Smooth Move — the Manipulation of Earnings
Traveling back to the U.S. from the recent CFA Institute Annual Conference in Edinburgh, Scotland, I had time to reflect on a portion of the program dedicated to ethical issues in financial reporting, part of our Challenging Industry Norms series debating critical issues facing the investment industry. Can you imagine two more boring topics — ethics and financial reporting — combined into one miserable hour? And I was the moderator.
But much to my happy surprise, the session generated large interest in one topic in particular: the controversial practice of earnings management. Simply stated, accounting rules allow management to create various accounts and reserves on a company’s financial statements that can then be used to “smooth” the quarterly earnings number reported to investors. Things like loan loss reserves, contingency reserves accounts, and my favorite account companies use for manipulating quarterly earnings — “R&D,” or research and development.
The game of earnings management is played liberally at Wall Street-traded firms. Companies first convene the stock analyst corps and provide them with quarterly earnings guidance, essentially telling them the company’s expected EPS for the next quarter. It is quite difficult to accurately estimate, to the penny, where a large company with divergent global businesses and operations will come in with its actual EPS number.
Or so you would think. That is where smoothing comes in. Like a box of Lucky Charms, you reach into your magically delicious reserve accounts and pick out a few marshmallows. In this case, a few pennies — and, presto, the EPS number comes in right on the proverbial mark.
The ethics in financial reporting panel did not like that very much, and neither did the audience, judging from the content of the question cards I received during the program. “It may be legal, but is not ethical or honest,” wrote one participant. “Companies are addicted to this cash stash,” commented another.
In defense of such practices, companies have stated that analysts need to get fairly precise earnings estimates, else they will misjudge the business and, thereby, their expected earnings. These companies also argue that it is just good use of accounting to manage the final number by adjusting flexible spending or savings accounts to ensure a smooth “meet or beat” earnings report. There are even companies that routinely sandbag the earnings guidance in order to beat the number each quarterly report. All good fun.
Our crowd was not so sure. When the smoothing options dry up or the line between benign management of earning and illegal manipulation of earnings is crossed, all hell can break loose, as some prominent companies can attest. Our audience seemed to advise against starting down this guiding-smoothing path in the first place. Play it straight, skip the quarterly guidance, focus on the longer term, and tell us the unvarnished story. Very sound ethical advice.