The Quality of Earnings Quality
(Third Quarter 2005)

The central premise around earnings quality is that the Average Investor pores over financial statements and makes an investment decision knowing that he/she can trust the information presented. When that trust is breached, as in the case of Worldcom, Enron or Parmalat, the investors feel betrayed by the company and the accounting profession, and the media plays up the stories putting into question the soundness of the 10,000 plus other companies out there. But these are cases of criminal fraud, not just earnings quality, where investors, employees, lenders, auditors and regulators were systematically deceived.

In the fixed income market, investors have Moody’s, S&P and Fitch to pore over detailed and sometimes non-public information before formulating an opinion on the credit worthiness of a firm. Equity investors, unfortunately, do not have such an insight and must rely on the disclosures made by company management, the opinion of the independent auditor, and the diverse consensus of analysts. As a result, earnings quality takes on several dimensions to the equity investor. Aside from fraud, which represents an investment risk, earnings quality can be thought in terms of 1) conservatism and objectivity, 2) timeliness and transparency of disclosures, 3) earnings sustainability and 4) surprises. Let’s look at each one of these qualities to see how they can help to pick stocks better.

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