Here’s Why Investors Are Punishing Companies That Beat Earnings Estimates

on July 25 2012 3:26 PM

The short answer is: Many companies lie about their earnings results.

A recent survey of 169 chief financial officers at publicly traded companies in the U.S. reveals that one in every five U.S. companies fudges the numbers to boost stock price. And for such firms, 10 percent of the earnings per share, or EPS, is typically managed.

Earnings management is mainly driven by a host of factors but capital market motivations and career and compensation concerns dominate, according to findings detailed in a recent paper published by Ilia Dichev and Shiva Rajgopal at Emory University and John Graham at Duke University.

In addition to conducting the survey, the researchers also interviewed 12 CFOs.

One interviewed CFO explained the magnitude and process of earnings management by saying, we were going to get a $1.50 EPS number and you could report anywhere from a $1.45 to a $1.55, and so you sit around and have the discussion saying well, where do we want the number to be within that range?

We talk about estimates: Do we recognize this in this quarter? Is there some liability that can be triggered that hasn't been triggered yet or has it really been triggered yet? Do we really have enough information to write this down?

All of those kind of things but mainly involving some sort of estimate and also a question of something where we had discretion of the time period in which we recognized the gain or the loss, the CFO said.

Investors are aware that companies can easily squeeze out a few more pennies from their loan-loss reserves or exploit other accounting gimmicks to pad their bottom lines. Since the process described above happens behind closed doors and are hard for outsiders to identify, investors tend to disregarded all headline beats on earnings -- real or not.

Thus, despite posting solid results for the past quarter, a company will still see its stock get slammed if revenue (the amount of money a company actually receives from the sale of goods and services) missed forecast or if it doesn't provide an upbeat outlook for future quarters.

Interestingly, of the 104 companies in the S&P 500 that have reported second-quarter results, 74 percent reported earnings beats, but only 45 percent managed to top revenue forecasts, according to data provided by FactSet.

Eighty-one percent of CFOs believe that the level of discretion today is lower than it used to be, suggesting that reporting discretion has been substantially curtailed over time, the survey also showed.

Motivation?

So why do CFOs misuse their reporting discretion?

Most CFOs talked about the desire to influence stock price and the unrelenting pressure from Wall Street to avoid surprises.

As one CFO put it, you will always be penalized if there is any kind of surprise. As a result, there is always a tradeoff. Even though accounting tries to be a science, there are a hundred small decisions that can have some minor impact at least on short-term results.

The next most popular survey answers relate to executives' career concerns: 88.6 percent say that executive compensation leads to earnings management, and 80.4 percent believe that senior managers fear adverse career consequences and hence misrepresent earnings.

It is also worthwhile noting that 60 percent of executives feel that managers manage earnings because they believe such misrepresentation will go undetected.

According to the paper, one CFO said that the chances that an analyst would spot an occasional instance of earnings management are low.

We have some three-year compensation plans involving restricted stock, and they're paid when managers achieve certain targets based on accounting numbers, and each quarter you have to make an estimate as to do you believe the company is going to actually hit these targets one, two, and three years out. And depending on a judgment call, you will start adjusting that accrual either up or down.

Last year, we had some wild swings at our company, and in the third quarter of last year it looked like we were not going to make the targets, and we reversed the accrual. The reversal was a penny a share and increased income.

Now let's stop for a minute and say, I did that appropriately - but how would (an outsider) know (what we had done)? They probably wouldn't because it's buried in general and administrative expense but it's not big enough on our income statement in one quarter to stick out. But it's enough to change the EPS number that Wall Street analysts are looking at, the CFO said.

The Red Flags

High quality earnings are sustainable and repeatable, free of one-time items, and backed by actual cash flows.

The researchers asked CFOs how one could detect a situation in which a company is misrepresenting earnings.

The answer is it's tough -- even for Wall Street analysts whose sole job it is to stay on top of how corporations report results.

However, they advocate paying close attention to the key managers running the firm, the lack of correlation between earnings and cash flows, significant deviations between firm and peer experience and unusual behavior in accruals, which is revenue recognized before cash is received or expense recognized before cash is paid out.