Wednesday, August 27, 2014

Corporate Managed Earnings - Don't Believe Everything That You Read

Updated April 2015

A paper by Ilia Dichev, John Graham, Campbell R. Harvey and Shiva Rajgopal entitled "Earnings Quality: Evidence from the Field" provides investors with some interesting insights into the quality of earnings statements from publicly traded companies.  Given that we always seem to be in the middle of one earnings reporting cycle or another, this study shows us that we can't always believe what we read.

Earnings statements form the heart of internal data used by most savvy investors to pick and choose their equity investment portfolio.  Since most of us invest in companies (and sectors) that we have no internal knowledge about, we rely heavily on the honesty of Chief Financial Officers and their fellow executives; we assume that because the data they release to the public has been verified by accountants, that it is trustworthy.

The authors of the report surveyed 169 CFOs and had in-depth interviews with 12 CFOs.  The authors selected CFOs rather than CEOs or other senior executives because CFOs are the direct producers of earning data and they "intimately know and potentially cater to consumers of earnings information such as investment managers and analysts."  CFOs usually have formal training in accounting which allows them to determine the quality of their own earnings statements.

The authors found the following:

1.) CFOs believe that quality earnings are sustainable and repeatable.  This viewpoint is consistent with the view taken by investors who believe that a given firm is a long-lived profit-generating entity and that corporate value is based on estimating and discounting a long stream of future profits.

2.) CFOs believe that reporting discretion has declined over time and that current GAAP (Generally Accepted Accounting Principles) standards are a constraint in reporting high quality earnings.  CFOs would like to see standard setters issue fewer rules and take the viewpoint that financial reporting has become a compliance activity rather than a means to innovate to deliver the best possible information to stakeholders, in other words, to be self-policing and self-determining.

To me, this is the most interesting find:

3.) CFOs estimate that in any given reporting period, roughly 20 percent of firms manage earnings and that the typical misrepresentation for such firms is about 10 percent of reported earnings per share.  They believe that 58.8 percent of earnings management is "income-increasing" and 41.2 percent is"income-decreasing" also known as cookie jar reserving or cookie jar accounting.  The cookie jar method of accounting is used during periods of good financial results to shore up profits in poorer performing years, giving investors a misleading impression that a company has a never-ending stream of increasing earnings.   CFOs of private firms believe that the proportion of private firms managing earnings is 30.4 percent compared to 18.4 percent for public firms.   This is often done using one-time charges and other special accounting items.  CFOs feel that earnings misrepresentation takes place for three main reasons:

1.) In an attempt to influence stock price.

2.) Because of internal pressures to meet or exceed earnings projections.

3.) Because of external pressures to meet or exceed earnings projections. 

Most CFOs that were interviewed agreed that there was "unrelenting pressure from Wall Street to avoid surprises" because "you will always be penalized if there is any kind of surprise.". 

As well, and even more importantly from their perspective, CFOs believe that by managing earnings, companies are able to avoid negative compensation and career consequences for the senior executive team.  This follows from the fact that many corporations now hinge their executive compensation, particularly stock- and bonus-based compensation, on meeting some arbitrary earnings threshold.  CFOs believe that the odds of getting caught managing earnings are relatively low because most outsiders (i.e. investors) would not be able to detect earnings adjustments.

Here is a summary table showing how CFOs perceive the rationale behind managed earnings:

For those of us that are small investors, here is an interesting look at what red flags CFOs believe will provide investors with a clue that a given company is managing its earnings:

1.) Earnings are inconsistent with cash flows:  For example, earnings grow continuously but cash flow deteriorates for a number of quarters.

2.) Deviation from industry or peer norms: For example, a given company sees its earnings grow continuously while its peers see their earnings contract.

3.) Consistently meeting or beating earnings projections.

4.) Frequent one-time or special items on a balance sheet.

5.) Earnings patterns that are very smooth when compared to the fundamentals for the industry.

6.) High turnover rate among the company's executive team.

7.) Using non-GAAP measures to make results appear better than they may be.

Here is a chart that shows all of the red flags that may indicate earnings management: 

With this study in mind, looking at the endless quarterly crop of earnings announcements should cause us to wonder which companies are among the 20 percent that deliberately misrepresent their earnings to influence their share price and provide tangible benefits to those who dwell on the executive floors.  Unfortunately, as millions of investors in some of North America's largest companies like Enron, Worldcom and Nortel found out, you should believe only a fraction of what you hear from the corporate world when it comes to earnings.

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