The corporate scandals of the last year have left regulators and Congress working overtime on remedies such as better accounting standards and tougher penalties for renegade executives. But stock investors could use something else: an advance warning system to identify potential threats.
Is there a way to tell, ahead of time, which publicly traded companies are most likely to cook the books?
There’s no perfect system, but Wharton accounting professors Scott Richardson and Irem Tuna, along with Min Wu, a professor at Hong Kong University of Science and Technology, identify some key risk factors in a new paper entitled “Predicting Earnings Management: The Case of Earnings Restatements.”
Richardson, Tuna and Wu examined 225 companies that had been forced to restate their financial results between 1971 and 2000. The researchers found those companies tended to have “poor quality earnings” – reported profits substantially larger than reported cash flows.
The results can be devastating for shareholders. Firms suffered stock-price declines averaging 25% around the time the restatement was announced. Restatements by Cendant, MicroStrategy and Sunbeam caused a combined $23 billion drop in market value in the week surrounding the announcements. “It’s an event that people are clearly interested in and would like to be able to predict,” the authors state.
Many investors assume reported profits represent cash that is left after expenses are subtracted from revenues. But modern accounting is far more complicated. Decisions must be made as to when revenues are earned and when expenses need to be matched to those revenues. For example, accounting must determine the portion of revenue to be recognized in the current period for contracts where the cash is expected to be received over several periods.
The portion of net income that is not accounted for in cash flow is known as accruals, and whenever net income grows faster than cash flow, accruals are the cause. While many elements of accruals are perfectly proper, accruals also leave room for accounting gimmickry or “earnings management” – fudging numbers to inflate income.
“We find that restatement firms report much larger accruals at the time of the alleged manipulation compared to non-restatement firms,” the researchers write. Among the restatement firms, accruals averaged 8.7% of total assets, compared to 3.9% for other firms. In addition, the paper notes, “firms that have the highest accruals experience the largest stock price decline when they announce an earnings restatement.”
Earnings can be inflated through accruals in many ways. A company might exaggerate its revenues or count money that is expected but not in hand. It might exaggerate accounts receivable, perhaps ignoring the fact that orders for future delivery can be cancelled. A company can pump up sales by offering customers easy credit, but not account for the fact that customers who are not creditworthy may fail to pay. A company might build up inventories toward the end of the year, making production figures look good but saddling itself with excess product that will have to be discounted to be sold, hurting future results.
“Firms that have high accruals today, on average are going to have lower earnings in the future,” Richardson says. “If the market doesn’t pick that up today, it will maintain a [stock] valuation that’s too high.” The stock is thus poised for a tumble when future earnings disappoint investors.
In one of the largest scandals this year, communications giant WorldCom has reported about $7.6 billion in accounting errors that inflated earnings over the past few years. The restatement involved improper capitalization of line costs, softening the impact of these costs on current earnings. WorldCom has since fallen into bankruptcy, its shares virtually worthless.
In another oft-cited case, MicroStrategy, a software firm, restated its financial results for 1998 and 1999, causing its stock to drop 62% in a day. In 1998, the company had counted as revenue money it was not to receive until future years. The maneuver resulted in substantial growth of the figure reported for working capital. In the future, investors noticing such growth might see it as a warning sign, a reason to dig deeper, Richardson says.
Compared to companies that did not run into trouble, those announcing restatements also tended to be high-growth firms – with high price-to-earnings ratios and low book-to-market ratios.
What drives companies to these extremes? Typically, these companies have led investors to expect high returns, perhaps as a stated goal, perhaps because they have produced them in the past, the researchers found. The restatement firms also tend to have high levels of debt and often need additional financing. About 41% of the restatement firms were in need of new financing during the year of restatement, compared to 31% of non-restatement firms. Furthermore, restatement firms are almost twice as likely to have reported four or more consecutive quarters of earnings that met or slightly exceeded analyst expectations.
Consequently, the restatement firms might inflate earnings in order to meet requirements of their current loans, or to raise new money at the lowest cost. They may, for example, inflate earnings to raise stock prices in order to get the most out of secondary stock issues. Or they may pump earnings up in order to get better credit ratings that will give them the lowest interest rates on new loans.
High accruals, of course, don’t guarantee that a company is fudging its numbers. But the restatement trends among high-accrual companies are strong enough that investors should use accruals to identify companies that deserve closer inspection. “It’s a useful first pass for investors to look at,” says Richardson.