canonical/modules/M021-earnings-quality-framework.md

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<!-- Module: 021 | Title: Earnings Quality Framework -->

## PART V - FORENSIC ACCOUNTING | MODULE 021

# Earnings Quality Framework

> Mission. Score how much reported profit is supported by cash generation, repeatable economics, and conservative accounting.

## Decision output

Objective: Score how much reported profit is supported by cash generation, repeatable economics, and conservative accounting. The completed work product must be reproducible from evidence, show the downstream financial or decision effect when material, state the strongest contrary case, and define a dated update rule.

## Explicit operating procedure

1. Start with multi-year cash generation and balance-sheet change, then evaluate whether reported earnings are supported by repeatable customer economics and conservative recognition.

1. Decompose earnings into recurring operating profit, cyclical/mix effects, working-capital timing, accounting estimates, non-operating items, tax effects, and genuinely unusual events.

1. Compare net income, EBIT, EBITDA, CFO, and FCF over a full cycle while reconciling capex, SBC, acquisitions, restructuring, and financing-like working-capital actions.

1. Score revenue quality, margin quality, cash conversion, balance-sheet quality, estimate sensitivity, and disclosure consistency separately rather than collapsing everything into one ratio.

1. Use peer and historical baselines to distinguish business-model-normal accruals from deterioration.

1. Translate quality concerns into normalized earnings/cash flow and valuation rather than using a qualitative red flag with no financial consequence.

## Required evidence and model bridge

- Primary-source set: multi-year statements, auditor reports, non-GAAP reconciliations, reserve disclosures, filing changes. Preserve exact document/version, date, period, and source location for every material factual input used in earnings quality framework.

- For each key concept - cash support, accruals, working capital, capitalization, non-GAAP, reserves - state whether it is a reported fact, analyst calculation, management claim, external estimate, or judgment. Quantitative concepts must retain raw components and units; qualitative concepts must retain the specific evidence and counterevidence.

- Map only economically relevant findings into the model or decision record. Process-control modules such as earnings quality framework may have no direct valuation line; in that case document the downstream error or governance risk the control prevents.

## Metrics and calculation controls

| Metric / concept | Construction | Required validation |
| --- | --- | --- |
| CFO/net income | Cash conversion = cash flow from operations / net income, interpreted over multiple years | CFO/net income: Recalculate CFO/net income from cited inputs; reconcile definition, period, units, signs, and source version; investigate and document any variance before use. |
| FCF conversion | Free cash flow divided by the relevant earnings base, typically net income, EBIT, or EBITDA; define consistently and reconcile every adjustment. | FCF conversion: Tie the dollar measure to filed statements/footnotes; reconcile classification adjustments, one-time items, acquisitions/FX, and period consistency before using it analytically. |
| accrual ratio | Total accruals proxy = net income - cash flow from operations; scale consistently, commonly by average assets | accrual ratio: Recalculate accrual ratio from cited inputs; reconcile definition, period, units, signs, and source version; investigate and document any variance before use. |



## Worked application

> Case: adjusted EBITDA rises while CFO is flat and capitalized costs accelerate.

- Reconstruct the relevant reported fact from primary evidence before interpreting the case. For earnings quality framework, show the raw components rather than only the resulting ratio or narrative.

- Build the causal chain through cash support, accruals, working capital, capitalization, then identify which link is directly observed and which link remains an assumption.

- Calculate CFO/net income, FCF conversion, accrual ratio from sourced components under the reported/base interpretation and at least one skeptical alternative interpretation.

- Translate the difference between cases into the variable that matters for earnings quality framework: evidence quality, revenue, operating profit/NOPAT, free cash flow, invested capital, financing/dilution, risk, or valuation. Mark non-applicable links instead of inventing them.

- Expert consistency test: score quality over a multi-year cycle and convert concerns into normalized cash flow.

- Precommit the specific future filing, KPI, customer/supplier observation, regulator action, or market input that would materially invalidate the earnings quality framework conclusion.

## Failure tests

- FAIL if cash support cannot be defined and reproduced from the source pack.

- FAIL if the quality conclusion relies on headline earnings without multi-year cash conversion, accruals, balance-sheet growth, recurring adjustments, and accounting-estimate review.

- FAIL if the earnings quality framework conclusion depends on an unstated assumption, unreconciled definition, or evidence that cannot be traced to its source/version.

- FAIL if evidence materially inconsistent with the earnings quality framework conclusion is omitted, reclassified, or dismissed without a documented definition, materiality, causal, timing, and source-quality analysis.

## Completion test

A senior reviewer must be able to reproduce the earnings quality framework conclusion, vary the most sensitive assumption independently, trace the change through the model, understand the strongest opposing case, and identify the next evidence that would force an update. If any link is missing, the module remains open.