The New Earnings Game

Overstating estimates doesn't do companies any good in the long run

Accrual accounting is the heart and soul of corporate financial reporting. It encourages companies to make estimates of a wide variety of key financial variables and allocate revenue to specific quarters or periods of time. Accrual accounting allows companies a great deal of flexibility, which is appropriate. But it can also be a problem. Too many companies are taking advantage of that latitude to push their estimates to the limits in order to boost earnings. Most of it is perfectly legal, but that's no solace to investors who are left to decipher hidden, confusing assumptions and judgments made in reported earnings. Despite all the recent accounting reform, more work remains to be done. Companies have to clean up their financial statements to give investors transparent and consistent financial data or prepare to be punished in the market. Wall Street is already catching on to the shenanigans on income, balance-sheet, and cash-flow statements.

Companies can play lots of games, even with cash. Some businesses designate certain stocks they hold as trading instruments to inflate operating cash flow when the securities are sold. Many lead and lag payments to raise short-term cash flow. Others lowball customers' bad debts to increase earnings and artfully adjust estimates of old inventories, receivables, and pension fund profits.

Ironically, it doesn't do companies any good in the long run. Research by Richard G. Sloan of the University of Michigan Business School and Scott Richardson of the Wharton School shows that companies making the largest estimates and reporting the most exaggerated earnings initially do well. They attract lots of investors, and their stocks soar. But later, when the estimates prove overstated, their stocks tank. Indeed, the shares of companies that overstate their estimates, on average, lag the stocks of similar-sized companies by 10 percentage points a year. This costs investors more than $100 billion in market returns. These too-aggressive companies also have more earnings restatements, Securities & Exchange Commission enforcement actions, and accounting-related lawsuits.

What to do? Companies should make sure all the estimates and judgments in reported earnings are transparent. They should simplify their financial statements to make them clear and comparable. And at the least, they certainly need to report income and cash flow for the same time periods. Clarity and honesty in accounting would not only make the financial markets more efficient but also might head off a second round of corporate scandal and regulation. Does anyone want Sarbanes-Oxley, Part II?

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