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Prevalence and Indicators of Earnings Manipulation

| | Posted in: Fundamental Valuation

How prevalent is earnings manipulation among U.S. public companies? What indications warn investors of the likelihood of earnings manipulation? In their July 2012 paper entitled “Earnings Quality: Evidence from the Field”, Ilia Dichev, John Graham, Campbell Harvey and Shiva Rajgopal explore earnings quality issues based on results of an anonymous survey of public company Chief Financial Officers (CFO) and in-depth interviews of a small group of CFOs and two standard setters. For context, they emphasize earnings based on Generally Accepted Accounting Principles (GAAP). Using results of 169 CFO responses to an emailed survey received during October 25, 2011 through December 9, 2011 and 12 associated CFO interviews conducted mostly via telephone, they find that:

  • High-quality earnings are conservatively sustainable (or at least parsed for repeatability) and backed by actual cash flows and consistent reporting practices.
  • Factors beyond management control (industry membership and macroeconomic forces) determine about half of earnings quality.
  • About 20% of firms manage earnings to misrepresent firm performance.
    • Such firms typically manipulate about 10% of earnings per share via mechanisms such as accruals, reserves and fair value assumptions.
    • Roughly 60% (40%) of earnings manipulation is income-increasing (income-decreasing).
    • Manipulation is predominantly an attempt to influence stock price (avoid earnings surprises) and to avoid adverse compensation and career consequences for senior executives.
  • It is difficult for outsiders to detect earnings manipulation. The most common red flags are:
    • Persistent discrepancies between earnings and cash flows.
    • Deviations from industry norms.
    • Large and unexplained accruals and changes in accruals.
    • Earnings and earnings growth too smooth for fundamentals, consistently meeting/beating benchmarks, frequent one-time items and inflated provisions for acquisitions.
    • Low regard for management/corporate culture among employees and peers.

In summary, evidence from interactions with public company CFOs indicates that about one fifth of U.S. public companies engage in earnings manipulation affecting roughly a tenth of company valuation.

Cautions regarding findings include:

  • As noted in the paper, the value of survey/interview-based data depends on free disclosure of practices by participating CFOs.
  • The interview sample size is very small.
  • Concentration of survey responses in manufacturing and financial services may affect aggregate response representativeness.
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