What Is Accounting Quality and Why It Matters

A Quick Walk Through the Recent Age of Miracle, Wonder & Other Lies

It has been a wild couple of years for financial statements. And by “wild,” we mean the quality of financial accounting information hit lows we could not have imagined. Let’s start with the basics.

The concept of accounting quality is predicated on the idea that financial reporting is designed to provide financial information that is both relevant and faithfully represents a company’s actual financial condition. Financial reporting quality is essential to maintaining vibrant and healthy capital markets. It is that simple.

KCR’s equity research team has been at this for a combined 55 years and has been publishing research via KCR since 2010. The academic on the team teaches accounting and is a blue-chip name in the field of behavioral finance. We cannot recall accounting distortions being this severe. Ever.

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Things are so off the charts that the new head of the SEC led out by implying that the sponsors of a company promising final mile delivery in…outer space had misled investors. We would later pan the improbable promises of Lilium, valued at $3.3 billion, which asserted they would revolutionize short-haul flight with yet to be built battery powered mini-planes.

Dishonesty like this led famed short-seller, Jim Chanos, to dub this “The Golden Age of Fraud” in an article for the Financial Times. Short sellers are often made into villains. But with hindsight, the world often wishes the good ones’ warnings were heeded earlier. We will venture a guess that the thousands of Enron employees who lost everything wish regulators paid more attention to investors like Mr. Chanos.

Why Does Earnings Management and Earnings Quality Matter in One Chart – Small & Mid Cap Universe

KCR’s equity ranking tools offer proprietary calculated information on 95 metrics in five major buckets. Those buckets are Valuation, Balance Sheet, Earnings Quality, Analyst Quality, and Market Quality. The chart below omits 4 out of the 5 buckets – not something we recommend – and shows the compound returns to the top-ranked 10% and bottom-ranked 10% stocks based on our Earnings Quality score.

Small Mid Cap Stocks with High Quality Earnings Obliterate Stocks with Low Quality Earnings

For those interested in the data from our S&P500 Universe, please reach out to

[email protected]

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As a reminder for our Financial Advisors: our models are available on a continuous basis, and most have been in production for over a decade. If you are looking for simple, concentrated, low turnover, and tax efficient model portfolios we would like to talk with you. KCR also offers a wide range of easy-to-use but sophisticated tools. Our toolkits can help identify mispriced stocks with the best and worst risk/reward characteristics, estimate a stock’s duration and warn you when a company is engaging in low-quality accounting. Over the last 12 years, KCR has built and offers time-tested and class-leading products built by experienced and proven money managers for fixed to low prices.
Kailash Capital Research, LLC ’s sister company, L2 Asset Management, runs market neutral, long/short, large-cap, and mid-cap long-only portfolios with a value and quality bias. L2 employs a highly disciplined investment process characterized by moderate concentration, low turnover, high tax efficiency, and low fees. While nobody can predict the future, we believe the recent resurgence in risk-adjusted returns seen across all products is the beginning of what may be a long period where speculation is punished, and prudence and patience rewarded.

ADDITIONAL READING

The topics discussed in this article are aimed at seasoned professionals, as such, we have included some extra for anyone seeking out more information related to the topics above.

Disclaimer

The information, data, analyses, and opinions presented herein (a) do not constitute investment advice, (b) are provided solely for informational purposes and therefore are not, individually or collectively, an offer to buy or sell a security, (c) are not warranted to be correct, complete or accurate, and (d) are subject to change without notice. Kailash Capital Research, LLC and its affiliates (collectively, “Kailash Capital Research, LLC ”) shall not be responsible for any trading decisions, damages or other losses resulting from, or related to, the information, data, analyses or opinions or their use. The information herein may not be reproduced or retransmitted in any manner without the prior written consent of Kailash Capital Research, LLC . In preparing the information, data, analyses, and opinions presented herein, Kailash Capital Research, LLC has obtained data, statistics, and information from sources it believes to be reliable. Kailash Capital Research, LLC , however, does not perform an audit or seeks independent verification of any of the data, statistics, and information it receives. Kailash Capital Research, LLC and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only and is not intended to provide, and should not be relied on for tax, legal, or accounting advice. You should consult your tax, legal, and accounting advisors before engaging in any transaction. © 2021 Kailash Capital Research, LLC – All rights reserved.

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