The Misrepresentation of Earnings

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Thursday April 3, 2014 at 9:12 am
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Editor’s Note: The following post comes to us from Ilia Dichev, Professor of Accounting at Emory University; John Graham, Professor of Finance at Duke University; Campbell Harvey, Professor of Finance at Duke University; and Shivaram Rajgopal, Professor of Accounting at Emory University.

While hundreds of research papers discuss earnings quality, there is no agreed-upon definition. We take a unique perspective on the topic by focusing our efforts on the producers of earnings quality: Chief Financial Officers. In our paper, The Misrepresentation of Earnings, which was recently made publicly available on SSRN, we explore the definition, characteristics, and determinants of earnings quality, including the prevalence and identification of earnings misrepresentation. To do so, we conduct a large-scale survey of 375 CFOs on earnings quality. We supplement the survey with 12 in-depth interviews with CFOs from prominent firms.

Why ask CFOs about earnings quality? We argue that CFOs are in a unique position to provide insights on earnings quality. The reason is simple: the CFOs’ choices determine, to a large extent, the quality of earnings. Almost all of the research on earnings has been empirically based where quality is assumed to be a function of observables, such as accruals and real decisions to massage earnings. In contrast, our approach focuses on the person that makes decisions with respect to accruals and real actions.

We find that CFOs believe that quality earnings are sustainable and predictable, with few one-time items, and solid backing by cash flows. Earnings quality is determined in about equal measure by uncontrollable factors like industry and economic conditions, and controllable factors like internal controls and corporate governance.

We also find that in any given period a remarkable 20% of public firms use discretion within GAAP to intentionally misrepresent their earnings. The magnitude of such misrepresentation is surprisingly large—of firms that do it, an average of 10% of the reported earnings is misrepresented. In addition, the misrepresentation goes both ways with a full one-third of perpetrators low-balling their reported earnings.

The most popular reasons for earnings misrepresentation are desire to influence stock price, related internal and external pressures to hit targets, and executive compensation and career concerns. Misrepresentation is also difficult to detect for an outsider. Accounting rules have become complicated, and the motivation for real actions like cutting valuable R&D initiatives often cannot be disentangled between business decisions and earnings management. Nevertheless, the CFOs provide a useful list of “red flags” that they would look for if they were searching out misrepresentation.

More than a decade after the Enron scandal, increased regulatory scrutiny following the Sarbanes Oxley Act and the demise of Arthur Andersen, the practice of earnings distortion continues unabated. As long as incentives to manage earnings to influence stock prices remain, either via managerial equity ownership or via pressure from the managerial labor market or from stakeholders such as analysts to “hit the numbers,” we believe that earnings misrepresentation will live on.

The full paper is available for download here. Tables and references are available here.

  1. Sirs and fellow readers,
    This is no surprise at all to those working within the investigative fields of intelligence or fraud.
    As far back as the Enron scandal, the U.S.S.S. fraud division located then in Cleveland, Ohio had a crystal clear understanding of fraud in most of the top American and other companies. The ”issue” was that they just could not and would not go about arresting everyone, but it was generally felt (used in context of investigations) that almost every C.F.O. and or C.E.O. were fudging the numbers.
    Enron was hit super hard to send a message outwards that if those persons pushed too much, and even had audacity to claim friendship with people in the highest of high, that the Justice system could take action.
    Has that message helped ? It would now a decade later seem not, for putting one self in a better light is a way of doing business, and if that the investor shall we say is not smart enough to be asking the tough pin-you-down type questions, then it is there where the crux of the complaint must be laid.
    Kodak suffered from senior management (circa 2000-2002) being so intently focused on share price values because that had direct influences upon Golden-handshake funding to their own pockets, whilst actual investments into research and development was kept to a minimum.
    An American institution was deflated and lost the household name to be bested by better, smarter and more readily available Japanese technology. That’s an example of what can happen and the tragedy of seeing 10,000 people lose their livelihood almost overnight.
    A simple solution would be format the manner of reporting, just like the tax form is done at year end and also to make sure that the penalty for ‘fudging’ is 25 years, same as trying to rob the local Federal Post Office.
    In my experiences, there is no soft option for white-collar crime, it should be just as ruthless and just as punitive in administration as that of a bank robber.
    Should anyone wish to ask more upon the subject matter, I am happy to converse via LinkedIn.

    Comment by Edward M. Rose — April 11, 2014 @ 12:53 pm

 

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