Earnings Quality Score

THE CORE IDEA, and it is one of the better-established results in accounting research. Net income is produced under accrual accounting: revenue is recognised when earned rather than when cash arrives, and costs are matched to it. That is the right basis for measuring a period's economics, and it also leaves room for judgement - on revenue recognition timing, provisions, capitalisation and depreciation. So the relationship between the ACCRUAL component of earnings and the CASH-FLOW component is the diagnostic.

SLOAN (1996) is the academic anchor. Sloan decomposed earnings into an accrual component and a cash-flow component, ranked firms by accruals (scaled by average total assets), and found the accrual component was LESS PERSISTENT than the cash-flow component: firms with relatively high accruals subsequently earned negative abnormal returns and low-accrual firms positive ones. That is the accrual anomaly, and it says the market appeared to weight the two components as if they were equally durable when they were not.

HOW HARD IS CASH TO SHAPE? Less easily than accruals, but it is NOT manipulation-proof, and overstating this is a common teaching error. Operating and free cash flow are affected by the timing of payables and receivables, receivables factoring, supplier-finance arrangements, classification choices between operating and investing, and the timing of capital expenditure. Note also that the Sloan decomposition compares earnings against OPERATING cash flow; free cash flow - commonly operating cash flow less capital expenditure - is a different measure with its own definitional variation.

EARNINGS SURPRISE is usually reported EPS minus consensus EPS for the same period and accounting basis, sometimes expressed as a percentage. What is consensus? A vendor-defined mean or median of the estimates that vendor chooses to include, governed by its own contributor, staleness and exclusion rules. So 'beating expectations' measures performance against a constructed, revisable, methodology-dependent benchmark rather than against the business - and comparing a surprise computed on one vendor's basis against another's is not valid.

A LIMIT THAT SHAPES THE OUTPUT. How CONSISTENTLY a business beats expectations, and whether a beat is a ONE-OFF or part of a pattern, are temporal properties that can only be established across several periods. This analysis reads only THE LATEST reported surprise, beside trailing net margin and free cash flow, so it measures no consistency and cannot tell a one-off beat from a pattern. It does not compare free cash flow with net income, so it does not measure accruals either. Its score is built from those inputs, up to three of them, and the inputs say more than the label.