Earnings Management and the Negative Impact on Investors

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

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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:

For those familiar with the accruals anomaly, please visit our piece, Enron Hat, to take a look at the screen that identified Enron as a fraud in 1998.

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FAQ

Is Earnings Management Legal? and What is Accrual Based Earnings Management?

Considering the degree to which earnings management appears in the data, it often brings up the question of legality. This is the domain of the SEC. Investopedia does a fine job of explaining this. They quote the SEC guidance of abusive earnings management being the “material and intentional misrepresentation of results.” This creates a gray area of sorts.

Why? Well the accruals accounting system that is designed to give investors a better picture of a firm’s economic position is, by design, setup to avoid the shortcomings of cash accounting. Assuming there is no explicit fraud, a diligent researcher should always be able to reconcile the variance between the accruals accounting and the cash accounting and make their own determination of just how credible the accrual figures are.

How to Detect Manipulation in Financial Statements

Per the prior, a diligent analyst can spot accounting issues through the manual reconciliation of cash and accruals accounting. This paper documents a powerful set of academically vetted methods of systematically identifying how earnings management can affect the quality of earnings. KCR’s proprietary earnings management tool takes these legacy concepts from academia as a good conceptual framework but has built a new, more powerful and more focused method of identifying situations where earnings management may have gone so far as to make a given stock vulnerable.

Understanding the Methods of Earnings Management

There are numerous methods by which a management team can “manage” earnings. These can stem from decisions around how to treat various expenditures. One of the most common is the decision on which costs get capitalized vs. expensed immediately. Let’s say a software company capitalizes all its development expenses for a piece of code. That means the cash outlays were not being deducted from the income statement and could overstate profits. The degree to which something like that happens is governed by the interaction of management, their accountants and their auditors. KCR believes the majority of these types of earnings management are actually made in good faith. With that said, as academic research and our own research demonstrates, even good faith changes in accruals can create potential pitfalls for investors. Understanding the methods and intentions of earnings management helps investors understand the motives of management teams. Our work in this paper and the associated ranking methodology we have created to score earnings management is designed to provide investors with a powerful tool that is as easy to use as it is effective. Even if you are not sure if our earnings management flag is warning of possible trouble, we encourage investors to ask “how much do you need this specific company in your portfolio?”

When in doubt, it has been our experience, that we can often just move on to another stock that offers similar products that does not have the earnings management flag flashing in our faces and find a better replacement. KCR’s ranking tools in the Large, Mid Cap and Small Cap universes are specifically designed to help investors navigate these waters more quickly and efficiently.

SERVICES

As a reminder for our Financial Advisors: our models are available on a continuous basis, and most have been in production for over a decade. If you are looking for simple, concentrated, low turnover, and tax efficient model portfolios we would like to talk with you. KCR also offers a wide range of easy-to-use but sophisticated tools. Our toolkits can help identify mispriced stocks with the best and worst risk/reward characteristics, estimate a stock’s duration and warn you when a company is engaging in low-quality accounting. Over the last 12 years, KCR has built and offers time-tested and class-leading products built by experienced and proven money managers for fixed to low prices.
Kailash Capital Research, LLC ’s sister company, L2 Asset Management, runs market neutral, long/short, large-cap, and mid-cap long-only portfolios with a value and quality bias. L2 employs a highly disciplined investment process characterized by moderate concentration, low turnover, high tax efficiency, and low fees. While nobody can predict the future, we believe the recent resurgence in risk-adjusted returns seen across all products is the beginning of what may be a long period where speculation is punished, and prudence and patience rewarded.

ADDITIONAL READING

The topics discussed in this article are aimed at seasoned professionals, as such, we have included some extra for anyone seeking out more information related to the topics above.

Disclaimer

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