THE TROUBLE WITH EARNINGS MANAGEMENTBy
The pressure to meet earnings expectations is high, but earnings management results in a distorted view of a company’s performance.
In an attempt to eliminate fraud, securities laws in the United States try to severely limit corporate management from promising a specific level of future earnings. U.S. Code §77z-2, “Application of safe harbor for forward-looking statements,” requires “meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those in the forward-looking statement.” Yet earnings guidance—and managing earnings toward meeting that guidance—are believed to be relatively common.
A 2015 study, “The Misrepresentation of Earnings,” found that CFOs believe 20% of publicly held companies intentionally distort earnings to misrepresent performance while adhering to U.S. Generally Accepted Accounting Principles (GAAP). When asked about private companies, the amount is closer to 30%. The average amount of alteration is believed to be about 10% of reported earnings. Two-thirds of the misrepresenting companies are thought to overstate actual earnings, with the remaining third understating performance.
Earnings guidance based on relevant management accounting support is critically important to publicly held companies. There’s often a Wall Street penalty for failure to meet the consensus estimates from analysts and a premium for consistently doing so. But that isn’t the only reason. The CFOs surveyed cited several other rationalizations for misrepresenting earnings, including the need to meet profitability goals set for executive bonus purposes, executives’ concerns for their performance reputation, and the desire to influence stock price.
“A Survey of Investor Relations and Earnings Guidance,” a 2015 research study published by IMA® and the Financial Executives Research Foundation (FERF), surveyed accounting and finance executives to assess the incidence of activities associated with investor relations, earnings guidance, and earnings management within their companies.
Roughly half of the respondents from S&P 500 companies provide projections of earnings per share. Guidance ranging from soft commentary to hard, time-bound projections “helps executives build reputations for transparency and competence, increase share liquidity, reduce the cost of capital, and protect against litigation through early disclosure of bad news.” The risk of such candor is that executives’ reputations are exposed to a loss of credibility if reported results miss guided estimates. Thus, the motivations to manage earnings are strong.
A causative link between earnings guidance and earnings management is less apparent. The IMA/FERF report notes that several studies suggest that companies providing guidance exhibit less earnings management. The studies use statistical and other analytic methods to attempt to differentiate between real earnings management (REM) and accrual earnings management (AEM). REM involves business decisions that require cash-flow activities like cutting research or other investments, stopping new product development, or selling appreciated assets. AEM involves using only accounting estimates to manage earnings. The REM activities are more harmful because they can hinder future profitability.
The IMA/FERF report contains six principal findings:
* The tone at the top can influence the quality of financial reporting.
* Larger companies with newer CEOs expand the scope of their investor relations and earnings guidance activities, but the perceived frequency of accrual earnings management is lower.
* Publicly held companies engage in more guidance and investor relations activities and are less likely to manage earnings. Such activities are also more common in companies where executives are paid on a variable basis and where the culture considers it a “big deal” to miss earnings expectations.
* There is considerable variety in investor communication. Qualitative, color commentary is the most usual communication method, while specific guidance, if given, typically takes place on an annual or quarterly cycle at the time actual results are announced.
* Accountants report the highest perceived incidence of earnings management among the roles within the finance department.
* AEM usually involves bad debts and tax reserves. Few respondents expressed willingness to alter depreciation charges. The most common form of REM was cutting travel and entertainment expenditures.
The IMA/FERF report concludes, “In general, guidance does not seem to harm a company’s financial management or reporting.” This benign conclusion fails to consider the reduced quality of reported earnings because of earnings management.
Perhaps the greatest damage to companies that engage in earnings guidance and earnings management results from a focus on short-term results rather than the long-term sustainability and growth. Some parts of the world are moving away from this. One example is the growing use of integrated reporting (<IR>), which the International Integrated Reporting Council (IIRC) describes as being designed to communicate “how an organization’s strategy, governance, performance and prospects, in the context of its external environment, lead to the creation of value in the short, medium and long term” (emphasis added). Unfortunately, the rate of <IR> adoption in the U.S. appears to be slower than elsewhere.
There are adverse consequences of poor earnings quality, including an increased cost of capital because of lower price-earnings ratios, negative attitudes of analysts who follow the company, and effects on bid-ask spreads. Earnings management of a material amount constitutes fraudulent financial reporting and should be vigorously pursued by external auditors and government regulators.
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