CFO Diaries: The Inside Skinny on Earnings Manipulations

CFO Diaries: The Inside Skinny on Earnings Manipulations

April 24, 2014 Research Insights
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(Last Updated On: January 18, 2017)

The Misrepresentation of Earnings

Abstract:

We ask nearly 400 CFOs about the definition and drivers of earnings quality, with a special emphasis on the prevalence and detection of earnings misrepresentation. CFOs believe that the hallmarks of earnings quality are sustainability, absence of one-time items, and backing by actual cash flows. Earnings quality is determined in about equal measure by controllable factors like internal controls and corporate governance, and non-controllable factors like industry membership and macroeconomic conditions. On earnings misrepresentation, CFOs believe that in any given period a remarkable 20% of firms intentionally distort earnings, even though they are adhering to generally accepted accounting principles. The economic magnitude of the misrepresentation is large, averaging about 10% of reported earnings. While most misrepresentation involves earnings overstatement, interestingly, one third of the firms that are misrepresenting performance are low-balling their earnings or reversing a prior intentional overstatement. Finally, CFOs provide a list of red flags that can be used to detect earnings misrepresentation.

Alpha Highlight:

This paper doesn’t try to guess about how companies manipulate earnings, instead, they take a more direct approach and ask the companies–a novel idea!

The first question the authors ask is “What are the motivations for earnings misrepresentation?”

why

Not surprisingly, a company will influence earnings to try and move the stock around–duh! That said, it looks like they manipulate to reduce expectations about the future and to play Jedi mind tricks with the competition–very interesting!

What are the biggest red flags for earnings manipulation?

redflag

Well, we already knew about net income and cash flow mismatches (Quantitative Value has several chapters dedicated to forensic accounting). All the others are common sense at some level. The trick for forensic accounting is to build a systematic checklist and/or automated screening process that ensures one identifies and analyzes situations that may be susceptible to manipulation.

This is an awesome paper!

Here is a slide deck that outlines the paper’s main points: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2347428


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About the Author

Wesley R. Gray, Ph.D.

After serving as a Captain in the United States Marine Corps, Dr. Gray received a PhD, and was a finance professor at Drexel University. Dr. Gray’s interest in entrepreneurship and behavioral finance led him to found Alpha Architect. Dr. Gray has published three books: EMBEDDED: A Marine Corps Adviser Inside the Iraqi Army, QUANTITATIVE VALUE: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors, and DIY FINANCIAL ADVISOR: A Simple Solution to Build and Protect Your Wealth. His numerous published works has been highlighted on CBNC, CNN, NPR, Motley Fool, WSJ Market Watch, CFA Institute, Institutional Investor, and CBS News. Dr. Gray earned an MBA and a PhD in finance from the University of Chicago and graduated magna cum laude with a BS from The Wharton School of the University of Pennsylvania.