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."
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?
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.
Dan Radovsky is a contributing writer to The Motley Fool.