Into the Breach. Can securities analysts bridge the gap between earnings management and financial reality? CFA MAGAZINE / MAY-JUNE

Transcription

1 Into the Breach Can securities analysts bridge the gap between earnings management and financial reality? BY SUSAN TRAMMELL, CFA Illustrations: Robert Meganck CFA MAGAZINE / MAY-JUNE

2 With an ever-growing number of accounting standards, statements, and guidelines, one might think that public companies have little opportunity to manage earnings. But managements may rush in where accountants fear to tread. In one study of senior financial executives attitudes toward performance measurement and disclosure ( Value Destruction and Financial Reporting Decisions, Financial Analysts Journal, November/December 2006) researchers found that a surprising 78 percent of the 401 survey respondents were willing to give up long-term economic value to meet earnings expectations. The most popular strategy by far was to decrease discretionary spending if a company appeared likely to come in below an earnings target. A full 80 percent of respondents reported that they would be willing to reduce spending on research and development, maintenance, advertising, and other discretionary areas. Another 55 percent said they would delay starting a new project. Other decisions included booking revenues in the current rather than the next quarter, providing customer purchase incentives, drawing down reserves, and postponing the taking of accounting charges. Interviews with 20 chief financial officers (conducted subsequent to the survey) revealed that 15 of them were willing to take such actions as long as the actions fell within generally accepted accounting principles (GAAP) and the sacrifice was not too large. Although many of the tactics described had the potential to destroy company value, executives appeared to be willing to make these choices rather than resort to accounting maneuvers. As managers pointed out, businesses are much more volatile than earnings figures suggest but the market rewards predictability. Many security analysts may be startled to learn the extent to which companies feel it is their duty to manage earnings. Moreover, such valuedestroying actions can only complicate the analyses of analysts who already have their hands full keeping up with accounting-based earnings management. What Measure of Value? In the survey, earnings stood out as the most important measure reported to outsiders. In fact, earnings received three times as many top rankings as did revenues or cash flows from operations. Quality earnings are not necessarily conservative, points out Ed Crotty, CFA, senior vice president, chief investment officer, and portfolio manager for equity income investment strategy at Davidson Investment Advisors, who is based at the firm s Great Falls, Montana, office. When people speak of quality earnings, it really should be what reflects the intrinsic economics of a company, what represents the reality of a business. In other words, the analyst s job is to figure out whether the company is generating earnings from its core business and whether the reported earnings numbers fairly present the reality of the company s performance. Seasoned analysts understand the corporate agenda and adjust their investigations accordingly. Accounting assumptions are usually disclosed in the small print of the footnotes, which is where a company is likely to reveal whether it is engaging in accounting shenanigans. Analysts typically focus on those line items that give executives the most discretion. For example, management judgments regarding inventory valuation, reserves for doubtful accounts, pension fund accounting, deferred taxes, and loan losses are likely to draw scrutiny. Companies with high levels of accruals, such as those using percentage-of-completion accounting, also trigger warning bells. Cash may seem to be a more reliable measure of performance than earnings, but in the survey, cash flows from operations and free cash flows ranked below both earnings and pro forma earnings as the most important measure reported to outsider stakeholders. A lot of people look at the cash flow statement as beyond reproach, but that can be manipulated, too, says Crotty. He points out that managers can shift flows that fall into financing or investment activities into cash flows from operations and vice versa. In his article Accounting Shenanigans on the Cash Flow Statement (CPA Journal, March 2006), Marc Siegel, global director of research at the Center for Financial Research & Analysis (CFRA) headquartered outside Washington, DC, looked closely at the myth of cash flow s supremacy as a performance metric. Certain accounting shenanigans can either artificially boost reported operating cash flow or present unsustainable cash flows, he wrote. Chief among the various ways of hiding a company s true cash flows are the following four tactics: STRETCHING OUT PAYABLES The simplest thing is to stretch out payables by slowing the rate of payment to vendors. Eventually, vendors will balk and force the company back 44 CFA MAGAZINE / MAY-JUNE 2007

3 to more agreeable terms, but in the meantime, analysts can monitor the extension of payables by calculating days sales in payables. FINANCING PAYABLES Next on Siegel s list is the financing of payables, a variation of stretching out short-term liabilities. For example, the company engages a financial institution to pay vendors in the current quarter and then reimburses the lender in a subsequent period, enabling it to manage the timing of its reported operating cash flows. Analysts should ask themselves why financial intermediaries are inserted in transactions that would ordinarily not require a third party. SECURITIZING RECEIVABLES Nonfinancial companies may bundle their longer-term and highest-quality receivables and transfer them to a financial institution or a variable-interest entity to be securitized. The company s cash flow from operations is boosted as the proceeds from securitization increase. Also, management can choose where to report gains between the book value of the receivables at the time they are transferred and the amount received for the receivables. An aggressive treatment would be to record the gain in revenues. Other options are to offset operating expenses or report the gain below the line. STOCK BUYBACKS Companies may buy back stock to offset dilution that results from the exercise of stock options. The tax benefits generated by exercising such options may be reported in operating cash flow. But the cash outflow is considered a financing activity. As option exercises grow, so does the boost to operating cash flow, while the outflows are recorded in the financing section of the cash flow statement. Broad Concerns When the market heats up and stocks go on a run, it becomes more and more tempting to take advantage of new loopholes, says Christopher Laudani, founder of North Andover, MA-based Short Ideas, which seeks to identify stocks that have the potential to make large-percentage moves downward. Years ago, Howard Schilit identified a bunch of shenanigans, and they re all the same tricks today. Manipulation can always be found, especially in the hot sector du jour. Howard Schilit founded CFRA in 1994 for the purpose of performing forensic accounting research and due diligence. In Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports (which was revised in 2002), Schilit identified seven broad areas where companies are likely to manipulate their numbers: recording revenue too soon or of questionable quality, recording bogus revenue, boosting income with one-time gains, shifting current expenses to a later or earlier period, failing to record or improperly reducing liabilities, shifting current revenue to a later period, and shifting future expenses to the current period as a special charge. As economies become increasingly service based, assets are becoming less tangible and impairment tests may become a bigger issue. When faced with difficult-to-value assets, the analyst should ask the company to explain, as explicitly as possible, how it conducts the valuation and then talk to competitors to see where the target company s approach differs from that of its peers. The analysts probably don t have the expertise and information to do their own analysis, advises Jeff Curtiss, CFA, who was the chief financial executive at several major exchange-listed companies. But if all the companies value similar assets the same way, there is a level of comfort. Even industry norms require a degree of skepticism. My view is that whatever is the metric that investors and analysts are valuing the most, that s where you should focus, advises Siegel. Take same-store sales. It s a made-up metric. What if you move a store, expand it, or close it? All these things can flatter same-store sales. In one analysis, CFRA looked at how the restaurant industry defined samestore sales and found that the definition differed from company to company. Seeing Red Regulatory actions may close some loopholes, but companies may simply become more creative elsewhere. Experienced analysts have become adept at spotting the red flags that may signal earnings management or deeper problems: CFA MAGAZINE / MAY-JUNE

4 TOO GOOD TO BE TRUE If a company is doing significantly better than its peers over a sustained period, one should question why. When you compare five or six companies going after the same customer, it makes you stop and think, Why is that one company s margins so much higher, why are their expenses so much lower, than their competitors? says Laudani, whose firm seeks to identify stocks that may be poised to take a dive. DEFERRED TAXES Because certain expenses are not deductible for tax purposes, a company may have paid more in taxes than is reflected in the income statement for the same period. The difference is accounted for as a tax deferral. Although the discrepancy is only a timing issue, I want to understand why there is a deviation between the IRS [tax] and the SEC filing, says Crotty. Paid taxes are a real economic event. It s cash going out to a government. DEBT MOVES OFF THE BALANCE SHEET Fixed-income analysts are particularly concerned with corporate maneuvers that attempt to veil the magnitude of a company s liabilities. A favorite ploy is the sale/leaseback arrangement, in which a company sells assets to another party and recognizes a gain on the sale. The company, however, still has need of those assets and leases them back. The arrangement will be disclosed in the footnotes. Conventional accounting presentation does a mediocre job of alerting analysts up front about sale/leasebacks. In the interest of transparency, some companies account for these arrangements by reporting EBITDAR (earnings before interest, taxes, depreciation, amortization, and rent). CHANGES IN DISCLOSURE If a company shifts its focus from one long-held performance measure to another, the analyst may have reason to be suspicious. For example, management may have always talked in terms of EPS but now direct investors attention to cash flow. Another red flag is a change in disclosure language. Much of the footnote language in regulatory filings is immutable from period to period; only the numbers change. That s wellvetted language, Siegel points out. We focus on changes in verbiage because they can signal a change in accounting policies without outright disclosing the change. CREATIVE PRESS RELEASES A company s broadcast media pronouncements are not required to reflect the minutiae of its SEC filings. Siegel offers the example of an entity that broke out two reserves in its 10-Q form but then combined them in its press release. The action drew CFRA s scrutiny, which concluded that the company s reserves were not adequately funded. SERIAL ACQUISITIONS Despite the phase-out of pooling-ofinterest accounting, corporate managers retain considerable latitude in how to allocate the purchase price to a merged company s assets. Serial acquirers may be masking poor performance, particularly in share-based metrics such as EPS or return on assets. FREQUENT NONRECURRING EXPENSES Ignoring the oxymoron, companies will sometimes characterize write-offs that actually occur on a fairly regular basis as nonrecurring events. THE BIG BATH A company s results may be so dismal that the managers decide to leap into the red, load all of its expenses into one period, and thus impair quality of earnings. As soon as you start doing that, Crotty says of such corporate antics, that s a slippery slope. To get to the reality of the company s performance, the analyst must take some of those expenses and attribute them to future periods. Highly Motivated The widespread belief is that self-serving earnings manipulation is undertaken to preserve managers bonuses, but the results of the survey do not bear out this assumption. The most overwhelming incentive for meeting or beating earnings benchmarks appeared to be building credibility with the capital markets. Next came maintaining or increasing the company s stock price, preserving management s external reputation, and conveying future growth prospects to investors. Maintaining employee bonuses ranked far down on the list. Whether by making windowdressing business decisions or adopting certain accounting treatments, many chief financial officers (CFOs) believe that smoothing earnings is an important part of their job. But the CFOs interviewed in the study on value destruction and financial reporting decisions mentioned earlier realize that short-term earnings management has long-term consequences. There is a limit to a company s ability to bury its problems, and eventually, the truth 46 CFA MAGAZINE / MAY-JUNE 2007

5 will come to light. What the CFOs hope is that by the time adverse consequences set in, the positive results achieved through growth will reverse the problems. Won t Get Fooled Again? So, how can analysts avoid getting fooled by financial shenanigans? First, be prepared with knowledge of the company s industry. Each industry provides specific areas of concern, but an analyst who is familiar with a company s business can anticipate the vulnerabilities in its financial statements. Second, speak with the people who have the answers. Analysts should thoroughly review the company s financial statements its 10-K or 10-Q form. They should not be afraid to ask tough questions when presented with the opportunity to meet with managers at such events as the company s Investor Day or annual meeting. Curtiss advises that analysts even ask a company s investor relations department for access to the person within the accounting department who actually prepared the financial statements. Third, have a natural curiosity about how companies work. Siegel cites the case of the company that had three bullet points explaining why its inventories were growing. But when the reasons were quantified, they didn t fully explain the build-up, which implied imminent pressure on margins. Next, stay alert and be skeptical. Remember WorldCom? asks Laudani. It was doing so much better than its competitors, yet they were all in the same business. They all had the same customers. They all had the same business model. Why was WorldCom making so much more money than everybody else in the industry? When you asked management, they told you, We re better. Investors swallowed it for years. But that wasn t the case at all. The books were cooked. It was there for all to see. You just had to stop and think about it. Finally, work hard. As the clamor for increased transparency has grown, so has the size of regulatory filings. Many now have the bulk of a small phone book. The trend has the potential to create a risk of suffocation by disclosure. My belief is that many analysts do not read the SEC documents that companies file carefully enough nor do they undertake adequate critical thinking in their evaluation of companies or management, Curtiss says. Most companies portray themselves in as positive a light as their facts permit so as to keep the confidence of a number of their critical stakeholders. And, he adds, The investment community should expect this. Susan Trammell, CFA, provides business plan writing and market research services through her New York City consulting firm. PRESSURE POINTS Nearly everyone interviewed for this article volunteered that they have found most companies to be essentially honest. This finding in itself is heartening because senior financial executives must withstand the enormous, and often competing, pressures of their companies stakeholders. Today s chief financial officer faces a triangle of interests. The auditors want the company to be conservative in its accounting and play by the rules; the board of directors is strictly charged with corporate responsibility; and the investors (often including employees) just want the stock to go up. CFOs have always had pressures on them, and a good CFO feels those pressures, says retired chief financial executive Jeff Curtiss, CFA. You can t please all constituents all the time. The percentage of public companies that have gone astray is very small. Curtiss points out that since the 2002 enactment of the Sarbanes Oxley Act in the United States, a company s outside and internal auditors must report to an independent audit committee of the board. Whistle-blowers have access to the audit committee, and many companies have instituted disclosure committees. Moreover, both the CEO and CFO are expected to certify that such regulatory filings as the 10-K and 10-Q forms fairly present the financial condition of the registrant in all material respects. The mere compliance with GAAP does not let the CEO or CFO off the hook based upon their certification, Curtiss says. Aggressive GAAP-compliant accounting principles must be adequately disclosed. CFA MAGAZINE / MAY-JUNE