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Do Large Earnings Surprises Result from Manipulation?

By Curtis C. Verschoor, CMA, CPA
October 1, 2018
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A study finds a trend of public companies using adjusted earnings to intentionally report quarterly earnings much larger than expected.

 

Researchers Paul Griffin of the University of California, Davis, and David Lott of the University of Otago in New Zealand believe that the increasing emphasis on non-GAAP earnings measures is resulting in greater earnings management designed to trigger a favorable stock-market reaction. Their study, “Evidence of a Positive Trend in Positive Quarterly Earnings Surprise over the Past Two Decades,” involved analyzing hundreds of thousands of earnings reports from approximately 4,700 companies. They found an increase in the number of companies using adjusted earnings to beat analysts’ quarterly expectations by large amounts. This contrasts with the results for these companies under generally accepted accounting principles (GAAP).

 

Reporting of earnings on a non-GAAP or adjusted basis, known as “street earnings,” continues to be a commonplace part of financial communications in press releases, conference calls, analyst forecasts, and clearinghouses that provide data on both predicted and actual earnings. The Griffin and Lott study analyzed consensus forecasts of adjusted earnings using a protocol published by Thomson Reuters based on a majority of analysts’ normalized estimates that exclude the costs of discontinued operations, unusual or extraordinary charges, and any other nonoperating items. Street earnings have been promoted as providing a more typical picture of ongoing corporate operations. Currently, about 90% of companies utilize non-GAAP calculations to report adjusted earnings.

 

Since there’s no generally accepted definition of adjusted earnings, companies are motivated to exclude as many costs and expenses as possible while including revenue of all types, even nonrecurring gains. And unlike annual results, quarterly results aren’t subject to external audit—even the GAAP earnings numbers aren’t audited. The U.S. Securities & Exchange Commission (SEC) has issued guidance requiring GAAP-compliant information to be most prominent in earnings releases, but it hasn’t penalized companies that fail to do so. Management is also motivated to continue to report non-GAAP results since they form the basis of executive compensation at many companies.

 

An example of the unique qualities of items eliminated from GAAP earnings is McKesson Corporation’s press release for the first fiscal quarter of 2019. It reported a quarterly loss from continuing operations on a GAAP basis of $0.69 per diluted share but adjusted earnings of $2.90 per diluted share. The excluded items include “amortization of acquisition-related intangible assets, acquisition-related expenses and adjustments, LIFO [last-in, first-out] inventory-related adjustments, gains from antitrust legal settlements, restructuring and asset impairment charges, and other adjustments, net.”

 

Another example is the second-quarter 2018 press release from TMK Group Limited, a Toronto, Canada-based financial services firm. The non-GAAP adjustments include “amortization of intangibles related to acquisitions, non-cash impairment charges, increase in deferred income tax assets resulting from capital loss carryback, write-off of deferred income tax assets, net income tax recovery on gain on sale of Natural Gas Exchange Inc. (NGX), gain on sale of interest in TMX FTSE, and commodity tax provision.” Earnings per share for the quarter under standard international accounting rules was $1.71 while adjusted earnings per share was $1.34.

 

Griffin and Lott’s study showed that during a 17-year period, large positive quarterly earnings surprises increased considerably but were essentially flat for earnings reported under mandatory GAAP metrics. The effect was more pronounced for companies in the S&P 500, with the portion of companies reporting a positive quarterly earnings surprise increasing from 12.1% to 25.5%.

 

The authors explain the likely cause: “It used to be that a significant number of firms reported earnings that either met or just exceeded Street expectations, suggesting that, to accomplish this result, managers would either make small late changes to pre-managed earnings or that analysts would intentionally under-forecast reported earnings by similar amounts….This behavior has mostly died out.” Small surprises became a trigger for penalization in the market. Evidence suggests that a large positive earnings surprise is now required to obtain a favorable market response.

 

Griffin and Lott express this change, noting, “Now, management’s earnings manipulation must be of a different form and, possibly, one more acceptable to shareholders’ agents such as auditors, directors, and regulators.” They say, “Non-GAAP earnings management is one such form. If these monitors [are] focused on small changes around zero earnings surprise…we would expect to observe fewer small positive earnings surprises…and more large earnings surprises.”

 

The authors also believe that analysts may share the blame for quarterly earnings manipulations and “increasingly bias their Street expectations downwards to generate a more favorable [market] response [from earnings surprises] for their clients.” Analysts may be biased toward the upside, as there are far more buy recommendations than sell recommendations. Yet, as the source of the information that analysts rely on for their forecasts, company management must retain a major portion of responsibility for the game of “by how much should we beat the quarterly numbers?”

 

The authors conclude, “There are those who might claim that so far this century the U.S. economy has experienced such an unusual period of economic growth that it has taken analysts and investors by surprise each quarter…for almost two decades. This view strains credulity.”

 

Overemphasis on quarterly rather than long-term results is another downside. Perhaps corporate guidance should be limited to annual terms only.

 

IMA ETHICS HELPLINE

 

For clarification of how the IMA Statement of Ethical Professional Practice applies to your ethical dilemma, contact the IMA Ethics Helpline.

 

In the U.S. or Canada, dial (800) 245-1383. In other countries, dial the AT&T USA Direct Access Number from www.usa.att.com/traveler/index.jsp, then the above number.

 

The IMA Helpline is designed to provide clarification of provisions in the IMA Statement of Ethical Professional Practice, which contains suggestions on how to resolve ethical conflicts. The helpline cannot be considered a hotline to report specific suspected ethical violations.

 

Curtis C. Verschoor, CMA, CPA, is the Emeritus Ledger & Quill Research Professor, School of Accountancy and MIS, and an honorary Senior Wicklander Research Fellow in the Institute for Business and Professional Ethics, both at DePaul University, Chicago. He is also a Research Scholar in the Center for Business Ethics at Bentley University, Waltham, Mass., and Chair-Emeritus of IMA’s Committee on Ethics. Trust Across America—Trust Around the World awarded him a Lifetime Achievement Award in 2016. In 2017, IMA published his book, Curt Verschoor on Ethics. His e-mail address is curtisverschoor@sbcglobal.net.
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