new $1.4 billion multipurpose sports venue was looking to incorporate advanced connectivity, audiovisual, and security technologies to draw larger event crowds, and Wesco helped the stadium ...
Straw burning is recognized as a significant contributor to deteriorating air quality, but its specific impacts, particularly on PM2.5 concentrations, are still not fully understood or quantified. In this study, we conducted a detailed examination of the spatial and temporal patterns of straw burning in Heilongjiang Province, China—a key agricultural area—utilizing high-resolution fire ...