Since management has considerable flexibility in making choices related to accounting policies and using estimates in measurements for the purpose of financial reporting, they may use these to tweak financial results and presentation. While a deterioration in financial reporting quality is easier to see, earnings management is harder to detect.
Companies may present non-GAAP (proforma) earnings numbers to provide more relevant information to users of the financial statements, but also to paint a more favorable picture of their financial performance and position. Such pro forma adjustments were prevalent in:
- Early-stage technology companies (because they had high valuations despite negative earnings).
- Companies engaged in acquisitions (because they wanted to exclude any impairment on goodwill charge subsequent to acquisitions).
- Established companies undergoing restructuring (because they wanted to exclude one-time restructuring charges from their net income).
EBITDA is a popular pro forma earnings measure which is often further adjusted by companies by excluding rentals (in which case it becomes EBITDAR), equity-based compensation, acquisition-related charges, impairment charges for goodwill and other intangible assets, impairment charges for long-lived assets, litigation costs, and loss/gain on debt extinguishments. Sometimes a company may disclose a performance measure specifically required by a lender under the loan agreement.
Regulators and accounting standards require companies to disclose, with equal prominence, comparable GAAP measures, whenever they report a non-GAAP measure and provide a reconciliation between the GAAP and non-GAAP measures. SEC prohibits exclusion of charges and liabilities requiring cash-settlement from earnings (other than EBIT and EBITDA). It also prohibits exclusion of an item as infrequent non-recurring if either it occurred during the last two years is expected to occur in the next two years. SEC may identify any misleading non-GAAP measures and require companies to change the presentation failing which it might initiate enforcement action against them.
Accounting choices and estimates
Management choices may have a profound impact on a company’s financial performance and financial position in a period. This does not necessarily involve accounting choices but may result from management’s decision to ship goods faster (in order to recognize more revenue in the current period) or slow down shipments (when sales are too high).
Estimates are important for the accrual basis of accounting because not all information is known with certainty. However, they create an incentive for management to manage numbers by changing estimates and associated assumptions. This is particularly problematic because no one can tell beforehand whether an estimate is right or wrong. Choices which can potentially become tools of earnings management include:
- Revenue recognition: Management may change shipment terms (FOB shipping point vs FOB destination) or engage in channel stuffing (offering extravagant discounts or threats of near-term price increases or just deliver goods not ordered). An analyst needs to look at receivable balance relative to sales, return history, revenue accounting procedures, and policies, etc.
- Provision for doubtful accounts: Compare with sales, past history, movement during the year, etc.
- Inventory cost formulas: compare with competitors whether the cost flow formula is appropriate, check for any provision for obsolescence, any LIFO liquidation, etc.
- Deferred taxes (and associated valuation allowance): Contrast with management commentary about future business prospects to see that assumptions for financial reporting are consistent with management expectations about profitability.
- Depreciation methods (and associated estimates regarding salvage value and useful life): An analyst needs to see when and why any changes in the estimates were made, whether there has been an asset write-down (which may indicate inadequate depreciation) and compare them for reasonableness with the company’s competitors.
- Policy regarding capitalization (particularly of intangible assets): Compare capitalization policies with competition and look at the balance sheet for research and development cost capitalization.
- Allocation of fair value to different assets in an acquisition—companies may have an incentive to assign a lower value to depreciable assets so as to decrease their depreciation and related charge and/or to increase goodwill (which would not be depreciated).
- Estimates and assumptions regarding goodwill amortization.
- Warranty reserves: Compare with sales and see there is not an unusual reduction.
- Related-party transactions: Because companies may route a transaction through a related party to mask its impact.
Financial reporting quality and cash flow statement
The cash flow statement is less prone to earnings management than the income statement. It is because cash flows are not as sensitive to estimates, assumptions and policy changes as net income. Hence, a company with a consistent relationship between cash flow from operating activities and net income, or the small gap between cash flow from operating activities and cash outflow on capital expenditure, debt service, dividends, etc. are likely to have high earnings quality.
However, cash flow figures are not totally immune to manipulation. For example, a company presenting a cash flow statement under the indirect method can increase its cash flows from operating activities by stretching its accounts payable. Investors can catch this by looking at the working capital changes part of the cash flow statement to spot any unusual variances. Companies may also misclassify operating cash outflows as investing or financing. It is useful to analyze a company’s cash flows in the context of its industry and competitors. Further, IFRS allows flexibility in the classification of interest paid and received and dividends paid and received.