Federal regulators are looking into companies whose executives, under pressure to hit certain targets, are manipulating earnings results, reports an article in The Wall Street Journal. Over 99% of S&P 500 companies have reported their 4th quarter earnings; those earnings are down 4.65% while expectations are higher for future returns.
It’s common for executives to exercise some creative flexibility in the accounting of such things as reserves for losses and revenue recognition in order to give reported earnings per share a boost, especially during periods of economic turmoil. Most of the time, that’s completely legal, but sometimes it can cross the line into breaking the law or possibly fraud. Actions that cross that line include manipulating the accounting to hide financial deterioration or reconfiguring the numbers in a way that steps outside the boundaries of accepted accounting practices. Given the current strained environment for earnings, regulators are paying close attention. Using their “EPS Initiative,” which utilizes data-driven analytics to determine whether manipulation has occurred, the SEC has brought cases against six companies and a significant number of executives, including five CFOs, The Journal reports.
By going after individuals, the SEC hopes to change corporate behavior and that other executives will be dissuaded from tweaking their accounting. Earnings manipulation has long been a thorn in the SEC’s side; 25 years ago, then-chairman Arthur Levitt called out “accounting hocus-pocus” as a major problem, to no avail. And in February, Warren Buffett slammed the practice in his annual letter to shareholders, calling it “one of the shames of capitalism,” according to the article.
But earnings management that smooths out the impact of one-off events can effectively help investors. Says David Farber, a professor at Indiana University’s Kelley School of Business, “Companies that among earnings well can have more predictable earnings and cash flows, and that’s reflected in the price of their stock.” Companies with highly skilled management teams are more likely to use smoothing practices more effectively, adding to the companies value. On the other hand, executives who participate in earnings manipulation can face heavy punishment and greatly damage the value of their companies: Peter Armbruster is currently serving two years for accounting fraud he committed as CFO of Roadrunner Transportation Systems, and the company paid $20 million to settle a class-action suit brought against it by shareholders.
