Cooking the Books- via the WSJ

It's the end of the quarter. Do you know where your chief financial officers are?
CFOs around the nation have been busy closing their books and preparing for yet another earnings season. (It kicks off in earnest on Oct. 9, as always, with Alcoa Inc.)

But what exactly have they been busy with? If you believe a recent academic study, one out of five U.S. finance chiefs have been scrambling to fiddle with their companies' earnings.

Not Enron-style, fraudulent fiddles, mind you. More like clever—and legal—exploitations of accounting standards that "manage earnings to misrepresent [the company's] economic performance," according to the study's authors, Ilia Dichev and Shiva Rajgopal of Emory University and John Graham of Duke University. Lightly searing the books rather than cooking them, if you like.

According to academic experts, many CFOs use clever, and legal, exploitations of accounting standards that "manage earnings to misrepresent economic performance." Duke Professor John Graham and WSJ's Francesco Guerrera discuss on The News Hub.

The sources of this revelation are none other than the CFOs themselves. Last year, the academics asked 169 finance chiefs of public firms what percentage of companies, in their experience, use accounting ruses to report earnings that don't fully reflect the companies' underlying operations. (Note the indirect nature of the question to avoid self-incrimination.) The answer: around 20%.

Judy Brown is chief financial officer of Perrigo, a drug maker that only provides long-term guidance rather than quarterly guidance to investors. "If you build expectations, then you have to live by those expectations," she said. 

Taken in isolation, this finding isn't that surprising. It is an open secret that companies play around with "cookie-jar" reserves, accruals, and other accounting instruments to flatter, or even depress, earnings.
The tricks are well-known: A difficult quarter can be made easier by releasing reserves set aside for a rainy day or recognizing revenues before sales are made, while a good quarter is often the time to hide a big "restructuring charge" that would otherwise stand out like a sore thumb.

What is more surprising though is CFOs' belief that these practices leave a significant mark on companies' reported profits and losses. When asked about the magnitude of the earnings misrepresentation, the study's respondents said it was around 10% of earnings per share.

Even the authors of the research were surprised. "That's a big number, considering that we often see companies missing earnings estimates by two cents a share or so," Prof. Graham told me.

The CFOs and accounting experts I canvassed sounded equally startled by the results and interpreted them as a symptom of a long-standing plague of corporate earnings: the pressure to meet Wall Street's quarterly expectations.

"You will always be penalized if there is any kind of surprise," said one of the CFOs in the study—a statement that I imagine is emblazoned on the minds of many finance chiefs.

Part of the problem is self-inflicted. Many companies provide quarterly guidance to investors, fueling a numbers game that ends up benefiting no one.

Judy Brown, chief financial officer of Perrigo Co., a drug maker that only provides long-term guidance to investors, put it best. "If you build expectations, then you have to live by those expectations," she said. "That's an art because you are looking into a crystal ball, whereas closing the books is a science. So you are trying to marry an art and science."

Robert Howell, an accounting expert who teaches at the Tuck School of Business at Dartmouth College, was more explicit: "The quality of earnings is inversely correlated with whether a company makes earnings estimates."

Given the situation—and the small probability that companies will ditch earnings guidance overnight—investors should try and spot misleading earnings and act accordingly.
The CFOs in the study named and ranked several red flags.

First and foremost, investors should keep an eye on cash flow: Strong earnings when cash flow deteriorates may be a sign of trouble. The advantage of this approach is that, unlike some of the other warning signs, it is easily measurable, arming the investors and analysts who do their homework with strong ammunition against management.

Secondly, stark deviations from the earnings recorded by the company's peers should also set off alarm bells, as should weird jumps or falls in reserves.

The other potential problem areas are more subjective and more difficult to detect. When, for example, the chief financial officers urge stakeholders to be wary of "too smooth or too consistent" profits or "frequent changes in accounting policies," they are asking them to look at variables that don't necessarily point at earnings (mis)management.

As the quarterly ritual of the earnings season approaches, executives and investors would do well to remember the words of the then-chairman of the Securities and Exchange Commission Arthur Levitt in a 1998 speech entitled "The Numbers Game."

"While the temptations are great, and the pressures strong, illusions in numbers are only that—ephemeral, and ultimately self-destructive."

—Francesco Guerrera is The Wall Street Journal's Money & Investing editor. Write to him at: currentaccount@wsj.com and follow him on Twitter: @guerreraf72.