Experienced investors have heard of now-bankrupt companies such as WorldCom and Enron. Both participated in scandalous accounting schemes.
Neither company exists today, but each left a trail of losses that are still keenly felt. Many employees had their life savings in company stock quickly made worthless.
The scandals involved tricks that these companies used and some still use today to make their financial situations seem better than reality.
By design, accounting standards are open to a lot of interpretation. This gives managers flexibility on how they report earnings or revenues.
Wall Street focuses strongly on quarterly earnings reports. The big investors obsess over whether companies might report better-than-expected or worse-than-expected earnings. Small changes in investor sentiment can affect positions valued in the billions.
However, astute investors view these periodic reports with caution.
Managers, of course, are driven to please shareholders. Their compensation and, by extension, their jobs depend on keeping investors happy. This relationship should drive efficiency and excellency, but it can encourage management to use accounting tricks instead to artificially boost earnings — or even participate in fraud.
Investors may hear managers use the term “earnings management.” It’s just another term for manipulated earnings.
Company managers may attempt to manipulate earnings or revenues, depending on what they want to accomplish. For instance, an investor may want to investigate whenever changes in accounting procedures occur.
Companies that sell products might change the procedures for the movement of goods. When a company uses last-in, first-out (LIFO), the costs associated with this method will be different for first-in, first-out (FIFO).
For instance, raw materials might be contracted but not shipped, so a cost is not yet recognized. Lower costs can make short-run earnings seem better, triggering bonuses in the C-suite.
Or, goods might be sold to a distributor and counted as revenue but then remain unsold in the distribution chain for many months. Goods pile up. Eventually, new sales halt as distributors choke on inventory.
A one-time change in movement of goods accounting for tax advantage reasons could be a good move for shareholders. If so, such a change eventually will trickle through. Yet if the company flip-flops on procedures regularly, that’s a red flag.
Revenue recognition is another area ripe for manipulation. Many companies are required to use accrual accounting when they reach a certain size.
With this method, they must match expenses during a given period to the revenues earned for that period. They must also recognize the revenues when the products or services have been delivered. There’s enough gray area here to make revenue seem better or worse in any given quarter.
What caused earnings to increase?
When earnings increase substantially, it may be time to dig more into the reasons why.
- Did company management announce significant initiatives in previous periods that would account for the surge in earnings?
- Has the company been boosting its research and development budget that could explain why earnings have increased?
- Have there been capital expenditures for new equipment or land that could explain the earnings situation?
Management should explain any developments that may have led to increases in earnings. Listen to management discussions on earnings calls, or read the transcripts when they are published.
Investors should read through earnings footnotes diligently. Companies know that most investors won’t read through these crucial details of the financial statements.
Often, companies can escape regulatory scrutiny by disclosing out-of-the-ordinary situations in the footnotes. For some managers, that is the purpose of footnotes — to hide the ugly truth of what’s going on.
Responsible management teams use footnotes with discretion. When investors find managers constantly posting to footnotes, that could be an indication management is looking to manipulate financial reality.
Companies can be justified in taking certain actions. As an investor, however, you are not required to stick with the company if those actions cause you discomfort.
It’s your money. If something seems out of place, you have the right to take action yourself. You can sell the stock, avoid investing in the company or reduce your investment substantially.