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The myopic focus that Wall Street places on near-term earnings-per-share (“EPS”) and the resulting price appreciation awarded to companies that “beat” EPS estimates creates a misguided incentive for executives to “manage” reported earnings. Though accounting rules have been tightened, there are still many ways which companies can use aggressive accounting to “beat” EPS targets. Naturally, financial engineering has become an all-too prevalent and sophisticated exercise.

One infamous example of this involved appliance maker, Sunbeam Corporation, which after a string of poor results initiated a restructuring to repair its image with investors. As sales continued to falter, newly hired CEO “Chainsaw Al” Dunlap initiated a scheme to improve results by shipping barbecue grills and air-conditioners to retailers—in December!! With generous rebates and return allowances Sunbeam successfully padded near term sales but the returns from retailers led to ballooning inventory, hurting pricing and leading to disastrous results and the collapse of Sunbeam. This kind of “channel stuffing” is often a warning flag of declining corporate performance and a lower future stock price.

Because, historically, EPS has been the primary measure of a company's performance, accounting rules have evolved that attempt to more precisely match the timing of a firm's revenue and expenses. Earnings are composed of cash flows and accruals. Accrual accounting strives to recognize revenue when it is “earned” and allocate expenses when they are “incurred” regardless of the timing of the actual cash flows. The benefit of accrual accounting is that more appropriately smoothes the operating results of a business. However, because accruals are based on assumptions about the future, corporate managements may be tempted to tweak assumptions in a manner that make the company appear more attractive.

Here are a handful of situations that highlight the importance of monitoring the level and trend of accruals:

1. Manipulation of depreciation and other non-cash expenses
Accounting rules allow managers wide discretion to determine the allotment of “non-cash” costs such as estimating the useful life of an asset. Waste Management (WMI) was recently penalized by the SEC for "juicing" its earnings by re-estimating the useful life of its garbage trucks, an action which had the effect of lowering its depreciation expense and reporting higher income.

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waste management earnings quality

2. Excessive capitalization of items which should be expensed
In 2002, AOL Time Warner (NYSE:TWX) was forced to take a charge of $54 billion as a result of the excessive purchase price of AOL and years of aggressive accounting policies that overstated the true economic value of the enterprise. AOL abused the accounting rules allowing certain expenses to be classified as assets and expensed over many years, rather than during the period when they were actually incurred. For example, as AOL was struggling during the late 1990s to show a profit, they extended the assumed useful life of the “starter kits” for dial-up internet service from two years to five years, dramatically lowering their current marketing expenses and increasing their reported income. AOL was grossly overestimating the useful life of these now-obsolete assets and, had they properly reported these expenses, the profits reported from 1997 through 2000 would in fact have been losses.

3. Inventory trends relative to sales
The collapse of Lucent and several of its telecom peers provides an example of where more careful monitoring of inventory trends may have protected investors from significant losses. While Lucent was keeping the Wall Street analysts pacified by consistently exceeding earnings expectations, investors overlooked that the company's inventories were growing at a dizzying pace. Increasing competition, product development missteps, and tempering demand was weighing heavily on Lucent’s cash flow. These factors together with the accelerating levels of accruals caused by the disproportionately higher inventory levels should have served as a warning regarding Lucent’s deteriorating business performance.

4. Accounts receivable (credit-based sales)
Lucent’s situation was exacerbated when the company loosened its credit standards and began offering very favorable financing terms to entice its customers to buy more equipment. The financing game stimulated some artificial demand by “borrowing” sales from future quarters and encouraging marginal customers and distributors to buy more products they otherwise likely wouldn't have purchased. While this stimulated near-term results, the higher-credit risk customers eventually defaulted on payment which contributed to the fall of Lucent’s stock.

While EPS (i.e. “accrual earnings”) is important, these four accounting situations highlight why we focus equal attention to a company’s ability to generate free cash flow (also know as "defensive earnings"). A recent study published by professors from the Universities of Michigan and Pennsylvania identify a phenomenon they call the “Accrual Anomaly”, where excess returns may be available to investors that buy companies with low levels of accruals. The results of their study are both robust and compelling as their model portfolio (long top 25%, short bottom 25%) beat its benchmark in 28 out of 30 years, and outperformed the market by almost 10% per year.

We view studies such as these as reaffirming of our practice of analyzing EPS quality and using earnings quality as a filter to our research process. In each investment we make, we closely evaluate levels of free cash flow trends in defensive earnings relative to accrual earnings, which we believe reduces the risk of earnings blow-ups amongst the names we own. This demand for strong earnings quality, in addition to seeking robust fundamental attributes of profitability, growth and valuation strengthen our portfolio holdings.

Source: Show Me the Money: The Importance of Monitoring Accrual Levels and Trends