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Hello fellow Fools. I just read Quality of Earnings and thought I'd share my thoughts on an overall Foolish book (with one glaring exception). Comments, both conforming and dissenting, are welcome.

A book by the author of The Quality of Earnings® Report. He uses this work as a capstone to summarize his views and findings from more than 20 years assessing and reporting corporate America's accounting practices. One may question his motives, but not his courage; this book doesn't pull any punches. The basic premise is that GAAP does not ensure accurate reporting by public companies and managers do not necessarily have the best interest of shareholders in mind. He offers some advice on ratios to keep your eye on while evaluating a firm for investment possibilities, his view on dividends, and cautions you to temper your optimism on a firm's performance following a “big bath”. Anecdotal evidence is presented in each chapter; one cannot tell if this was prospective or retrospective however.

The Author
Thornton O'Glove - a stockbroker and analyst in the 60's noticed early in his career, and at b-school, that research uncovering positive company traits was highly valued while research that uncovered negative traits was shunned. His contrarian temperament kept him looking for and writing about the skeletons in the closets of publicly traded companies. After his views earned him persona-non-grata status he left the Wall Street brokerage houses and started his own reporting service with the same title as the book.

Chapters 1-2: Don't take anything you hear or read at face value. There is a conflict of interest for your broker/analyst. Accountants/Auditors have many tricks up their sleeves.

Chapters 3-7: These chapters are a strong thesis on why you should read all that management puts in print. He reminds us that companies employ public relations experts to write the annual report so the investor must dig deeper than the glossy pages. His term 'differential disclosure' is quite descriptive…managers sometimes present a rosy picture in the annual report while airing the dirty laundry in the 10-K. He presents several examples of this behavior by management of high-profile firms and provides some guidance on how & where to look for these discrepancies.

Chapters 8-9: Presentation of some important ratios to keep track of…early warning signs that things aren't all sunshine & lollipops. Look at these in all cases: Accounts receivable, inventories, debt level (leverage), and cash flow. [I strongly recommend works by David & Tom Gardener on these topics.]

Chapter 10:
This chapter discusses dividends; how they, dividends, can be a trap for a firm and what Mr. O'Glove believes is a better use of “excess” cash. I agree that Wall Street over-reacts to any dividend changes in the short run, but the Foolish investor knows the stock price will accurately reflect how well management is deploying earnings in the long run. Next, I believe the author took leave of his senses. He suggests that companies should not use this excess cash to pay dividends; instead they should either lower prices to increase market share or diversify in order to grow. [WARNING…there's a rant coming up.] Now, I can acknowledge there are some, a few, situations where increasing market share through lower prices/margins is a sound financial decision (reference: Nagle & Holden). What I cannot accept is the blanket statement that a firm should increase market share w/ lower prices/margins rather than distribute earnings to the shareholders. And to propose to management to diversify rather than paying dividends is tantamount to giving a drink to an alcoholic! If these guys have resisted the “institutional imperative” on their own, then they have more will power than a vast majority of American executives. I paraphrase Buffet: Management must generate at least an additional dollar of income for each dollar retained. If this is not possible then earnings should be distributed to the shareholders, either through share buybacks or dividends, so the shareholder can reallocate the equity to someone who can. [End of rant.]

Chapters 11-12:
There are two situations that require extra-special attention by the investor: (1) when a firm changes it's accounting methods and (2) following a “big bath”. The author documents the most common accounting changes that affect the quality of earnings and how management uses a period of loss, whether single quarter or a year, to cover a host of sins.

My Favorite Line
'Indeed, so loose is GAAP that a few years ago…accountant Abraham Briloff suggested the term be changed to “Commonly Reported Accounting Principles,” or CRAP.' [p. 164]

• Do Your Homework – don't rely (solely) on advice from others. “…there is no substitute for information and knowledge.” [p. xii] You are responsible for your own investments. You are in charge.
• Read Beyond the Annual Report - be sure to read both the annual report and the 10-K to check for discrepancies (what O'glove calls 'Differential Disclosure').
• Read the Footnotes – keep your eye out for (1) how non-operating & non-recurring expenses & income have been handled and (2) whether or not the firm has changed how it reports the factors that affect earnings (depreciation schedules, stock options, deferred costs, funding of pension plans, etc…). [Recall that this was written in the mid-80's; subsequent changes in GAAP and the advent of SOX prevent some of the shenanigans referenced in the book but we all know that wiggle-room still exists and so the point is still valid.]
• Key Ratios for Quality of Earnings - accounts receivable & inventories, debt levels, and cash flow.
• There's Nothing New Under the Ticker Symbol – same accounting mischief, different decades.

I give this book a mild “do not recommend” for Fools. Although the advice is solid, with the notable exception of Chapter 10, and the material is in line w/ what is taught at TMF, it is presented in an inferior manner and so one's valuable time is better spent reading a work by: Buffet, The Gardener Brothers, Buffet, Graham, P. Fisher, Buffet, Lynch, Porter, TMF Staff, or the TMF Community (just to name a few), or by reading a work that covers new territory for you.

If you do decide to read the book please check w/ your local library first…although there is good information in here I cannot envision this being a reference work for anyone.

Forever critical,
LA Feaz

Final Note
I just reviewed my review & some may wonder why I read the book all the way through (I've come across a bit more negative than I really am). I think the primary reason for the extra dose of harshness is his suggestion to lower price, and thus margins, or “diworsify” [Peter Lynch] rather than distribute excess cash to shareholders through dividends really set me off. This passage doesn't appear until chapter 10 (of 12). Besides, its been raining for four strait days here in LA & I can't go outside to play…perhaps its time to read another book?
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