In a recent article in the Financial Analysts Journal, titled “The Misrepresentation of Earnings,” Ilia Dichev, John Graham, Campbell R. Harvey, and Shiva Rajgopal explore the defining characteristics of earnings quality and the misrepresentation of earnings. As part of their inquiry, they interviewed 12 CFOs and surveyed and additional 169 CFOs of public companies and 206 CFOs of private companies. Their reasoning for interviewing solely CFOs was, as they put it, that “CFOs know best the intersection of business operations and accounting rules, which determines earnings, and their choices largely determine the quality of earnings.”
During the course of their interviews most CFOs stated that they believed one in five companies intentionally misrepresented their earnings, they estimated, about 10 cents on every dollar. They also stated that roughly one-third of companies intentionally understate their earnings. Most CFOs responded that the reasons for misrepresenting earnings stem from a desire to influence stock prices, internal and external pressure to hit earnings targets, and executive compensation.
When asked what red flags one should look for to identify misrepresentations of earnings, the CFOs gave similar answers. The red flags that came up the most were: a lack of correlation between earnings and cash flows; unwarranted deviations from industry and peer norms; the presence of accruals and one-time charges; and consistently beating analyst forecasts.
Additionally the CFOs reflected on what characteristics were found in high quality earnings. Again, many of them came back with similar answers: consistent reporting choices over time; avoiding long-term estimates; and sustainability of cash flow.
Further into their discussion of what makes for high quality earnings, a theme became prevalent. High quality earnings reports must be clear, open, and sustainable. Alternatively, as one CFO said, “if something is too good to be true, it probably is.” Many of the CFO’s seemed to have the same idea, a high quality report is transparent and easily understood. They warn that if reports are confusing, or contain too many one-time items, investors might begin to lose trust in the company.
The ability to detect misrepresentation of earnings, however, is a bit difficult. When asked, one CFO estimated that it could take years before an analyst might detect mismanaged reports, since most misrepresented earnings are buried within publicly disclosed filings, and that only persistent abusers face the dangers of being detected.
The paper concludes that while detecting misrepresentation may be difficult the motivation for doing so tends to come from the declines in stock prices, and increase in cost of capital associated with poor earnings quality. Dichev, et al. also reiterate that the most prevalent characteristics in misrepresented earnings are a lack of clarity, and correlation between earnings and cash flow, mirroring what many of the CFOs said about clarity and transparency being the top characteristics of a high quality earnings report.
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