Does it seem that companies beat earnings a little too regularly and by the slightest of margins (1-2 pennies per share)? Does it seem strange that companies can give precise guidance as to earnings and revenues for the year ahead? Well, it should not because as it turns out, it is quite easy for company officers to manage (manipulate?) earnings even after Sarbanes-Oxley, which was supposed to prevent companies from inflating earnings or committing fraud. I recently found this survey from CFO magazine which asked company CFOs a few interesting questions.
According to the survey of CFOs:
1. More than half of CFOs admit that they can legally manage earnings by 3% or more. (This would explain why companies always beat by 1-2 pennies)
2. About a quarter of CFOs confess to influencing earnings upward. (Surprisingly, 8% admit to influencing earnings down. These honest souls risk being fired because of their moral character!)
3. A few of the more common ways of distorting earnings were: delaying operational spending, accelerating order processing, and putting pressure on the sales force.
4. CFOs rarely faced problems from auditors. After all, the auditors are paid by the company.
While the survey results are disturbing, they are not new. In fact, Jack Welch (former GE CEO) wrote in his memoirs how easy it was to "find earnings." He noted that to mitigate $350 million in write-offs, GE managers "said they could find an extra $10 million, $20 million, and even $30 million from their business to offset the surprise." Ahh, wasn't Jack a great CEO? He showed such leadership when it came to beating Wall Street earnings at any cost. His real claim to fame was GE capital which operated like a black box trading system, always producing earnings for GE when it was really needed through the abuse of reserve accounts. The real genius was the simplicity--during good years GE capital would over reserve for credit losses, and then when GE needed to "find earnings," the company would release the reserves to beat by a penny.
The only reason I bring up this topic up is because I see analysts, fund managers, and market commentators always arguing over S&P 500 earnings and whether the market is cheap or not. The truth is that the frequent managing (manipulation) of company earnings it is really impossible to discern whether or not the market is cheap or expensive. I know that some skeptics or apologists will claim that not all companies doctor their earnings statements. To this argument I say: look at what corporate officers themselves think about company financial statements. Only 27% of CFOs assert that if they were investing their money, they would feel very confident about the financial information from public companies. Furthermore, an older golf survey conducted in 2002 by Starwood hotels of Fortune 500 executives revealed the following:
99% consider themselves to be honest in business,
87% played with someone who cheats at golf,
82% cheated themselves at gold,
82% hated others who cheat at golf, and
72% believe that business and golf behaviors are parallel.
Source for article
CFO Magazine (2007) and Starwood Hotels Golf Survey (2002)
Black Swan Insights