The results of a survey conducted among nearly 400 CFOs, targeting the definition of drivers of earnings quality with a special emphasis on the prevalence and direction of earnings misrepresentation, are revealing and disturbing.
Broc Romanek, editor of the CorporateCounsel.net newsletter, highlights the findings that in any given year, CFOs believe that 20% of companies misrepresent their earnings intentionally by using discretion within GAAP (generally accepted accounting principles). The degree of the typical misrepresentation, according to the survey, is quite a substantial figure, averaging about 10% of reported earnings.
The objective of most of the misrepresentation is to overstate earnings, but equally concerning is that fully one third of misrepresentation is to deliberately understate earnings. The main consequences of the misrepresentation are investor confusion and a lack of trust which in turn can lead to stock price increases and a higher cost of capital.
The survey results should not be quite that surprising taking into account that many companies actually hire finance and accounting executives who have a willingness to manipulate earnings numbers. In an earlier report, Ling Harris, Scott Jackson and Joel Owens - from the accounting faculty at the University South Carolina’s Darden School of Business - conclude: Individuals who ascend to power and authority in corporate accounting are predisposed by their personality and values to manage earnings and they are hired and promoted precisely for that reason.
The researchers quoted above, define earnings management as when senior accounting managers alter estimates and judgments to achieve a particular level of earnings or other desired financial results. In a nutshell, this means that the company’s financial statements are not an accurate reflection of the actual economic performance.
As early as 1998, in a speech entitled “The Numbers Game” delivered by then chairman of the SEC, Arthur Levitt, he warned about the intense pressure on companies and their executives to meet earnings estimates. Not much has changed since then as investors still severely punish companies that have not met analyst forecasts, very often needlessly reducing the value of the company stock.
The survey report includes a number of danger signals that warn of misrepresentation which analysts and investors can apply to identify manipulated earnings. The absence of a correlation between earnings and cash flows tops the list, followed by unexplained deviations from industry or other peer norms. Excessive accruals and one time charges should be watched for, while results consistently beating analyst forecasts are very often another sign that the numbers have been fudged.