THE WALL STREET
CURRENT ACCOUNT | Updated October 1, 2012, 7:04 p.m.
By FRANCESCO GUERRERA
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
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
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
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.
Ralph Alswang for The Wall
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.
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
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
"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:
email@example.com and follow him on Twitter:
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