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],” researchers from Duke, Emory and Columbia universities found.
“The economic magnitude of the misrepresentation is large, averaging about 10 percent of reported earnings.”
Of the firms that do misrepresent earnings, 2 out of 3 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 CFOs themselves didn’t give much credit to audit committees as a safeguard, giving them a low ranking in a listing of factors that influence earnings quality.
If audit committees don’t strike fear in CFOs, neither do regulators. Even lower on the list, second last, was the Securities and Exchange Commission.
Interestingly, CFOs were more complimentary about debt investors and analysts, who usually pay closer attention to cash flows and less to flashy “growth” stories.
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.
How to sift high-quality earnings from the rest?
There is an old expression “cash flows never lie,” and CFOs appear to agree. When asked to name red flags for misrepresentation more than one-third emphasized the importance of seeing earnings that don’t correlate with cash flow from operations, or firms that show strong earnings despite falling cash flow.
As Enron and others have proved, one should also look out for firms that always meet or beat analyst expectations.
The upshot of all 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.
Good or bad, earnings are read with a gimlet eye and taken with a large dose of salt.
James Saft is a Reuters columnist.