Quality of Earnings

O'glove worked as a forensic analyst and wrote this in 1987 as a practical guide to determining whether reported earnings represent economic reality. Its central claim is that reported earnings are a product of accounting choices and that an analyst must reconstruct them.

His specific techniques include comparing the tax books to the shareholder books, since a company reporting high earnings to shareholders while reporting low income for tax purposes is using accounting choices rather than generating cash; examining changes in accounting policy and calculating their effect separately; analysing the relationship between accounts receivable and sales, since receivables growing faster than revenue indicate either aggressive recognition or collection problems; analysing inventory relative to sales for the same reason; examining non-operating and non-recurring income that has been included in operating results; and reading the footnotes, which he argues carry the information the statements conceal.

He also covers the differential disclosure between what a company tells shareholders and what it tells the Securities and Exchange Commission, and the specific practice of reading both. His treatment of the sell side is direct: he argues that analysts are structurally unable to publish negative conclusions and that their earnings estimates are anchored on management guidance.

The book is from 1987 and the accounting standards have changed substantially, including the treatment of many specific items he discusses. The general method of reconstructing earnings from primary disclosures, and the specific ratio checks, transfer completely. Schilit's Financial Shenanigans covers similar ground with more recent cases. O'glove is more concise and more focused on the analyst's working method.