Quality of Earnings

by Thornton L. O'glove

An indispensable guide to determining how much money a company is really making and for buying and selling stocks without making costly blunders.

Genres: Finance, Business, Accounting, Economics, Nonfiction, Money, Personal Finance

224 pages, Paperback

First published April 27, 1987

Reviews

[Zhou Fang · Rating 2 out of 5]

This book is an interesting relic from 1987, and has a lot of useful concepts and tips. The main idea of this book is to do your own homework, read the primary documents, and look carefully at the financial statements. Focusing on a single number like EPS is likely to obscure many things going on under the surface. All of these principles are useful for any investor. However, the book suffers from a few problems: 1) It's a fairly dry read and much of the book involves writing out calculations. 2) The book is too advanced for the novice and too surface-level for the practitioner. Many of the issues in the book have been rectified by standardized reporting of the cash flow statement, and investor focus on operating earnings/free cash flow. Notably, this is likely because Thorton L. O'glove's ideas have been very influential. But the adjusted earnings that many companies report today suffer from the opposite problem: companies try to paint a picture of what "normalized adjusted earnings" are when there really is no such thing for businesses who will inevitably face hiccups from time to time. 3) To the extent that some of the concepts are helpful, they're diminished by the author's focus on short-term year-over-year comparisons vs. "Street expectations." The book would benefit from some overall contextualization of the goal: to find how much free cash the business can actually generate.

A few of the key concepts in the book:
1. Don't trust Wall Street analysts, and don't trust your auditor. Both have conflicting incentives (street analysts want to be liked by management, auditors get paid by the Company who they audit who also presents cross-selling business opportunities). Ultimately you have to look at and interpret financial statements for yourself.
2. It can be useful to compare the management tone in annual shareholder letters against what the 10-K SEC disclosures actually say. If management is excessively positive while the financials and SEC disclosures paint a different picture, you have a problem. Differential disclosure is also a sign of trouble, where management says one thing in the shareholder letter but discloses another in the 10-K.
3. Compare non-operating/non-recurring items from year to year and adjust accordingly so that you can get a more clear picture of the operating results of the business
4. Compare cost differences year to year to see if there are one-time costs in one year that are not in another (making the comparison easier). Also, think about cost differences such as increased advertising spending that may depress EPS in the short term but increase EPS in the long-term as dollars increase/spending decreases.
5. Watch A/R and Inventories. This is the most important part of the book. If A/R or inventories are rising faster than sales, this can be problematic. Inventory builds of finished products are especially troublesome as they signal lack of demand. This is especially problematic in businesses where inventory becomes obsolete quickly, like high tech and seasonal/fashion businesses. Inventory builds of raw materials are the opposite and likely reflect increasing production to meet demand. Decreases in inventories with increases in A/R might reflect the "hard sell," or channel stuffing.
6. Be wary of accounting changes as they can benefit EPS for years to come. For example, if useful life is increased, depreciation will be decreased for multiple years.

[InvestingByTheBooks.com · Rating 4 out of 5]

Recently, there was an article about Chinese IPOs in a Shanghai newspaper. The writer spoke to Yan Ding, head of Ceibs Research Center in Shanghai about the merits of investing in the avalanche of IPOs coming the market’s way this year. “If somebody asks me whether to invest in an IPO, my answer is ‘Yes’! If they should read the prospectus? ‘No’! If they should borrow money? ‘Yes’!” Feeling somewhat dizzy and rudderless, now seemed like a particularly good point in time to re-read Thornton O’glove’s classic Quality of Earnings, built on his ground- breaking monthly report with the same name first published in 1971. The report was conceived during the author’s early days working as a stock- broker in the 1960s, during which time an “issue craze” swept through the market, rendering prospectus-reading irrelevant. Considering today’s +40 percent opening-day rigged China IPOs, this reviewer for one hears alarm-bells ringing. Hence, entrée of the seminal work on how diligent reading of corporate accounting does matter over time.

Quality of Earnings first and foremost deals with market inefficiencies via secrets hidden in (almost) plain sight. Accounting is said to be the language of business and some companies tell more lies than others. But who is the chicken and where is the egg? The companies? Investors? Auditors? Clients of investors? Society? Chapter 7, dealing with the differences between shareholder reporting and tax reporting is a case in point. But then of course it all circles back to the meta-debate of whether any of this matters, i.e. will it impact stock prices during the fund manager’s tenure? Hence, the derogatory naming of these matters as “academic”. Wouldn’t the more appropriate designation be as part of the time-arbitrage playbook?

One of the most important questions upon re- reading the book is the issue of aging. Quality of Earnings is likely a cornerstone in most investors’ bookshelves, albeit somewhat dusty. But this 1987- book can certainly be read with your 2014 glasses on. But obviously, some aspects of breaking new ground are lost 27 years later. Howard Schilit’s Financial Shenanigans and Financial Fine Print by Michelle Leder are more contemporary examples of successor books. The common denominator is the passion of teaching the reader the importance of forensic study of the accounting. As they say, offense wins games but defense wins championships. Doing tedious, time-consuming, mostly dead-end forensic accounting work is tough. And it won’t make you the next-play hero. But over time plain ol’ number crunching is a requirement to avoid permanent losses of capital. And the reasoning and case studies in this book will help you on that path.

The book is organized alongside order-of- complexity, common-sensical first. I found the early chapters “Don ́t Trust Your Analyst” and “Don’t Trust Your Auditor” slightly clichéd and over- simplified. Despite the overflow of events in this direction since the book’s publishing, has anything really changed? Do portfolio managers read more 10Ks and proxy statements now, skipping sell-side reports? Not likely. As the book progresses through the common snake pits in the P&L – non- recurring income, tax-reporting, working capital, debt, accounting changes etc. - complexity is turned-up a notch. The main drawback is the lack of actuality aspect in the case studies. They are certainly instructive still, but it does require a more dedicated reader. Overall, the book certainly fits in the mold of literature whose modus operandi centers on the “give a man a fish and you feed him for a day, teach him how to fish and he’ll feed himself for life”. The irony of course is that the Quality of Earnings® report, Footnoted® et al, live off of unwilling fishers.

“Because the documents were lengthy, very few [people] would take time out to read them. Accordingly, I concluded that one could obtain some edge on the market by diligently reading a prospectus from cover to cover”. I believe this to be true today as well, even though Mr. Ding and his friend Mr. Market might burst out laughing.

[Viktor Nilsson · Rating 4 out of 5]

After 36 years this book is still relevant, although things have changed quite a bit. I find the explanations very clear and the calculation exercises a good practice in doing thorough security analysis. If you want some inspiration for red flags to look for in financial statements, or if you want to get some practice in adjusting income statements, this is great material. If you want a clear guide for best practice to deal with accounting/valuation issues today, however, it is a bit outdated.

How so? Some of the advice is outdated, in the sense that best practice in security analysis today already encompasses the authors advice, or has come up with better solutions yet. Take the example of accounting for interest income, which could be very high at the then prevailing interest rates in the 80's. In the case of one company which issued stock at the beginning of the year, the proceeds of which then generated interest income for the year only to be used for repurchasing shares at the end of the year. The author goes through a cumbersome exercise of taking out these numbers as being "extraordinary income" for that year, to make the per-share earnings better reflect the operations of the business. I think it is quite common today to use EV/EBIT valuation which takes away this (and many other) problems in how P/E ratios can be skewed by non-operating items on the income statement.

Some other suggested fixes are just very hard to justify at all. For insurance companies carrying securities at cost on their balance sheet, earnings can be engineered by selling of some investments at a gain. This can be done even if the portfolio as a whole is trading at less than cost, as long as some individual holdings are trading at a premium. Once again, the author choses to classify such earnings as non-operational/non-recurring, which to me seems to substitute one problem for another. Why not replace the number in the balance sheet (cost of investments) with their market value? We could then ignore realized gains/losses from the income statement and perhaps put the total gains from investments (both realized and unrealized) into the "net financial income" section of the income statement. Again, this would prove EV/EBIT to to be more valuable than P/E.

Many issues in accounting still remain today, such as changes in depreciation method, realized profits from the sale of wholly-owned subsidiaries, changes in advertising expenses, one-time write-offs by new management, etc. Also, new issues in accounting constantly develop, since accounting is only a model of reality and models are always in a process of being refined and adjusted. So if you read this book with an open mind into the author's thinking, you might be able to find your own way of dealing with these issues. I think this is the greatness of this book. If you read something more modern, the problem is that it has already been "priced in" by the markets, so you'd be better of deriving some general principles and creating your own adjustment tools. This book does a great job of getting you there.

The subtitle's promise of finding out "how much money a company is really making" is a bit misleading. O'glove's analysis mostly focuses on adjusting income statements in one year to better compare to previous years, rather than to bring them to some absolute correct level. It is a good method for adjusting how fast a business is growing however, which is at least of as much importance, especially around inflection points.

[Edward Turner · Rating 3 out of 5]

3.5/5

A bit dated as can be expected from a book over 35 years old, though the principles and concept remain robust to this day. Chapters 7-12 had the most important takeaways and worth keeping as a reference, while the beginning chapters couldve been summarised in half the length. Key chapters: 7. Shareholder vs tax reporting, 8. A/R and inventories 9. Debt & Cash flow analysis, 11. Accounting Changes 12. Restructuring.

A/R and Inventories chapter is incredibly insightful; the knowledge of how to disect working capital movements is extremely pertinent to any equity or credit analysis of a company.

[Yanis Giavridis · Rating 4 out of 5]

Especially the parts where tangible examples are provided (most chapters of the book) are quite valuable. Despite the use of lots of numbers things are still kept relatively reader friendly compared to other investment books. Would recommend

[Henry · Rating 5 out of 5]

- Accounting is so nuanced, never use a single number measure (such as EPS) to measure different companies (even companies within same industry). For instance, an oil company uses Successful Effort accounting would have a wildly different result than a company that uses Full Cost accounting (even if their end result is identical)

- Shareholder letters could accidentally give investors insights into cover-ups and blunders (the author note it’s important to read them slowly and reference with statistics). The author also suggests always compare shareholder letters to past years’ shareholder letters (he believes it’d be rewarding about 10% of the time)

- “Managements often use ‘challenge’ to mean ‘trouble’.” This echos Peter Lynch's sentiment that managers by nature are up-beat type of people. While it’s probably wise to read into their strategies, one should always not take their opportunism on face value but rather degrade them to something that is more concrete

- (According to IRS #6103, a shareholder who is substantial enough owner of a company, this shareholder can request to see the company’s IRS return)

- The author suggest readers to compute their own company’s IRS return by looking at their tax accounting depreciation as well as income taxes paid

- Pay close attention to other metrics that might cloud what a company’s true earning is (sometimes for the better). The author noted that GE for many years used GECC as a “federal tax-refund cow”. GECC as the credit arm of GE (which has since been sold off to become Synchrony and GE Capital) has a robust leasing arm, which result in a hefty depreciation in terms of tax write-offs. As a subsidiary of GE in the consolidated financial filings, GECC’s paper loss weighted GE’s earning down, resulting in tax refund (rather than taxes) as well as decreased paper earning (but in reality since depreciation is not a cash event, no decrease of actual earning occurred)

Successful Effort (SE) vs Full Cost (FC) accounting

- SE allows the company to expense (book expenses right away) failed drillings but capitalize (depreciate asset over a fixed period of time) successful drillings.

- FC on the other hand, capitalize everything regardless of successful drillings or not.

SE vs FC for Tax Purposes

- Inflationary Environment: In terms of taxes, as an owner, in a healthy inflationary environment I’d prefer to expense as much as possible (given the inflation will eat away expense the longer it is not recognized). Thus, SE should be the optimal choice.

- Deflationary Environment: In an exceptional (because it happens rarely) deflationary environment, money is worth more today than in the future, thus I’d prefer to expense as little today as possible so in the future deflation will boost my tax recognition. Thus, FC should be the optimal choice. By capitalizing cost, assuming (unlikely in real world given deflation usually don’t last a long time) deflation runs the entirety of the capitalization period, the depreciation expense towards the very end of the capitalization period will worth a lot more than the depreciation expense towards the very beginning of the capitalization period (and by capitalization, one would be at the very disadvantage of it in a deflationary environment)

- When tax reporting is much lower than actual reporting, it’s possible that the company has an aggressive revenue recognition. A rapidly growing company could also see a divergence between tax reporting and revenue recognition. Careful discretion is required

- (If a single company accounts for 10% or more of a company’s revenue, a company must disclose that under 10-K item 101 per SEC regulation)

- (Auditors are required to mention if a company changes its revenue method, thus reading auditor report is also important)

- Look carefully at the trend of sales, accounts receivable (companies often book revenue when the item is shipped) and inventories (rising inventories is a warning sign of company unable to offload goods). Companies often shift inventories to receivable just to book sales (in the case of Sunbeam, they didn’t even bother to ship the item under the “bill-and-hold” method). Read footnotes!!!

- (Avoid sectors with rapid changes in taste, such as “high fashion, seasonal goods, and especially high tech”)

- Surge in sales yet less increase in receivable in terms of percentage implies business is booming yet money collection is sound; when receivable percentage increases more than sales, it means business is having issue collecting the fund, could due to its customer being late or it could due to (yet everything is nuanced, important to read through the footnotes and management’s discussions)

- When raw material advances faster than finished products, it implies that the company is selling at a much faster pace than it is producing. Whereas the opposite means the company is building up inventory, often due to inability to sell (obviously this should get paired up with receivables to see if the company is cooking its book or not)

- (Really, really avoid chasing the glamorous companies in fast growing sectors. This book was written several decades ago, and many of the star companies the book mentioned has now long gone defunct whereas boring companies like Coca-Cola is still around)

- Big Bath/Restructuring: GAAP requires the company to write down asset during the quarter it books the write down. Given the fact that the street prefers write-down-at-once over multiple periods of write down (which would seen as a company not having handle on things), the management has incentives to excessively write down rather than doing it conservatively. The stock tend to be overly pessimistic before the restructuring and only to rebound afterwards: pay less attention to descriptions of how things are down, rather, solely focus on the fundamentals of the company

- On the other hand, restructuring with a visionary CEO really can turn a company around (such as the case of Coca-Cola and Warren Buffett’s ability to sense the change). The market often does not react to boring company with a visionary CEO at first

- “Sum are worth less than parts”, conglomerates are almost always worth less than individual pieces. Thus when a company is too big and is willing to sell off its subsidiaries that have no synergies between each other, the company post restructuring will worth more than before

[Zhong Sheng · Rating 3 out of 5]

author slightly over-confident and a few examples are over-interpreted a bit too much to lead to a strong conclusion. But it is thought provoking and content rich book.

[Daniel Ottenwalder · Rating 4 out of 5]

Key Lessons from Quality of Earnings

1. Don’t Trust the Surface
• Analysts often have conflicts of interest (access to management, investment banking fees, herd mentality). Their job is attention, not truth.
• Auditors aren’t flawless either—hypercompetitive industry, pressured by clients. They ensure accounting rules are followed but don’t guarantee truth.
• Always do your own work—don’t outsource judgment.

2. Management’s Story vs. Reality
• Shareholder letters and annual reports are marketing documents. Focus on what’s in the footnotes, filings, and cash flow statements.
• Honest management doesn’t equal a good investment—many still spin a narrative (“beauty contest”).
• Always ask: Is this narrative true, or just persuasive?

3. Disclosures Hide the Truth
• Look for differential disclosure (inconsistent numbers between PR, MD&A, and 10-K).
• Read everything—what’s omitted is as telling as what’s included. The “smoking gun” is often buried in the footnotes.

4. Non-Recurring & Non-Operating Income
• Watch for “one-time” or “special” items.
• Companies use discretion to manage earnings—classifying expenses/income in ways that distort reality.
• Always strip away non-core items to see true profitability.

5. Rising Expenses & Margins
• Track expenses (esp. SG&A, R&D) as a % of sales.
• Identify whether increases are investment (good) or waste (bad).
• Compare per-share figures to bottom line.

6. Tax & Shareholder Reporting
• Differences between tax reporting and shareholder reporting can hide manipulation.
• Example: GE using GECC losses to reduce tax obligations but not consolidating in shareholder reporting.
• EPS is easily distorted—dig into cash flow vs. earnings.

7. Working Capital & AR
• Accounts receivable turnover and DSO (Days Sales Outstanding) show whether customers are paying reliably.
• Excess receivables = bad credit terms or weak collection.
• Inventory analysis:
• Excess finished goods = slowdown ahead.
• Raw materials piling = potential overproduction.
• If inventory grows faster than sales, red flag.

8. Debt & Cash Flow
• Debt isn’t inherently bad—but it magnifies outcomes.
• Key metrics: Debt-to-equity ratio, Interest coverage (Operating Income ÷ Interest Expense).
• Always test whether operating cash flow can cover obligations.

9. Dividends & Buybacks
• Dividends can be inefficient if they force poor capital allocation.
• Buybacks are often superior—but only when done below intrinsic value.
• Beware of companies selling assets or borrowing just to pay dividends.

10. Accounting Choices Matter
• EPS is subject to accounting discretion: FIFO vs. LIFO, depreciation method, expensing vs. capitalizing R&D, pension assumptions.
• Changes in accounting policy signal earnings management.
• Always read footnotes for shifts year-to-year.

11. Big Baths & Restructuring
• “Coming clean” after a big bath (one-time restructuring, write-offs) can be a signal of reset.
• Management incentives may drive overstatement of losses to set up future earnings growth.
• Track whether the business really improves afterward.

12. Small Investor Advantage
• Institutions move slowly, small investors can act faster.
• Your edge: carefully reading filings, footnotes, and disclosures.
• Intelligent investing comes from skepticism + independent analysis, not following headlines.

⸻

Overall takeaway:
Earnings quality is about digging beneath the numbers—separating sustainable cash generation from accounting noise, management spin, and market hype. The key is skepticism, attention to footnotes, and relentless focus on cash flow over reported EPS.

[Zayed · Rating 4 out of 5]

This book teaches us about the information investors commonly overlook when analysing the financial performance of a company. It teaches us about the important sections of financial statements and annual reports that are commonly overlooked and deserve special analysis.

Though some of the information is dated, it also offers many timeless principles about investing. The writer mainly uses practical examples of accounting gimmicks used by companies to inflate their share earnings, and how to avoid pitfalls by investing in these companies. It also offers examples of opportunities where an investor can profit from underestimated share earnings.

This book is especially relevant to serious investors in current times when stock prices are inflated, and decisions to invest must be carefully considered. This book can be recommended to those who are already familiar with accounting concepts and wish to broaden their knowledge.

[Eduard · Rating 3 out of 5]

Thornton O’Glove’s Quality of Earnings remains a sharp, concise guide for spotting red flags in financial statements. Despite being nearly 40 years old, its core message—that reported earnings can mislead without context or scrutiny—remains highly relevant, especially in an era of adjusted EBITDA and non-GAAP metrics. The book offers timeless lessons on reading footnotes, analyzing inventory practices, and questioning management incentives.

However, some examples and accounting practices feel dated, and the book lacks discussion of modern financial engineering tools, such as stock-based compensation, fair value adjustments, and today’s complex capital structures. Still, for any investor or credit analyst, it’s a worthwhile refresher on how to think independently about reported numbers—a skill that doesn’t age.

[Chris Gilbert · Rating 4 out of 5]

In the world of stocks, people generally prefer illusion to reality. Thornton makes a compelling case based on incentives as to why you should never trust an analyst and never trust an auditor, instead learn to do the work yourself. Through 12 chapters of dense, witty, example-laden text, Thornton captures several of the key ways corporations conceal the real earnings of their companies

Favorite Chapters
- Non operating / Non recurring income: Can't describe it with precision, but I know it when I see it
- Increasing and decreasing expenses: SG&A cuts both ways
- Shareholder vs Tax Books: A good accountant knows income is whatever you want it to be
- Accounts Receivable & Inventory: Spotting smokeless smokestacks

[Alexander Karlsson · Rating 3 out of 5]

The book itself has a very interesting subject that I as an investor really wanted to dig deeper in to. I bought the book in hope of getting insights in how I could really be, so to say, a financial report maniac.

Yes I got a lot of tips but to be honest, the most of the books are a lot of the same. How to adjust posts for non-recurring posts and see the underlying performance. Of course he gives a lot of examples and yes, theres a lot of small things I’ve never thought of before but I must say that I am not so sure it makes the biggest difference to your estimation. As long as you adjust for the big posts, that’s gets mentioned in the companies reports, you should be fine. Kind of boring written too unfortunately.

[Skywalker Hu · Rating 5 out of 5]

This is a must-read for aspiring money managers, stock analysts, and any layman who wants to seriously participate in the long-term investing game. Depending on your investment time horizon, a great short candidate was once the star stock of Wall Street, only exposed later by fundamental short sellers and skeptics. Nonetheless, IMHO, this book is simply gold. I will next delve into Bernstein’s Financial Statement Analysis.
By the way, I really enjoy all those dry, technical contents of this book. If this is not your cup of tea, drink elsewhere.

[Adham Gasser · Rating 4 out of 5]

A very good read on how to review financial statements and read what’s behind the numbers. The author gives plenty of examples clearly showing traps and minefields in management letters, EPS results, and balance sheet representation. Concludes that the individual investor can beat Wallstreet large investors by investing time in analyzing financial statements and evaluating fundamentals. Quality of books and quality of earnings matter on the long term.

[Pterotaktyl · Rating 4 out of 5]

It is an "ok book". One can learn a bit about what to focus on when reading financial reports.
In my opinion, it was a bit random and just scratched the surface.
If you know something about accounting, you might find the most information in the book redundant, but still there might be one or two new facts. Hence, the book is worth reading.
Maybe the most important thing to mention: the author seems to be rather short-term focus and sometimes seems to miss the forest for the trees.

[Paulo Cardoso · Rating 5 out of 5]

Bill Ackman recommends this book as a batch of books to reach if you plan to start investing. It explain the multiples ways that financial statements show potential traps in future growth of companies and cases where growth will happen.
From tax accounting to dividends there about everything here.

Requires user to know some financial concepts for a better understanding.

[Andrew · Rating 4 out of 5]

Excellent guide to reading in between the lines and seeing through common accounting tactics public companies use to dress up earnings. Replete with case studies and examples. Four stars because it was a bit dry—not sure many people care for the painstaking walk-through of various forms of depreciation & amortization. But maybe some "accounting alpha" for those who care to find it.

[Divyanshu · Rating 4 out of 5]

Book covers all the aspects related to earnings which are not in general i.e. not related to general operations of the company, a must read for retailers who are somehow or other get intangle in stock just for showing earnings growth. The books just not deal with theory, but it explains with many case studies.

[Dennis Ooi · Rating 4 out of 5]

Thornton was very thorough with his examples, though it was rather dense at times due to the amount of words used to explain changes for instance. Nonetheless, good read with a lot of empirical evidence provided as credible sources.

[Jared · Rating 4 out of 5]

Principles of analysis remain as valuable today as when this text was written. However, the dramatic change in tax treatment of corporate earnings (especially for multinationals) does render the text more useful as a guide than as a direct copy-paste into your analytical toolkit.

[Reader · Rating 5 out of 5]

You shall be blessed by it. Can't think of a better way to put it. Thanks to Thornton for generously sharing his lifetime work. A genius in his own rights.Bringing to your attention various internal dynamics of a company.

[Julian · Rating 4 out of 5]

I really liked this book, as it gives valuable insights on what to look for in financial statements. Even though the examples discussed are already from 40 years ago, most of them are still relevant today.
It is important to note, that much of what is described in this book is short-term focused.

[Nick · Rating 4 out of 5]

Very dry, but practical and eye opening

[Max Lapin · Rating 5 out of 5]

Truly amazing classical book on accounting gimmicks. You won’t believe but it is thrilling and flows as a good detective book. Thumbs up.

[Alessandro Orlandi · Rating 3 out of 5]

Interesting insights on what to look to. Nothing major. A little bit difficult to read though.

[Shlomo Bergmann · Rating 4 out of 5]

The simplicity on how he provides ideas and examples is really amazing. Another book that I will need to review to reap its true ideas and rewards.

[Maciej Foremski · Rating 4 out of 5]

A difficult book, but worth reading. Especially for short-term investors.

[Alexander Han · Rating 3 out of 5]

Would have been a fantastic book back in the day (1980s), but a lot of the concepts are outdated now, putting too much emphasis on PE ratios

[Kiril · Rating 4 out of 5]

Informative but very dry reading

[Michael Lim · Rating 2 out of 5]

Adequate handbook for novice investors looking to learn how to inspect financial statements