ETF Securities: Earnings Quality

March 11, 2015

[The following "ETF Issuer Perspective" is sponsored by ETF Securities]


Should you care about quality?

It is well-documented that there is a positive relationship between the quality of earnings and future stock performance. Although the concept is fairly straightforward, the key question is whether it is possible to implement a profitable strategy based on that concept. ETF Securities aims to provide access to an alpha model based on earnings quality through its partnership with Zacks Investment Research.

Accrual accounting assumptions and their consequences
Accrual accounting is the standard practice used by companies. It relies on the idea that a company’s performance and position should be based on economic events rather than on cash changing hands. For instance, when a company sells a good to a customer, the revenue is booked immediately even if the payment occurs later.

Accrual accounting presents several advantages, in particular its ability to consider future economic benefits and obligations. For instance, the fact that the customer will pay at a later date does not negatively affect current earnings. However, it has one major issue: because accrual accounting considers future events, it has to rely on management estimates. Management would need to assess the customer’s ability to pay at a later date; otherwise, that asset would need to be written off.

One would expect accounting rules to strictly limit the potential impact of these estimates. However, it is not possible to consider every single real life situation, hence the usage of generally accepted accounting principles (GAAP) allows some degree of freedom for management with regard to its application. The common result is that estimation errors can occur around these assumptions and the stated accruals.

Earnings quality
A reasonable assumption is for these estimation errors to average zero over time. Academic research has shown that it is actually not the case and on average, the reversal of accruals has generally had a negative impact on future earnings (see Allen, Larson and Sloan in 2011 for an extensive summary of the academic research on that subject). In a report published in 2013, the CFA Institute offered some reasons that can often lead management to adopt such behavior: the desire to meet earnings expectations, beat historical earnings, maximise compensation and to meet covenants set in debt contracts.

Following these findings, the concept of “Earnings Quality” has emerged, with the goal to assess if the reported earnings are actually sustainable. One of the solutions has been to focus on operating cash flows, which consists of eliminating the accruals from the reported earnings.

Basically, higher levels of reported accruals are considered a sign of lower earnings quality.

The accrual anomaly
There is a natural expectation that firms reporting low levels of cash earnings (i.e. low earnings quality), would see their stock prices underperform. However, just as important may be how quickly the information is incorporated into the stock price.

For instance, if a company reports earnings in line with expectations, but a review of the financial statements shows the company offered much longer payment terms to its clients, it would result in an increase of account receivables and deterioration of the operating cash flows. Would the stock price immediately react and fully incorporate this information, or would the time needed to process the information and determine its impact result in a lagged stock price reaction?

In a paper published in 1996 in the Accounting Review, Richard Sloan of the University of Pennsylvania found that there was a lagged reaction: investors started to react only after the reversal of the accruals started to impact the earnings. In a way, investors were fixated on the earnings reported rather than on their composition. Since then, extended research has supported the observation that companies with lower accruals have higher short term stock returns. This is generally referred to as the “Accrual Anomaly”.

In 2006, Lev and Nissim observed that some active investors have historically reacted more quickly to the level of accruals reported by adjusting positions accordingly, while some investors only started to react once the stock price began to be impacted. In other words, the earlier the reaction to the level of accruals reported, the higher the chances have been to earn alpha out of the accrual anomaly.



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