Byron MacleodBy Byron Macleod, CFA
Associate Director of Research, Gradient Analytics LLC (a Sabrient Systems company)

Given that Gradient Analytics’ research is primarily focused on forensic accounting, this common client question falls into our sweet spot. However, the link between earnings quality concerns and share price underperformance can be difficult to assess for two reasons:

   1.  Investors and sell-side analysts tend to focus their attention on the income statement, but there is not always a predictable correlation between the highlighted balance sheet trends and the income statement impact.
   2.  Because management has a huge amount of discretion over how accounting entries are handled (including when to recognize built-up expenses, impairments, non-cash gains, etc.), earnings quality concerns often have ambiguous timing.

Thus, investors often are left wondering just how and when eroding earnings quality in their portfolio holdings – whether long or short – will ultimately impact their fund’s performance.

Nevertheless, to illustrate how such red flags may indeed lead to notable share price decline, I will describe three real-life examples. For compliance reasons, I won’t disclose their names, but will simply refer to them as Company A, B, and C. Read on.... Read more about “How will earnings quality issues impact the company’s share price?"

Brent MillerBy Brent Miller, CFA
President & COO, Gradient Analytics (a Sabrient Systems company)

“Change is the law of life. And those who look only to the past or present are certain to miss the future.” – JFK

When evaluating the earnings quality of a given company, a forensic accounting firm like Gradient Analytics focuses on key indicators that may indicate that a company has taken liberties to cosmetically enhance its financial performance via aggressive revenue recognition and/or the understatement of expenses. Signals that a firm may be engaging in financial gamesmanship include:

  1. Divergence between reported earnings and free cash flow (i.e., an increase in accruals)
  2. Overstatement of assets
  3. Understatement of liabilities
  4. Negative or decelerating organic revenue growth
  5. Persistently widening gap between GAAP and non-GAAP EPS

In this article, I discuss a new amendment to the accounting standards that seeks to reduce inconsistencies and improve standardization of revenue recognition practices.  Read more... Read more about New Accounting Standard Changing Software & Telecom Industries