CFO’s see earnings shenanigans in 20 pct of U.S. public firms: James Saft

September 23, 2015

Sept 23 (Reuters) – If you think the fact that a U.S.
company’s earnings conform to accepted standards means they are
to be trusted, then allow me to introduce you to the 20 percent
of chief financial officers who disagree.

A survey of nearly 400 chief financial officers and top
finance executives found the belief that earnings
misrepresentation is widespread.

“CFOs believe that in any given period a remarkable 20
percent of firms intentionally distort earnings, even though
they are adhering to generally accepted accounting principles
(GAAP),” Ilia Dichev of Emory University, John Graham and
Campbell Harvey of Duke University and Shiva Rajgopol of Emory
and Columbia University write.

“The economic magnitude of the misrepresentation is large,
averaging about 10 percent of reported earnings.” (here)

Think about that for a moment: a portfolio of 50 companies
might include 10 which, though they are abiding by the letter of
the regulations, are still giving a misleading view of their
earnings and position.

Of the firms that do misrepresent earnings, two out of three
overstate, with the remainder understating.

The survey polled 375 CFOs and others in equivalent
positions, of whom a little less than half were at public
companies. The authors also supplemented the data gathering with
12 anonymous, in-depth interviews with CFOs at large firms.

The CFO’s themselves didn’t give much credit to the
existence or strength of an audit committee as a safeguard,
giving them a low ranking in a listing of factors that influence
earnings quality.

“I think you can fool them, but what the audit committee is
essentially going to ask is whether the CEO and controller are
basically honest people who are going to report faithfully,” the
report quoted one CFO as saying.

“That’s about all they can do at the end of the day.”

If audit committees don’t strike fear in CFOs, neither do
regulators. Even lower on the list, second last, was the
enforcement process of the Securities and Exchange Commission.

CFO’s gave even lower marks to privately held companies,
estimating that earnings are misrepresented among them 30
percent of the time. That’s a statistic that ought to alarm both
private equity buyers of private companies and private equity
investors.

In some ways that gap makes sense. Private companies face
less scrutiny from public analysts and regulators, making the
chances of being caught lower. Interestingly, CFOs, while not
rating the ability of sell-side equity analysts to sniff out
trouble, were more complimentary about debt investors and
analysts, who usually pay closer attention to cash flows and
less to flashy “growth” stories.

WHO STOLE THE COOKIE FROM THE COOKIE JAR?

We have a pretty clear view of why companies misreport
earnings. They do so to impress Wall Street and drive their
stock price. There is also internal pressure, either as a means
of rigging executive compensation or because they feel they face
sanction if they report poor performance.

Similar motivations may be behind understating earnings.
Companies may wish to stash away what one CFO termed “cookie-jar
reserves,” funds that can be tapped later to flatter earnings if
they fall short. It is also possible, but not supported by this
data, that executives sometimes wish to create downward
volatility in share prices as a means of maximizing the value of
the share options they hold.

That company insiders benefit from and work to game
incentives that are against the best interests of shareholders
is not news. The sheer extent of this, though, if this survey is
reliable, is shocking.

A practical question for investors is how to sift
high-quality earnings from lower-quality ones.

There is an old expression “cash flows never lie” and CFOs
appear to agree. When asked to name red flags for
misrepresentation more than a third emphasized the importance of
seeing earnings that don’t correlate with cash flow from
operations, or firms which show strong earnings despite falling
cash flow.

As Enron and others have proved, another thing to look out
for is a firm that never puts a foot wrong at earnings season,
always meeting or beating analyst expectations. Large or
frequent one-time or special items, like restructuring charges,
can also flash red.

The upshot of all of this is more caution and due diligence
by investors. Theoretically, this information will lead, or
already has led, to investors demanding a higher risk premium in
exchange for bearing accounting risk. Since we don’t have a
benchmark for this particular survey from before Sarbanes Oxley
regulatory changes more than a decade ago, it is hard to know if
the trend is for more fibbing or less.

Good or bad, earnings are read with a gimlet eye and taken
with a large dose of salt.
(At the time of publication James Saft did not own any
direct investments in securities mentioned in this article. He
may be an owner indirectly as an investor in a fund. You can
email him at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(Editing by James Dalgleish)

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