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A recent survey of 169 chief financial officers at publicly-traded companies in the U.S. reveals an interesting finding: 20 per cent of the publicly-traded companies that are required by law to report earnings results on a quarterly basis are probably fudging the numbers, and almost every single one of the CFOs surveyed agrees this is the case.Business professors Ilia Dichev and Shiva Rajgopal at Emory and John Graham at Duke published a paper detailing their findings. Here are a few bullets from the introduction:
- “CFOs estimate that in any given period, roughly 20% of firms misrepresent their economic performance by managing earnings.”
- “For such firms, the typical misrepresentation is about 10% of reported EPS.”
- “A large majority of CFOs feel that earnings misrepresentation occurs most often in an attempt to influence stock price, because of outside and inside pressure to hit earnings benchmarks, and to avoid adverse compensation and career consequences for senior executives.”
In addition to conducting the survey, the researchers also sat down for one-on-one interviews with 12 CFOs. These conversations were particularly illuminating regarding how the process of “managing earnings” works:
One interviewed CFO opined “I would say on average 10-15% of earnings are managed through various accruals, reserves, fair value assumptions.” Another shares the following comment about the magnitude and process of earnings management: “we were going to get a $1.50 EPS number and you could report anywhere from a $1.45 to a $1.55, and so you sit around and have the discussion saying well, where do we want the number to be within that range? We talk about estimates: do we recognise this in this quarter? Is there some liability that can be triggered that hasn’t been triggered yet or has it really been triggered yet? Do we really have enough information to write this down? All of those kind of things but mainly involving some sort of estimate and also a question of something where we had discretion of the time period in which we recognised the gain or the loss.”
And here, according to the survey, is why companies are misrepresenting earnings:
The researchers also asked CFOs how one could detect a situation in which a company is misrepresenting earnings. The answer is it’s tough – even for Wall Street analysts whose sole job it is to stay on top of this stuff.
Check out what one CFO had to say about fooling Wall Street analysts with inaccurate earnings announcements:
Another CFO points out “I think when people are dishonest it is very hard for an analyst with just public information to tell, at least in the short-term. Eventually absence of cash flows always catches up with you. By doing comparisons and some detective work, an analyst can start to smell that something is not right, but unless it’s very egregious behaviour, it usually takes a long time before they can have a conclusive argument that earnings are managed.”
However, there are “red flags” that one should be aware of. Here are the top 5 things CFOs who were surveyed said to watch out for:
- “GAAP earnings do not correlate with cash flows from operations; Weak cash flows; Earnings and cash flows from operations move in different direction for 6-8 quarters; Earnings strength with deteriorating cash flow”
- “Deviations from industry (or economy, peers’) norms/experience (cash cycle, volatility, average profitability, revenue growth, audit fees, growth of investments, asset impairment, A/P, level of disclosure)”
- “Lots of accruals; Large changes in accruals; Jump in accruals/Sudden changes in reserves; Insufficient explanation of such changes; Significant increase in capitalised expenditures; Changes in asset accruals, High accrued liabilities”
- “Too smooth/too consistent of an earnings progression (relative to economy, market); Earnings and earnings growth are too consistent (irrespective of economic cycle and industry experience); Smooth earnings in a volatile industry”
- “Large/frequent one-time or special items (restructuring charges, write-downs, unusual or complex transactions, Gains/Losses on asset sales)”
The researchers note in the paper that CFOs they interviewed also stressed the human element when it comes to detecting earnings misrepresentation, including one CFO who said that “intensive fundamental analysis of the backgrounds of the top people running the company” should be conducted alongside any fundamental analysis of the stocks in question.
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