This new paper discusses the results of a survey of approximately 400 public and private company CFOs about earnings quality, with an emphasis on GAAP-conforming earnings misrepresentation (i.e., not fraud).
Key results include:
– CFOs say that the key characteristics of high quality earnings are sustainability, the ability to predict future earnings, and backing by actual cash flows. More specific features include consistent reporting choices through time, and minimal use of long‐term estimates. The factors that determine earnings quality are about half controllable (corporate governance, internal controls, proper accounting and audit function), and half noncontrollable or innate (nature of the business, industry membership, macroeconomic conditions).
– CFOs believe that in any given year 20% of companies intentionally misrepresent their earnings using discretion within GAAP. The magnitude of the typical misrepresentation is quite material – about 10 cents on every dollar. While most misrepresentation results in the overstatement of earnings, a full one‐third of firms that are misrepresenting are intentionally lowballing their earnings.
– Main consequences from poor earnings quality are investor confusion and lack of trust in management, leading to stock price declines and higher cost of capital. CFOs acknowledge that investor confusion could also result in higher bid‐ask spreads and lower analyst following but think that such effects are minimal for most sizable firms. In addition, firms with poor earnings quality frequently attract considerable short interest.
– CFOs provide a list of red flags (see Table 2, pg. 17) that outside observers like analysts and investors can use to identify poor earnings quality. Lack of correlation between earnings and cash flows is the top choice, followed by unwarranted deviations from industry or other peer norms. Presence of lots of accruals and one‐time charges, and consistently beating analyst forecasts, also score highly.
The chief motivations to misrepresent earnings are to influence stock price and in response to outside pressure to hit earnings benchmarks. Here is a relevant excerpt:
Most CFOs think there is unrelenting pressure from Wall Street to avoid surprises. As one CFO put it, “you will always be penalized if there is any kind of surprise.” As a result “there is always a tradeoff. Even though accounting tries to be a science, there are a hundred small decisions that can have some minor impact at least on short‐term results. So that is a natural tension, and one that, depending on the company, the culture, and the volatility of the company, can be a source of extreme pressure or it can be a minor issue.”
See my previous blogs on long-term/short-term behaviors, creating a formal framework for accounting judgments, and audit committee oversight in connection with accounting changes, and our “Investor Composition” Practice Area.
Push Toward Elimination of “Quarterly Capitalism”
Replacing quarterly financial reports with less frequent updates was reportedly among the ideas suggested at the Institute of Corporate Directors’ recent conference in Toronto. The theme of the conference was short-termism. Quarterly reporting, aka, quarterly capitalism, is deemed to drive a short-term outlook and short-term behaviors, as companies repeatedly scramble to meet earnings expectations.
The Financial Post article notes the recent change in the UK by the FCA that allows companies to forgo mandatory quarterly reporting and report only twice a year. The UK’s largest asset manager, Legal & General, recently announced that it had sent a letter to each of the FTSE 350 company boards supporting the change and asking those companies to discontinue quarterly financial reporting:
“Reporting which focuses on short-term performance is not necessary to building a sustainable business as it may steer management to focus more on short-term goals and away from future business drivers… ‘For many businesses, we believe, reducing the time spent on frequent reporting could help management to focus more on long term strategies and articulate more on market dynamics and innovation drivers that will enhance their performance over time.'”
More on “The Mentor Blog”
We continue to post new items daily on our blog – “The Mentor Blog” – for TheCorporateCounsel.net members. Members can sign up to get that blog pushed out to them via email whenever there is a new entry by simply inputting their email address on the left side of that blog. Here are some of the latest entries:
– “Fresh Eyes” in the Boardroom
– Survey: Auditor Evaluations Falling Short
– Governance Roadshows for Mid-Caps
– Reframing the Board Succession Dialogue
– Adapting to Mainstream Shareholder Activism
– by Randi Val Morrison