Alex Berenson, writing in the New York Times in the summer of 2002 at the end of Jack Welch’s CEO tenure, noted, “For years, Wall Street has known that companies manage their earnings. Some companies, like General Electric, almost always seem to beat estimates by a penny or two a share, no matter what the economic climate.” Real trouble begins, however, when earnings management starts to descend toward earnings manufacture. When that happens investors are virtually guaranteed to come face-to-face with very significant declines in share price at some point. The only question is when they will and which of those investors will still be shareholders in the company when it happens.
Creating an Earnings Reserve
Earnings management is having earnings that could have been reported but were not, in order to create an earnings reserve. Picture this as a bucket labeled “earnings” that management fills up over time and then can dip into when needed. Managers can do this when they need to report numbers higher than those reflected in the actual earning period. Because the bucket never really goes totally empty, overall earnings are never exaggerated and, when viewed over time, the company’s growth rate is not exaggerated. This is the simplified model of earnings management that companies admit to practicing. Here, however, the growth rate would be understated if there were still earnings in the bucket, and investors would have been harmed because share price would not be at its full potential value.
Of course, the level of earnings in the bucket at any point in time is never disclosed. Neither do companies report whether or not they’ve poured some additional earnings into or dipped some out. To do so would defeat the purpose of earnings management. If one could monitor additions and subtractions to the reserves, actual earnings instead of reported earnings could be and would be calculated.
That is why the earnings reserves kept in the bucket differ in principle from the type of reserves normally recognized by GAAP. Companies usually disclose the reserves recognized by GAAP at the time they are established, along with the level of the reserves and how much has been used. They are less diligent at reporting what should have been used. Earnings management reserves, on the other hand, are not disclosed and in fact do not exist officially until managers need them.
In practice, earnings management can deteriorate into earnings manufacture quite rapidly. At first, managers may create earnings by changing their accounting policies or by adjusting their accounting estimates and assumptions. For example, they can adopt progressively more aggressive GAAP interpretations, but still be in conformity to GAAP. Obviously, companies should have the ability to adopt an accounting convention that conforms to GAAP if that change reflects reality, even if it is a more aggressive interpretation that increases a period’s earnings or earnings in all periods going forward. They may have very legitimate reasons to do so. A change in accounting practices does not necessarily indicate earnings manufacture, but an undisclosed accounting change that comes to light at a later time will most likely point to earnings manufacture. A series of new accounting interpretations that all result in higher earnings should raise the possibility of earnings manufacture. The pressure builds as they continue to follow these practices period after period, until what they may have thought of as “benignly” managed earnings turns into something more serious.
Michael Young, author of Accounting Irregularities and Financial Fraud: A Corporate Governance Guide (Aspen Publishers, Inc., 2001), succinctly describes the danger of managed earnings and its likely deterioration to manufactured earnings when top management establishes a culture that embraces earnings management. “Managerial acceptance of managed earnings, and in particular cookie jar reserves, can send an extraordinarily dangerous message to the troops: ‘Where it is for the good of the corporate enterprise, it is all right to camouflage the truth.’ Once that genie is out of the bottle, it will never go back. Managers at all levels will perceive themselves as having the license, if not the encouragement, to do what they have internally tried to resist all along—camouflage their own dismal inadequacies by subtle rearrangement of the numbers.”
A thorough understanding of why decisions were made and their impact is needed to identify the patterns and trends and to distinguish between earnings management and earnings manufacture. A pattern of more aggressive accounting interpretations is sometimes referred to as deteriorating “quality of earnings.” Not surprisingly, quality of earnings is often associated with the risk of whether earnings levels can be sustained; a company with poor earnings quality has less cushion. In other words, managers find it harder to fill the bucket because they’ve already manufactured earnings, and they become hard pressed to find new manufacturing methods. The insidious nature of manufactured earnings rests in the fact that management can justify within GAAP each individual interpretation that resulted in the appearance of extra earnings.
In GAAP, there is never a “right” number. There are only numbers that are closer or farther from an accurate description of the actual risks and performance of the enterprise.
All this should make investors very suspicious of executives who proclaim that the business will grow steadily at some rate year after year. By setting an earnings growth goal, and announcing it publicly, they have defined their own success and failure, and one would expect they would do “whatever it takes” to meet their goal.
The Trouble With Managed Earnings
Assume, for argument’s sake, that a company has the discipline to only manage earnings. They fill the bucket with earnings that they have not recognized but could have, and dip into the bucket to smooth earnings as needed, never allowing the bucket to go dry. Management justifies changing accounting estimates and assumptions because changes presumably both help and hurt earnings over time. The argued benefit is that investors will experience less stock price variability as earnings consistently increase at a certain rate. As investors perceive the stock to be less risky, it will trade at a premium price.
The problem with this argument is that investors buy and sell their stock constantly. By managing earnings, companies deny investors accurate information about the real earnings of a company at all times. Companies might counter that because all investors are equally denied information, the playing field remains level, and no investor is disadvantaged by this lack of transparency. Investors are buying and selling for reasons other than the difference between actual and reported earnings, so harm is randomly allocated. If in fact there is always some level of earnings available in the bucket, one could argue that all investors have been equally harmed because actual earnings were really higher than reported.
Although earnings management may disadvantage all investors equally, the reason they are disadvantaged is because performance of their investments becomes a function of random timing or someone having inside information rather than because they have great insight or do superior analysis. Everyone is disadvantaged because incremental capital is allocated based on the promise of false earnings and growth at the expense of better real opportunities. In truth, not all shareholders are disadvantaged by earnings management: Insiders who own stock or options (and who know the real results and the real growth rates) have a clear advantage over outside investors.