Forum Home Page [see Broadridge note below]

 The Shareholder ForumTM`

Fair Investor Access

See related case examples of

Dell Inc.

appraisal rights for intrinsic value realization

and

Walgreen Co.

stock buyback policies

"Fair Access" Home Page

"Fair Access" Program Reference

For graphs of specific company and related industry returns, see

Returns on Corporate Capital

For graphs of specific company voting for the past 5 years, see

Shareholder Support Rankings

 

 

 

 

Source: Wall Street Journal, October 1, 2012 column

THE WALL STREET JOURNAL.

CURRENT ACCOUNT  |  Updated October 1, 2012, 7:04 p.m. ET

Earnings Wizardry

By FRANCESCO GUERRERA

Columnist's name

It's the end of the quarter. Do you know where your chief financial officers are?

CFOs around the nation have been busy closing their books and preparing for yet another earnings season. (It kicks off in earnest on Oct. 9, as always, with Alcoa, Inc.)

But what exactly have they been busy with? If you believe a recent academic study, one out of five U.S. finance chiefs have been scrambling to fiddle with their companies' earnings.

Not Enron-style, fraudulent fiddles, mind you. More like clever—and legal—exploitations of accounting standards that "manage earnings to misrepresent [the company's] economic performance," according to the study's authors, Ilia Dichev and Shiva Rajgopal of Emory University and John Graham of Duke University. Lightly searing the books rather than cooking them, if you like.

According to academic experts, many CFOs use clever, and legal, exploitations of accounting standards that "manage earnings to misrepresent economic performance." Duke Professor John Graham and WSJ's Francesco Guerrera discuss on The News Hub.

 

The sources of this revelation are none other than the CFOs themselves. Last year, the academics asked 169 finance chiefs of public firms what percentage of companies, in their experience, use accounting ruses to report earnings that don't fully reflect the companies' underlying operations. (Note the indirect nature of the question to avoid self-incrimination.)

The answer: around 20%.

Taken in isolation, this finding isn't that surprising. It is an open secret that companies play around with "cookie-jar" reserves, accruals, and other accounting instruments to flatter, or even depress, earnings.

image

Ralph Alswang for The Wall Street Journal

Judy Brown is chief financial officer of Perrigo, a drug maker that only provides long-term guidance rather than quarterly guidance to investors. "If you build expectations, then you have to live by those expectations," she said.

 

The tricks are well-known: A difficult quarter can be made easier by releasing reserves set aside for a rainy day or recognizing revenues before sales are made, while a good quarter is often the time to hide a big "restructuring charge" that would otherwise stand out like a sore thumb.

What is more surprising though is CFOs' belief that these practices leave a significant mark on companies' reported profits and losses. When asked about the magnitude of the earnings misrepresentation, the study's respondents said it was around 10% of earnings per share.

Even the authors of the research were surprised. "That's a big number, considering that we often see companies missing earnings estimates by two cents a share or so," Prof. Graham told me.

The CFOs and accounting experts I canvassed sounded equally startled by the results and interpreted them as a symptom of a long-standing plague of corporate earnings: the pressure to meet Wall Street's quarterly expectations.

"You will always be penalized if there is any kind of surprise," said one of the CFOs in the study—a statement that I imagine is emblazoned on the minds of many finance chiefs.

[image]  

Part of the problem is self-inflicted. Many companies provide quarterly guidance to investors, fueling a numbers game that ends up benefiting no one.

Judy Brown, chief financial officer of Perrigo Co., a drug maker that only provides long-term guidance to investors, put it best. "If you build expectations, then you have to live by those expectations," she said. "That's an art because you are looking into a crystal ball, whereas closing the books is a science. So you are trying to marry an art and science."

Robert Howell, an accounting expert who teaches at the Tuck School of Business at Dartmouth College, was more explicit: "The quality of earnings is inversely correlated with whether a company makes earnings estimates."

Given the situation—and the small probability that companies will ditch earnings guidance overnight—investors should try and spot misleading earnings and act accordingly.

The CFOs in the study named and ranked several red flags.

First and foremost, investors should keep an eye on cash flow: Strong earnings when cash flow deteriorates may be a sign of trouble. The advantage of this approach is that, unlike some of the other warning signs, it is easily measurable, arming the investors and analysts who do their homework with strong ammunition against management.

Secondly, stark deviations from the earnings recorded by the company's peers should also set off alarm bells, as should weird jumps or falls in reserves.

The other potential problem areas are more subjective and more difficult to detect. When, for example, the chief financial officers urge stakeholders to be wary of "too smooth or too consistent" profits or "frequent changes in accounting policies," they are asking them to look at variables that don't necessarily point at earnings (mis)management.

As the quarterly ritual of the earnings season approaches, executives and investors would do well to remember the words of the then-chairman of the Securities and Exchange Commission Arthur Levitt in a 1998 speech entitled "The Numbers Game."

"While the temptations are great, and the pressures strong, illusions in numbers are only that—ephemeral, and ultimately self-destructive."

—Francesco Guerrera is The Wall Street Journal's Money & Investing editor. Write to him at: currentaccount@wsj.com and follow him on Twitter: @guerreraf72.

Copyright ©2012 Dow Jones & Company, Inc. All Rights Reserved

 

 

This Forum program is open, free of charge, to anyone concerned with investor interests in the development of marketplace standards for expanded access to information for securities valuation and shareholder voting decisions. As stated in the posted Conditions of Participation, the Forum's purpose is to provide decision-makers with access to information and a free exchange of views on the issues presented in the program's Forum Summary. Each participant is expected to make independent use of information obtained through the Forum, subject to the privacy rights of other participants.  It is a Forum rule that participants will not be identified or quoted without their explicit permission.

This Forum program was initiated to address issues and objectives defined by participants in the 2010 "E-Meetings" program relevant to broad public interests in marketplace practices, rather than investor decisions relating to only a single company. The Forum may therefore invite program support of several companies that can provide both expertise and examples of leadership relating to the issues being addressed.

Inquiries about this Forum program and requests to be included in its distribution list may be addressed to access@shareholderforum.com.

The information provided to Forum participants is intended for their private reference, and permission has not been granted for the republishing of any copyrighted material. The material presented on this web site is the responsibility of Gary Lutin, as chairman of the Shareholder Forum.

Shareholder Forum™ is a trademark owned by The Shareholder Forum, Inc., for the programs conducted since 1999 to support investor access to decision-making information. It should be noted that we have no responsibility for the services that Broadridge Financial Solutions, Inc., introduced for review in the Forum's 2010 "E-Meetings" program and has since been offering with the “Shareholder Forum” name, and we have asked Broadridge to use a different name that does not suggest our support or endorsement.