America's CFOs Admit: Lots of Companies Are Fudging Their Numbers

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America's CFOs Admit: Lots of Companies Are Fudging Their Numbers
If sometimes you have that nagging feeling that the investment playing field is not exactly tilted in the individual investor's favor, you just might be on to something.

Last week, a survey of 500 financial professionals revealed there is indeed real reason to hold onto one's wallet when dealing with those "helping" us invest our life savings: Almost one-third of respondents to the survey had firsthand knowledge of wrongdoing in the workplace. And one-third of these financial pros reported feeling pressured to violate the law or engage in unethical conduct at work.

The Shenanigans Continue

Now, another study just out further undermines our confidence in the investing world: Researchers at the business schools of Emory and Duke universities came to the conclusion that "in any given period, about 20% of firms manage earnings to misrepresent their economic performance."

The research team came to this finding after surveying 169 CFOs of publicly traded companies and interviewing 12 others on their opinions of "earnings quality."

A great majority of those CFOs said that the reason to manage earnings was to "influence stock price." Other reasons given were external and internal pressures to hit benchmarks. Wall Street, most of those interviewed said, hates surprises.

Earnings also can affect executive compensation. One CFO said, "Over the last five years, compensation consultants have shifted many companies toward using a GAAP-based earnings hurdle for their stock compensation. ... I think earnings management is still done, and in many cases it is for executive compensation."

Red Flags

The study uses the term "earnings management" as meaning "aggressive reporting choices within GAAP, i.e., we explicitly rule out fraudulent transactions in both our survey instrument and interviews."

OK, so if earnings management does not entail outright lying, how are the numbers fudged and how can one know when they are?

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One of the first places to look for managed earnings, according to the CFOs surveyed, is at cash flow. "[E]arnings strength with deteriorating cash flows," and when "earnings and cash flows from operations move in different directions for 6-8 quarters," should raise eyebrows, they said.

Another red flag would be deviations from industry norms in "cash cycle, average profitability, revenue and investment growth, and asset impairments." The research team points out that these items would have shown up in the Enron and WorldCom earnings manipulations cases.

The study suggests one should also look at "unusual behavior in accruals, including large jumps in accruals." Accrual accounting puts a transaction on the books when it occurs, not when actual payment is made or received. However, accruals without the cash to eventually back them up make the bottom line look good, but won't show up where it really matters: the cash flow statement.

Other suspicious activities could include "earnings and earnings growth that are too smooth for fundamentals," and "frequent one-time items."

One aspect of earnings management that could do real and lasting harm to a company is when company executives pretty up the bottom line by cutting items such as R&D, maintenance expenses, and marketing expenditures. Whether those actions are justified or not is hard for those on the outside to know.

Buyer, Really Beware

So the disappointing bottom line is, in any given quarter, one-fifth of those earnings reports that investors and analysts doing their due diligence are poring over might just as well be copies of Great Expectations for all the useful financial information they will provide.

Then again, for the optimists out there, that leaves 80% or earnings reports that could be helpful.

Highest Paid CEO's
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America's CFOs Admit: Lots of Companies Are Fudging Their Numbers

In 2011, Ford (F) paid Mullaly $29.5 million, a 11% raise over the previous year. Mullaly has long had an interesting, somewhat fraught, relationship with compensation. In 2008, as the auto industry was taking a nosedive, he drew fire when he and other auto execs traveled to Washington, D.C., on private jets seeking help for the industry. Shortly thereafter, Mullaly sold most of Ford's corporate jets and drove a hybrid car to Washington for his next meeting. That year, Mullaly agreed to accept a $1 annual salary if Ford received a government bailout. Instead, the automaker kept its head above water without federal aid, and Mullaly took home $13.6 million. The next year, he made $17.9 million.

Daane has been the CEO of Altera (ALTR) since 2000. One of the nation's largest producers of programmable logic devices, the company is a major player in semiconductors. Daane's 2011 salary was $29.6 million, a 278% increase over the prior year.

In 2011, Marathon (MRO) paid Cazalot $29.9 million, a 239% raise over the previous year. Unlike many top CEOs, Cazalot's training isn't in law or business, but rather in geology, and under his leadership, Marathon has vastly expanded its overseas investments. While Marathon has certainly had a good year, the majority of Cazalot's raise came from a change in the company's incentive program, and likely will not be repeated.

In 2011, Iger was paid $31.4 million. A modest 12% increase over the previous year, Iger might be one of the few CEOs who was underpaid that year. A major force behind the studio's 2009 purchase of Marvel Entertainment, Iger's management decision that has given Disney (DIS) a major cash cow. With The Avengers breaking box office records and sequels to Thor, Iron Man 2, Captain America, The Avengers and The Hulk in the pipeline, it looks like Iger's purchase will continue paying for itself long into the future.

Cote has been leading Honeywell (HON) for 10 years, but 2011 was a particularly good one. He was paid $35.7 million, a 135% raise over the previous year. Then again, Honeywell seems to have a lot of money to spend: Between 2008 and 2010, it spent over $18.3 million on lobbying, laid off 968 workers, made $4.9 billion in profits and increased compensation by 15% for its top five executives. During the same period, it not only paid no taxes, but actually received $34 million in tax rebates.

On the surface, Dauman's $43.1 million 2011 salary seems to be a disappointment; after all, it's a 49% drop from the previous year. Then again, he received a 148.6% raise in 2010, the top CEO raise that year. And things might be a bit tight in the Dauman household: Earlier this month, he sold 286,447 shares of Viacom stock (VIA), almost a third of his personal holdings, for $13.8 million.

Motorola Mobility CEO Jha was widely reviled by his employees. In fact, he has received a 50% approval rating from Motorola workers, who also give their workplace a failing grade of 2.6 out of 5. So why did the mobile phone exec receive a 2011 compensation package worth $47.2 million -- a 262 percent increase over his 2010 pay? Well, this huge windfall reflects Google's purchase of the company, a deal that gave Jha a golden parachute of three times his yearly salary, in addition to an eventual payout of $52.5 million for his stock options.

In 2011, Discovery Communications (DISCA) paid Zaslav $52.4 million to run its collection of networks. A 23% increase over his 2010 salary, this reflects, among other things, Zaslav's efforts to develop OWN, the Oprah network.

Depending on who's doing the accounting, Moonves' compensation package in 2011 totaled either $68.4 or $69.9 million. Either way, he got a salary boost of over 20% last year, making him the highest paid media CEO in the U.S. Several pundits have questioned his high salary and amazing bonuses, but CBS' stock (CBS) took a 42% boost last year, and it is currently the top-rated television network, a position that many credit to Moonves' stewardship.

In addition to being the highest paid CEO in the U.S., Simon also got the biggest raise. In 2011, he brought home $137.2 million, a 458% increase over his previous year's salary. Shares in Simon Property Group (SPG) -- America's largest mall operator -- went up by 22% last year, a promising trend in a business that has long been facing declining sales.


Dan Radovsky is a contributing writer to The Motley Fool.
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