Earnings Quality: Learning from Past Cases of Corporate Misreporting and Improving Analytical Models

With the corporate earnings season heading into the home stretch, it’s an ideal opportunity to examine whether users of financial statements — investors and securities regulators — have learnt lessons from the recent misreporting by corporations and are now effectively judging the earnings quality of reporting companies.

The potential downside faced by investors when they fail to effectively assess earnings quality, including detecting earnings management, was evident during the recent episode of alleged inflated earnings by U.K. software company Autonomy prior to its acquisition by Hewlett Packard. It was eerily reminiscent of accounting scandals in the early 2000s involving several well-known corporations, including Enron, WorldCom, and Parmalat.

These scandals showed how capital misallocation occurs and the risk of subsequent losses investor face when they blindly trust reported earnings.

Straight from the Horse’s Mouth: a CFO’s Perspective on Earnings Quality

Three leading academics published a working paper in 2012 featuring results based on a survey of global CFOs on the concept of “earnings quality.” The working paper provides the perspective of a financial statement preparer, someone who ultimately reports earnings. It is worth highlighting the following feedback from one of the CFO respondents:

“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 behavior, it usually takes a long time before they can have a conclusive argument that earnings are managed.”

Several CFOs felt that sell-side analysts are not particularly good at detecting earnings management while the buy side, the bond market, and the short sellers do a better job — a stark reminder of the need for analysts, and all those who monitor company reporting, to sharpen their ability to evaluate earnings quality, including the extent to which earnings management occurs across reporting companies.

Earnings Management Is Common and Impacts on Earnings Quality

High-quality earnings should faithfully reflect underlying economic reality. Thus, instances of egregious misreporting and misapplication of accounting rules, such as the high-profile corporate failures seen in the early 2000s, illustrate the pernicious nature of earnings management.

The 2012 working paper highlighted the prevalence of earnings management via feedback from the CFO survey and interview respondents:

• Roughly 20% of firms engage in earnings management during any reporting period.
• The misrepresentation arising from earnings management affects 10% of earnings per share (EPS).

CFOs also characterized the following as “red flags,” or likely indicators of earnings management:

• Large and abnormal accruals as well as changes in accruals
• Differences in financial metrics of reporting firms when compared with other industries
• Sustained deviations of earnings from cash flow.

One CFO pointed out the following:

“Unless the firm is in a huge growth phase, I expect a significant discount in the firm’s stock price if the gap between earnings and cash flows is persistently high, because ultimately if the cash is not being generated, then the earnings are artificial or are not a good indicator of value creation.”

The paper further pinpoints that earnings management is rife through acquisition accounting. One respondent noted the following:

“Acquisition accounting would be the biggest area where I’ve seen some CFOs taking advantage. I have seen acquisitions used to establish numerous balance sheet items and those provide huge opportunities in the future to manage the P&L. They would set up provisions that are always worth more than they were set up for. I’ve watched numerous managements earn big incentives by being able to manage a balance sheet accrual. They are set up at the time of the acquisition, they include everything from integration to many different things that you assume, but they’re an estimate at that point in time. When the future happens then you take charges against that and in reality it was an estimate so it’s going to be (imprecise) but whenever I have seen this it was always less than what got set up, so it got released into favorable earnings. These accrual reversals did impact the earnings and sometimes for a period of time, two-three years because they were big acquisitions.”

Clearly, there are a myriad of accounting techniques and approaches that can make it easy for preparers to pull the wool over the eyes of investors through financial reporting information.

Shortcomings of Existing Earnings Quality Analytical Approaches

The challenge for investors is exacerbated because the required indirect cash flow statement does not sufficiently disaggregate the cash flow from operations in a manner that allows investors to monitor the link between cash flow from key components of operating earnings versus the accruals-based operating earnings. For example: monitoring cash collections from revenue versus actually recognized revenues.

While there are several academic methods designed to detect earnings management (e.g., the modified Jones method), it is challenging to conclusively determine whether any large, or seemingly abnormal, levels of accruals are always necessarily synonymous with earnings management practices. There can be legitimate reasons for companies to have large accruals. Therefore, methods that identify abnormal accruals are prone to yielding “false positives.”

Emerging Analytical Approaches

The U.S. SEC, through a December 2012 speech made by its chief economist, Craig Lewis, has communicated its intention to formally incorporate and apply analytical diagnostic tools of accounting quality as part of its review of company reporting, and that such models would have multiple purposes and benefits for the SEC. Mr. Lewis noted:

“Identifying reporting anomalies could be useful to SEC review teams when completing reviews of corporate filers and allow staff to assist them in providing disclosures that comply with GAAP. But, of course, it also has the potential to be used by the Enforcement to identify firms with intentional potentially fraudulent reporting practices.”

The SEC, whilst proposing its accounting quality model, acknowledged the shortcoming of false positives arising from existing academic analytical approaches. The SEC indicated that in order to enhance the ability to accurately identify abnormal accruals, it would incorporate into its accounting quality model a series of reasonableness checks based on known indicators of corporate incentives to manage earnings, such as declining market share. The SEC model would also factor the risk associated with particular accounting policy choices (such as off-balance-sheet accounting) as well as consider conflicts of interest by a company with its independent auditors. The basis upon which the SEC proposed to refine its accounting quality model resonates with the feedback from CFOs articulated in the 2012 working paper. The paper identifies that the past experience and track record of the CFO, alongside the quality of audit committees, can be useful indicators of earnings management.

Opportunity for Investors to Ratchet up the Analytical Potency of Models

Similar to the approach adopted by the SEC, there is a need for investors and their information intermediaries to ratchet up their ability to precisely identify any abnormal accruals that distort firm performance. Enhanced analytical potency can be achieved by incorporating a broader array of company-specific attributes into any earnings quality diagnostic model. The factors considered by the SEC accounting quality model provide a useful start.

In addition, the CFO feedback pointed to various factors, such as the quality of human capital and risks associated with acquisition accounting. Including these additional company, business model, and industry-specific factors into any “earnings quality”-oriented analytical models should enhance their effectiveness.

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Photo credit: Reuters