How Accurate are Corporate Earnings Reports?
Author: Tim McPoland
Researchers from Duke University and Emory University recently released surprising results of their study on the prevalence of corporate earnings “management.” As described in the report, “Earnings Quality: Evidence from the Field,” the researchers surveyed 169 CFOs of public companies and conducted in-depth interviews of 12 CFOs and two setters of accounting standards. Their report provides valuable insight into earnings manipulations that potentially could affect damages calculations and other legal matters.
Signs of quality
The report explains what constitutes high-quality earnings. According to the surveyed CFOs, a company’s earnings are “high quality” when they’re sustainable and backed by actual cash flows. Other, more-specific characteristics of quality include consistent reporting choices over time and avoidance of long-term estimates.
The study’s researchers indicate that this view of earnings quality is consistent with a valuation perspective because a company’s value is assessed by estimating and discounting the stream of future profits. Thus, current earnings should be considered high quality if they serve as a reliable guide to a company’s long-term profits.
What’s wrong with management?
For its part, earnings management is defined as manipulation that misrepresents performance but nonetheless falls within Generally Accepted Accounting Principles (GAAP). The CFOs estimated that, in any given period, roughly 20% of companies manage earnings, and that the typical misrepresentation was about 10% of reported earnings per share.
The study’s subjects believe that 60% of earnings management increases income, while 40% decreases income. While the latter figure may sound counterintuitive, the researchers attribute it to accounting practices such as “cookie jar reserves,” whereby, for example, a company records a discretionary expense in a period with high profits because it can afford to take the income hit.
“Big baths” is another accounting practice that could explain the 40% decrease. In that scenario, a company manipulates its income statement to make weak results appear even worse by, for example, shifting profits from a bad year forward to artificially enhance the following year’s earnings. Such manipulation produces a performance bonus.
Watch for red flags
Researchers asked the participants to list three red flags that would help detect earnings misrepresentations. The most commonly cited were:
- Earnings inconsistent with cash flows. More than 100 CFOs identified this or the similar “weak cash flows” and “earnings strength with deteriorating cash flows” as warning signs. The authors noted that the importance of the link between earnings and underlying cash flows was prominent throughout the study.
- Deviation from norms. Deviations from industry norms or experience registered 88 responses. Specific examples include disparity in financial statement items such as cash cycle, average profitability, revenue and investment growth, and asset impairments.
- Unusual accruals. Another red flag is “lots of accruals or unusual behavior in accruals,” including large jumps. The CFOs emphasized changes in accruals, as opposed to extreme levels of accruals.
With reported earnings playing a critical role in a variety of legal matters — from damages calculations to transaction prices — your clients can’t afford to take them at face value. A qualified financial expert can help detect managed earnings that misrepresent performance.
If you have any questions about reported earnings or any other forensic accounting issue, give us a call at 716.847.2651, or you may contact us here.