Whenever TV pundits talk about investments, you generally hear them mention price/earnings (PE or P/E) ratios as the best way to value a stock, and there is usually talk about earnings estimates and whether a company exceeded or failed to live up to analyst forecasts. But behind the camera, most investment professionals recognize that a company’s value can be surprisingly hard to pin down, in part because you don’t know whether you can trust the earnings reports.
A new working paper at the Harvard Business School (“Earnings Management from the Bottom Up: An Analysis of Managerial Incentives Below the CEO”) summarizes an impressive amount of literature that shows how and why so many executives manipulate their company’s earnings reports. One study found that CEOs who are paid large stock options are more likely than average to mysteriously report earnings that almost exactly meet or barely beat analysts’ forecasts. Another showed that when top executives are holding a large number of vested (but unexercised) stock options, there is a higher probability that the company will eventually be sued for earnings manipulation.
Others reported that executives had slashed research and development expenses and advertising costs in order to give their after-expense numbers a short-term boost at the end of the year, particularly if their year-end bonus was tied to earnings. Executives might also stop investing in their own companies during periods when they wanted to exercise their options or sell some of their stock at a higher price. CEOs and field managers were also caught shifting future orders to the current fiscal year or moving this year’s expenses into future time periods.
The working paper found a connection between these accounting shenanigans and higher-than-average bonuses and stock incentive options for CEOs and chief financial officers—the executives who are responsible for compiling the data that goes into earnings reports. The authors found that CEOs and CFOs have a tendency to shift sales to the fourth quarter to meet bonus targets, and that high bonuses tend to be associated with future lawsuits around shady accounting practices. In general, the more stock options that were granted, the greater likelihood of manipulation.
These exaggerated earnings don’t change the economic reality at the company; they give executives a larger bonus payment or more stock option wealth. After the manipulation, the stock temporarily looks more valuable to outside investors, who see the boost in earnings or the tempting PE ratio, buy shares of the company, and experience disappointing investment results. Those investment losses are an indirect, hard-to-measure transfer of wealth from investors to corporate executives—and earnings manipulation is yet another contributor to market volatility. If you hear about shareholder rights battles, proxy initiatives and analysts talking about companies with good stakeholder relations, chances are this is more relevant than somebody who simply parrots the latest earnings report.
Maybe this is what Wall Street executives are thinking when they see the Occupy Wall Street protesters: http://www.borowitzreport.com/2011/10/17/a-letter-from-goldman-sachs/.