In our other accounting estimates articles, we talked about the discretion that management has in the income statement and the balance sheet. In this article, we will dive deeper into the incentives that management may have to manage these estimates.
What is Earnings Management?
Despite the discretionary nature of some of the income statement items, there are usually only one or two right ways to record a transaction. If management records it in a way that misleads investors on the company’s financial performance (but still within IFRS or GAAP), it is known as earnings management.
Earnings management is believed to be widespread, and has been cited as such in many journals and papers. There is empirical evidence of earnings management – abnormally smooth earnings is one of them. A good example is Enron: it had predictable, smooth earnings that beat analyst estimates quarter after quarter, until they could no longer hide their losses. Anecdotally, there are many instances of earnings management getting past auditors, knowingly or unknowingly.
Earnings management may be predictable in the short-run, but reduces predictability in the long-run. The reduction in predictability is known as lower earnings quality.
What is Earnings Quality?
Earnings quality reflects how representative the company’s financial performance is to their economic performance. Good quality earnings are good indicators of future earnings. Enron had poor earnings quality – even though their earnings were predictable in the short-run, it failed to reflect the true economic performance of the company. Unsurprisingly, it became unpredictable in the long-run.
Why do Companies Manage Earnings?
Companies manage earnings for many reasons, and they can manage it up or down. The most frequent case is aggressive revenue or expense recognition, where earnings are managed up. The primary reason why earnings are managed up is to meet or beat analyst expectations. Stock prices typically increase when earnings beat expectations, and consistent positive surprises usually translate to consistent out-performance. A contributing factor is the short-term nature of the stock market – quarterly results is favored over long-term plans. Combining these conditions with the stock and option-based compensation that many executives get as a part of their package results in improper incentives.
There are also less self-interested incentives for managing earnings. Many bond covenants are based on certain financial ratios that would be affected by net income. If the company is getting close to breaching a covenant, there is an incentive for aggressive recognition to meet those covenants. Broken covenants are usually undesired by all parties. Credit ratings are another reason – especially for management of the balance sheet. Meeting certain liquidity or solvency ratios is critical in getting a good credit rating and maintaining cheap access to funds.
External targets such as covenants are not the only targets for management, internal targets are important as well. Many times, management bonuses will be tied to a metric like ROI or Profit Margin. To meet those goals and maximize bonuses, bankers could be incentivized to meet those internal metrics. Other considerations are tax, political and special events like IPOs or Secondary Offerings.
Managing down is not uncommon, especially when new management is installed, or there was no chance that the company can meet earning expectations. The general principle is the same – take a larger loss (by accelerated recognition of expenses or one time write-downs) now so that you can do better later. The technique, known as big bath, depends on irrationality – a bigger loss now is better than a smaller loss with small losses distributed randomly across future reporting periods. For incoming managers, they usually claim that the losses are non-recurring and unrelated to future operations (they are of course, not responsible). General Electric recently used this in the form of a billion dollar write-down, when the new CEO was installed.
How do Companies Manage Earnings
The most common methods to manage earnings are:
Overly optimistic management estimates – management could be recognizing revenue with a more aggressive method, such as recognizing contracts immediately. On the cost side, management could be recognizing costs with aggressive methods such as percentage of completion for long term contracts, units of production depreciation, or lower bad debt expense. Conversely, management could use conservative revenue and expense recognition to take a big bath before resuming profitability.
Channel stuffing – management could be using their market power over customers or distributors to sell more goods. This is usually done at the end of a reporting period, when management knows for certain that they will miss analyst estimates. One example could be car manufacturers forcing car deals to purchase more cars from them before quarter end. Similarly, car dealerships also push their associates to sell more cars and give bigger discounts at month end.
Strategic disclosures – management could use the information asymmetry between them and investors to strategically release positive and negative news. Similarly, contracts and transactions could also be timed. For example, if they are close to meeting analyst estimates, they may decide to sell a piece of land that is worth more than its book value. Conversely, if they are far away from meeting analyst estimates, they may decide to not sell that land or take a non-recurring loss.
Mischaracterizing transactions – management could disguise transfers between related parties to be actual sales to customers. This could be between a company and its subsidiary, or another company that it has significant influences over. Special Purpose Vehicles (SPVs) are also common at one point in time, where they were used to hide balance sheet imperfections and used for transactions between related parties.
Identifying Companies that Manage Earnings
It is difficult to spot earnings management – management is heavily incentivized to make sure you do not find out. However, it is not impossible, and there are some common themes: powerful CEOs with weak board (corporate governance), high forecasts, overly smooth earnings, consistent positive surprises, and companies used to high growth and beating estimates. A combination of these factors may be more indicative of possible earnings management.
A more robust way to combat earnings management is to simply avoid using earnings to measure company performance. Finance already does this with FCFF and FCFE, as cash is much more difficult to manipulate.