Identifying Accounting and Earnings Manipulators – Fundamental Information’s Role in Locating Earnings Manipulation

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Identifying Accounting and Earnings Manipulators – Fundamental Information’s Role in Locating Earnings Manipulation
  • The Accruals Anomaly
  • A Fundamental Framework
  • The Terrible 23
  • Toolbox Teacher
  • Appendix

“The results indicate that earnings performance attributable to the accrual component of earnings exhibits lower persistence than earnings performance attributable to the cash flow component of earnings. The results also indicate that stock prices act as if investors “fixate” on earnings, failing to distinguish fully between the different properties of the accrual and cash flow components of earnings. Consequently, firms with relatively high (low) levels of accruals experience negative (positive) future abnormal stock returns that are concentrated around future earnings announcements.” – Richard G. Sloan, “Do Stock Prices Fully Reflect Information in Accruals and Cash Flows about Future Earnings?”, The Accounting Review 1996.

We do not know if Richard Sloan fully appreciated the academic and environmental consequences these three sentences would have in the years following their publication. Untold acres of forest have been felled as accomplished academics worked furiously to create an endless array of papers wrestling with the power and problems of the “accruals anomaly.” Sloan demonstrated that between 1962 and 1992 an investor purchasing the decile of firms with the lowest accruals and shorting an equal dollar amount of the firms with the highest accruals would have experienced hedged returns over 10% per year with only 2 losing years. In a market many academics believed to be “efficient,” the idea that a single factor could create a nearly perfectly hedged return stream was heresy.

For those unfamiliar with Sloan’s work, he defined “accruals” as follows:

Accruals = (∆CA – ∆Cash) – (∆CL – ∆STD – ∆TP) – D&A
Where: ∆CA    = change in current assets
∆Cash = change in cash/cash equivalents
∆CL     = change in current liabilities
∆STD  = change in short-term debt
∆TP     = change in income taxes payable
D&A     = depreciation and amortization
            Accounting Review, p. 293

Sloan used operating income after depreciation as his measure of “earnings” which required the deduction of taxes payable to true up the accruals figure. Ultimately, the formula above allows you to decompose a firm’s earnings into cash and non-cash components. To put it crudely, the concept was utterly intuitive—firms whose earnings were the result of non-cash accounting items were more likely to see reversals in reported profitability while those with fewer accruals (and higher cash earnings) were less likely to have profit declines in the future. The problem for some academics was that this information was readily available and in theory should have been understood by the market. Working with other noted academics, Sloan would later write that examining analysts’ and auditors’ work indicated that they both failed to appreciate the implications of accruals in their actual forecasts.1

Looking at some of the more recent literature, a reader will find talented authors working with determination to show that the accruals effect was merely a necessary premium for taking unusually high bankruptcy risk or was largely a function of improper risk analysis or even that it is merely capturing value spreads. Look a little bit more and you will find phenomenally accomplished authors rebutting virtually every one of these contentions. Kailash’s house view is that the accruals anomaly is very real, and this opinion is partially informed by the peripheral evidence that some of the most successful stories in the active management industry over the last decade appear to have been at least partially, if not largely, founded on the concept.

More recently however, the accruals issue has received newfound scrutiny because the effect appears to have faded in the post 2001 period:

Disclaimer

The information, data, analyses and opinions presented herein (a) do not constitute investment advice, (b) are provided solely for informational purposes and therefore are not, individually or collectively, an offer to buy or sell a security, (c) are not warranted to be correct, complete or accurate, and (d) are subject to change without notice. Kailash Capital, LLC and its affiliates (collectively, “Kailash Capital”) shall not be responsible for any trading decisions, damages or other losses resulting from, or related to, the information, data, analyses or opinions or their use. The information herein may not be reproduced or retransmitted in any manner without the prior written consent of Kailash Capital.

Kailash Capital, in preparing the information, data, analyses and opinions presented herein, has obtained data, statistics and information from sources it believes to be reliable. Kailash Capital, however, does not perform an audit or seeks independent verification of any of the data, statistics, and information it receives.

Kailash Capital and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.

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