I think that accounting quality is the single most neglected area of investing. There are few that spend time trying to analyze whether the financial statements are fairly presented. For value investors like me, that can be the difference between a value investment and a value trap.
Accrual entries on the balance sheet can be true or false, but cash rarely lies.
- Are the accounts truly receivable?
- Will the inventories sell?
- What is the property, plant and equipment truly worth?
- Do the goodwill and intangibles have any value?
- What are the revenue recognition policies?
- Some expenses can be capitalized as assets because of cash flows that are expected in the future. How reasonable is that expectation?
And with financial companies, the questions are different — what are the nature of the cash flows promised and purchased? Tough questions for anyone to answer, but at least the questions point us in the correct direction.
There are also the gambits to distract us from whether value is being created or not. Operating earnings are not wrong, but many companies abuse the concept. The idea should be to estimate what earnings are repeatable in future quarters/years.
There is a lot to chew on in this book, but it all boils down to:
1) What do we allow to be accrued for cash flows in the future?
2) How do we adjust those accruals as events change?
This is a great book — worthy of being in every person’s library.
Who would benefit from this book:
All individual and institutional investors would benefit from this book, bar none.Disclosure: I bought this book with my own money.