The Small-Cap Investor by Ian Wyatt

Author:Ian Wyatt
Language: eng
Format: epub
Publisher: John Wiley & Sons, Ltd.
Published: 2010-05-11T04:00:00+00:00

The Quality Gap in GAAP: High- versus Low-Quality Earnings

None of the analysis of financial statements is simple. In fact, the best you can hope for is a consistent and honest attempt to accurately report transactions. That sounds easy, but it is not. Accounting is complicated and involves a lot of interpretation, and this is where mischief can easily rise to the surface. And the GAAP rules leave a wide margin for interpretation of virtually any and all of the numbers.

One broad example of this is found in the disparity between high-quality earnings and low-quality earnings. High-quality earnings are the product of conservative accounting practices that provide a clear and reliable picture of the company’s financial status. You spot high-quality earnings in several ways:• The trend in earnings is growing consistently over many years.

• Earnings track growth in revenues consistently, without questionable increases in earnings that exceed the rate of revenue growth.

• A company with high-quality earnings tends to move up on the competitive ladder within a sector, indicating that those earnings are accompanied by a strong core business.

• The dollar level of earnings increases each year, and the net return (percentage of net to revenues) remains consistent or grows over time.

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