Tag Archives: Quality of Earnings

Screening out Earnings Manipulators; Quality of Earnings

budget cuts

Accounting shenanigans have a way of snowballing: Once a company moves earnings from one period to another, operating shortfalls that occur thereafter require to engage in further accounting maneuvers that must be even more “heroic.” These can turn fudging into fraud. (More money, it has been noted, has been stolen with the point of a pen than at the point of a gun.)” –Warren Buffett, Shareholder Letter, 2000.

We pick up from the last lesson and read Chapter 3 in Quantitative Value: Hornswoggled! Eliminating Earnings Manipulators and Outright Frauds.

This is an important chapter for improving as an investor. Your goal might be to understand accounting up to the intermediate level so as to adjust accounting principles into economic reality. What story are the numbers telling you?

Think of this chapter as a way to build an early-warning system for companies with weak accounting.

The authors propose three ways to detect aggressive accounting that lead to poor quality of earnings:

  1. Scaled total accruals (STA), which uncovers early-stage earnings manipulations
  2. Scaled net operating assets (SNOA) which captures a management’s historical attempts at earnings manipulation.
  3. The third is the probability of manipulation, or PROBM, a tool that identifies stocks with a high probability of fraud or manipulation.

When the growth in cumulative accruals (net operating income) outstrips the growth in cumulative free cash flow, the balance sheet becomes “bloated.” Stocks with balance sheets bloated in this way find it difficult to sustain earnings growth.  When managements take the low road in aspects that are visible, it is likely they are following a similar path behind the scenes. There is seldom just one cockroach in the kitchen.

A warning sign is high accruals that show much higher income than cash flow. See pages 64 to 68 in Quantitative Value.

Though you should read this chapter carefully and for the nerds, dig into the research papers below, but I highly suggest studying Chapter 8 in Quality of Earnings, Chapter 8 (sent via email to Deep-Value at Google Groups).   A gem of a book. and Defining Earnings Quality CFA Publication

Earnings Management, Fraud Detection and Adjusting for Accruals

How a group of Cornell Students sold Enron before the collapse



Information in Balance Sheets for Future Stock Returns

Earnings Mgt and LR Stock Performance of Reverse LBOs

Earnings Mgt and LR Performance of IPOs 1998

Can Forensic Accounting Predict Stock Returns

Analysts do not adjust adequately for accruals 2004

After a few days of digesting this post, we will tackle Chapter 4: How to Avoid the Sick Men of the Stock Market, in Quantitative Value.

How can we avoid bad news as investors through our knowledge of financial statement analysis and human motivations (incentives)?

Sound Money


A Banker for All Seasons John Exeter

An American Original: Voodoo Child

Have a Great Weekend!


Tawes Hockey

Cisco (CSCO) Case Study; The Lord of Dark Matter


Next the statesmen will invent cheap lies, putting the blame upon the nation that is attacked (Syria), and every man will be glad of those conscience-soothing falsities, and will diligently study them, and refuse to examine any refutation of them; and thus he will by and by convince himself that the war is just, and will thank God for the better sleep he enjoys after this process of grotesque self-deception.” –Mark Twain

“When the rich make war, it is the poor that die.”–Jean-Paul Sartre

Case Study of Cisco:

CSCO Chart

Case Study on Cisco Third Quarterly Earnings  (includes 2012 for comparison purposes).  Instructions and questions in the document.

CSCO_VL   (for reference) CSCO March 2013 Qtr Report

Please explain what you see.

The Lord of Dark Matter

Fleckenstein:  “Probably anyone who listens to your wonderful interviews already understands that money printing can’t solve anything … Most recently the housing bubble led to the collapse in 2008/2009, and now we’ve got QE of biblical proportions being foisted upon us by the Fed, BOJ (Bank of Japan), Swiss National Bank, and probably the BOE (Bank of England) soon, etc.

The irony of it all is that 5 years into zero rates, and America alone (with) $5 or $6 trillion of deficit spending, the economy is still crummy.  No one ever says, ‘Why is that?’  Well, the reason is because money printing doesn’t work.”

….Everybody and his brother is bearish.  I get sent two articles a day about some knucklehead who’s bearish on gold.  Well, you know what?  They are all bearish for the same two reasons:  The chart looks bad, and the price is wrong.  Like they know what the price (should be).  How do any of us know what the price is supposed to be?  It’s just a price.

Click the link below to hear the twelve-minute interview:



Serial Bubbles: 



P.S. I have been a bit swamped with work, so I will post next week. Be well and BE CAREFUL!