CFOs Identify 11 Red Flags In An Earnings Announcement

red flag madrid spain may

Photo: Wikimedia Commons

A recent study by business professors Ilia Dichev and Shiva Rajgopal at Emory and John Graham at Duke revealed that 20 per cent of publicly-traded companies are regularly lying about earnings results in quarterly announcements.The researchers surveyed 169 chief financial officers at publicly-traded companies in the United States and did longer interviews with 12 of them. One of the questions they asked the executives was how investors can detect whether or not companies are lying about their earnings results.

The CFOs offered several red flags investors should watch out for when analysing quarterly results.

#11: Lots of earnings volatility

15 per cent of CFOs said to watch this.

The executives surveyed said to watch out for 'large volatility (wide swings) in earnings, especially without real change in business.' Normally, fundamentals should drive earnings, and if they are clearly not lining up over and over, that's a bad sign.

Source: Dichev, Graham and Rajgopal (2012)

#10: Receivables piling up

15 per cent of CFOs said to watch this.

Receivables are payments owed to companies, and an unusual build in receivables could be a sign that companies are recognising revenues that should be assigned to later quarters or that customer cash payments are coming in more slower than normal.

Source: Dichev, Graham and Rajgopal (2012)

#9: Reporting using non-GAAP accounting metrics

15 per cent of CFOs said to watch this.

GAAP stands for 'generally accepted accounting principles' and is the set of rules that governs financial reporting in the U.S. The rules are meant to provide some consistency across different companies' financial statements. Using non-GAAP metrics is one way companies try to paint a different picture with regard to their earnings results.

Source: Dichev, Graham and Rajgopal (2012)

#8: Sudden and/or frequent personnel changes in management

15 per cent of CFOs said to watch this.

Executives interviewed by the researchers stressed the importance of the people behind the numbers. One said, 'I would start with the top management or senior executives. That sets the tone or culture which your internal accounting function will operate under.

#7: Inventories piling up

15 per cent of CFOs said to watch this.

Greater inventory levels mean a lower cost of goods sold in one period relative to the next period, which means that overstated inventories lead to overstated profits. This provides an incentive for managers to overstate inventories if they are struggling to hit earnings targets.

Source: Dichev, Graham and Rajgopal (2012)

#6: Always beating analysts' earnings targets

27 per cent of CFOs said to watch this.

A company that is always posting earnings results above analysts' estimates should be an obvious signal that earnings are being manipulated, especially because 93 per cent of the executives surveyed said companies lie about earnings 'because there is outside pressure to hit earnings benchmarks.'

Source: Dichev, Graham and Rajgopal (2012)

#5: Lots of write-offs

34 per cent of CFOs said to watch this.

You hear a lot of companies reporting 'adjusted earnings,' which don't take into account special one-time items that affect financial statements. Large or frequent write-offs, write-downs, restructuring charges, or complex transactions should be a warning.

Source: Dichev, Graham and Rajgopal (2012)

#4: Too much earnings consistency in volatile markets

36 per cent of CFOs said to watch this.

It can be tough for companies to hit consistent targets quarter after quarter, especially in a volatile market. That alone is enough of a reason for several of the executives surveyed to bring it up.

Source: Dichev, Graham and Rajgopal (2012)

#3: Big accruals or changes in accruals

42 per cent of CFOs said to watch this.

High accruals mean a company is booking a lot of revenue before the cash actually comes in. Some traders and investors even employ a trading strategy based on the accrual anomaly -- in which they buy companies with low accruals and sell companies with high accruals -- that appears to be quite profitable.

Source: Dichev, Graham and Rajgopal (2012)

#2: Results way out of line with the rest of the industry

52 per cent of CFOs said to watch this.

Accounting metrics inconsistent with the rest of the industry were part of the Enron and WorldCom stories. Executives said to especially keep an eye on these:

  • cash cycle
  • average profitability
  • revenue and investment growth
  • asset impairments

Source: Dichev, Graham and Rajgopal (2012)

#1: Cash flows that aren't consistent with earnings

60 per cent of CFOs said to watch this.

So goes the saying, 'cash is king.' Things to watch out for, according to the executives:

  • weak cash flows in general
  • earnings strength with deteriorating cash flows
  • earnings and cash flows that move in different directions for several quarters

Source: Dichev, Graham and Rajgopal (2012)

But check out what companies are saying about the economy

NOW WATCH: Money & Markets videos

Want to read a more in-depth view on the trends influencing Australian business and the global economy? BI / Research is designed to help executives and industry leaders understand the major challenges and opportunities for industry, technology, strategy and the economy in the future. Sign up for free at research.businessinsider.com.au.