By |Published On: April 24th, 2014|Categories: Research Insights|

The Misrepresentation of Earnings

Abstract:

We ask nearly 400 CFOs about the definition and drivers of earnings quality, with a special emphasis on the prevalence and detection of earnings misrepresentation. CFOs believe that the hallmarks of earnings quality are sustainability, absence of one-time items, and backing by actual cash flows. Earnings quality is determined in about equal measure by controllable factors like internal controls and corporate governance, and non-controllable factors like industry membership and macroeconomic conditions. On earnings misrepresentation, CFOs believe that in any given period a remarkable 20% of firms intentionally distort earnings, even though they are adhering to generally accepted accounting principles. The economic magnitude of the misrepresentation is large, averaging about 10% of reported earnings. While most misrepresentation involves earnings overstatement, interestingly, one third of the firms that are misrepresenting performance are low-balling their earnings or reversing a prior intentional overstatement. Finally, CFOs provide a list of red flags that can be used to detect earnings misrepresentation.

Alpha Highlight:

This paper doesn’t try to guess about how companies manipulate earnings, instead, they take a more direct approach and ask the companies–a novel idea!

The first question the authors ask is “What are the motivations for earnings misrepresentation?”

why

Not surprisingly, a company will influence earnings to try and move the stock around–duh! That said, it looks like they manipulate to reduce expectations about the future and to play Jedi mind tricks with the competition–very interesting!

What are the biggest red flags for earnings manipulation?

redflag

Well, we already knew about net income and cash flow mismatches (Quantitative Value has several chapters dedicated to forensic accounting). All the others are common sense at some level. The trick for forensic accounting is to build a systematic checklist and/or automated screening process that ensures one identifies and analyzes situations that may be susceptible to manipulation.

This is an awesome paper!

Here is a slide deck that outlines the paper’s main points: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2347428

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About the Author: Wesley Gray, PhD

Wesley Gray, PhD
After serving as a Captain in the United States Marine Corps, Dr. Gray earned an MBA and a PhD in finance from the University of Chicago where he studied under Nobel Prize Winner Eugene Fama. Next, Wes took an academic job in his wife’s hometown of Philadelphia and worked as a finance professor at Drexel University. Dr. Gray’s interest in bridging the research gap between academia and industry led him to found Alpha Architect, an asset management firm dedicated to an impact mission of empowering investors through education. He is a contributor to multiple industry publications and regularly speaks to professional investor groups across the country. Wes has published multiple academic papers and four books, including Embedded (Naval Institute Press, 2009), Quantitative Value (Wiley, 2012), DIY Financial Advisor (Wiley, 2015), and Quantitative Momentum (Wiley, 2016). Dr. Gray currently resides in Palmas Del Mar Puerto Rico with his wife and three children. He recently finished the Leadville 100 ultramarathon race and promises to make better life decisions in the future.

Important Disclosures

For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. Third party information may become outdated or otherwise superseded without notice.  Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency has approved, determined the accuracy, or confirmed the adequacy of this article.

The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Alpha Architect, its affiliates or its employees. Our full disclosures are available here. Definitions of common statistics used in our analysis are available here (towards the bottom).

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