The rapidly unfolding diesel emissions scandal at Volkswagen has battered the company’s share price, prompted potentially costly criminal inquiries and triggered an unprecedented governance crisis at one of Germany’s most storied brands. The lesson for shareholders is clear: integrity matters. Unfortunately, the pressure to perform often leads companies astray. In less forgiving market environments, the signs might be subtle but the forces of short-termism, the temptation to manage earnings and outright accounting fraud can lead to equally pernicious outcomes. During these times, institutional investors must be especially diligent and take steps to assess the earnings quality of their holdings.
It’s no secret that the investing climate has changed radically in the past few months. On Aug. 13, the CBOE S&P 500 Implied Correlation index declined below 44, its lowest level since the recession. Just a few days later, on Aug. 17, the CBOE Market Volatility index spiked to 28.03, its highest level in three years. With correlations down and volatility up, securities are once again trading on reported revenue, earnings, and guidance. Without a rising tide of positive macro and economic data to lift all boats, companies might be tempted to pursue aggressive accounting practices. Assessing the risk is no easy task. Aggressive practices are not always obvious to institutional investors — or to company management. They are often not illegal or even inconsistent with generally accepted accounting principles. But investors who fail to recognize the warning signals are destined to incur material losses.
The stakes are high. Surveys of CFOs suggest, time and again, that earnings management and inappropriate accounting practices are likely pervasive and maddeningly difficult to spot from the outside. Outright accounting fraud is especially costly. According to an August 2014 working paper — “How Pervasive is Corporate Fraud?”, by Alexander Dyck, professor of finance and business economics, Rotman School of Management, University of Toronto; Adair Morse, assistant professor of finance, Haas School of Business, University of California at Berkeley; and Luigi Zingales, Robert C. McCormack distinguished service professor of entrepreneurship and finance, University of Chicago Booth School of Business — only a quarter of all fraud may be detected in normal times. The authors imply that from 1996 to 2004, on average, one out of seven large, publicly traded U.S. firms was engaged in fraud — and that firms committing fraud destroy, on average, a fifth of their enterprise value, which includes market capitalization and the value of debt. Based on their work, the authors estimate the average cost of fraud in large corporations to be $380 billion a year.
Any judgment about the quality of reported earnings must begin with an assessment of revenue sustainability. Elevated receivables could suggest that channel inventory is potentially too high. A spike in customer finance receivables could indicate a deterioration in the quality of the company’s customer base. In the current environment, weaker-than-expected revenue or guidance over consecutive periods should be treated by investors as a clear warning signal. In the second quarter, unlike in previous quarters, many companies were punished by investors despite disclosing prior weakness. This less forgiving attitude is likely to persist.
Earnings management tactics represent another accounting red flag. The danger is that companies seeking to reduce near-term costs for “window-dressing” purposes could ultimately impair long-term shareholder value. Over the last year, for example, some companies in people-intensive industries such as consulting have felt financial pressure to reduce compensation and non-payroll-related expenses. Even when sales and marketing expenses as a percentage of revenue decline impressively – to their lowest level in years, for some firms – the long-term health of the business might suffer from high attrition and a newfound dependency on less experienced consultants.
Similarly, technology companies operating in highly competitive markets might be tempted to reduce research and development spending in an effort to offset higher than expected expenses and enable a company to meet consensus earnings expectations. But the predictability comes at a cost. The quality and sustainability of the earnings might be highly suspect. Research and development is the lifeblood of most leading technology firms and any reduction in spending is likely to impair growth over the long haul.
A final method of assessing the quality of reported earnings is to look at a company’s internal control systems. Problems are often visible well in advance. Companies may change auditors, for example, or disclose significant internal control issues over time, such as errors in data used for projections, or inaccurate disclosures. A surge in working capital levels concurrent with such internal control issues is a clear sign of trouble and a potential precursor to costly earnings restatements.
Sometimes good news can obscure the bad. Companies on an acquisition spree or those that pursue a consolidation strategy may overstate revenue and earnings growth for years if appropriate financial reporting systems are not in place. Disparate systems may create an environment where it is difficult to manage billing, apply inventory costing methods, and implement uniform accounting policies. The result, sadly, may well be earnings restatements and a plunge in the stock price plunge.
