By Nicholas Yee
Director of Research, Gradient Analytics LLC (a Sabrient Systems company)

Over the past five years, Gradient Analytics has observed a shift from companies making acquisitions for strategic purposes to companies acquiring mainly for short-term financial gains. This stems at least in part from investors and a sell-side community that have become complacent in accepting managements’ accounting statements at face value without looking “under the hood.” To be sure, the complexity of acquisition accounting and the opaqueness of financial performance analytics is daunting. Therefore, it is incumbent upon earnings quality analysts to try to understand whether a company’s senior management may have other motives fueling an acquisition platform (aka “roll-up”) strategy.

Where previously we might have screened for deteriorating free cash flow and accruals to identify poor earnings quality trends, we now find that some managers have been circumventing cash from operating activities (CFOA) and moving working capital into investing activities on the cash flow statement through acquisitions. Why is this important, you ask? Should analysts always lump the cash paid for an acquisition into free-cash-flow calculations? Not necessarily; there is no hard and fast rule here to put into an automated screener in this situation. Rather, our analysts must perform a deep dive to determine whether the company is a “serial acquirer.” Is this a one-time acquisition that integrates seamlessly into the parent company, or is this just one of a series of mediocre acquisitions used to aesthetically grow the top-line and obfuscate traditional performance metrics?  Read on....

By Brent Miller, CFA
President & COO, Gradient Analytics (a Sabrient Systems company)

“Change is the law of life. And those who look only to the past or present are certain to miss the future.” – JFK

When evaluating the earnings quality of a given company, a forensic accounting firm like Gradient Analytics focuses on key indicators that may indicate that a company has taken liberties to cosmetically enhance its financial performance via aggressive revenue recognition and/or the understatement of expenses. Signals that a firm may be engaging in financial gamesmanship include:

1. Divergence between reported earnings and free cash flow (i.e., an increase in accruals)
2. Overstatement of assets
3. Understatement of liabilities
4. Negative or decelerating organic revenue growth
5. Persistently widening gap between GAAP and non-GAAP EPS

In this article, I discuss a new amendment to the accounting standards that seeks to reduce inconsistencies and improve standardization of revenue recognition practices.  Read more...

By Rachel Bradley
Analyst, Gradient Analytics LLC

“Trust but verify.” – Ronald Reagan

Before launching an initial public offering ("IPO"), a company must submit extensive disclosures to the Securities & Exchange Commission (SEC) on Form S-1; however, the data listed therein does not include a complete history of financial results while the firm was private. In fact, as a result of the JOBS Act emerging growth companies may now elect to include fewer years of financial history than was previously required.

In an attempt to provide a more comprehensive view of recent IPOs, our analysts perform a deep-dive review of the firm’s prospectus and accounting practices, and compare the firm’s financial data to its close peers to gain a better grasp of the quality and sustainability of its reported earnings.    Read more