(Financial shenanigans cost shareholders billions of dollars. This is part of an ongoing series about how to spot Wall Street wrongdoing before it puts your portfolio in jeopardy. See last week's "Is There an Enron Sitting In Your Portfolio?" for more.)
For many companies, meeting or beating quarterly earnings estimates matters more than anything else. Add stock options to the mix, or big cash bonuses tied to short-term earnings or stock price targets, and executives' temptation to focus exclusively on quarterly results becomes irresistible. In the worst cases, this tunnel vision can drive companies to creative accounting, or even fraud.
Consider these shameless words from former CEO Joe Nacchio in January 2001, months before his company, Qwest Communications, began a precipitous decline that took its stock from the mid-$30s to a low of less than $2 by August 2002:
The most important thing we do is meet our numbers. It's more important than any individual product; it's more important than any individual philosophy; it's more important than any individual cultural change we're making. We stop everything else when we don't make the numbers.
Congratulations, Mr. Nacchio! Qwest may have made its numbers, but it did so via methods that eventually cost shareholders billions.
Qwest ultimately restated its earnings, increasing its losses in 2000 and 2001 by more than $2 billion. Nacchio resigned in June 2002; he was later convicted of insider trading and carted off to jail.
Unfortunately, what happened at Qwest isn't all that uncommon.
Why Earnings Are So Easy to Manipulate
Bad companies always ultimately lose the expectations game. Accounting trickery can only cloud a company's struggling operations for so long. Astute investors can look behind the numbers and spot the red flags that clue us in when a company's earnings results aren't worth the paper they're printed on.
Earnings are at the very bottom of the income statement (hence the term "bottom line"). They're the end result after all expenses -- raw material costs, salaries, marketing expenses, research and development, interest, and taxes -- are taken out of revenue. Unfortunately, that also makes earnings the figure most susceptible to manipulation.
Shift some expenses around, draw down some reserves, play with your tax rate a bit, and presto! That quarterly earnings per share (EPS) result suddenly goes from a miss to a beat. Hey, what's a penny or two between friends, if it leads to that fat year-end bonus and a higher stock price?
4 Signs of Earnings Funny Business
Howard Schilit, founder and CEO of the Financial Shenanigans Detection Group, has written extensively on the subject of earnings shenanigans. Here are a few of the major earnings red flags he discusses in his book, Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports. According to Schilit, these signs may indicate that a company is trying to pull a fast one:
1. Smooth and predictable EPS
Wall Street loves steady earnings results, and that's what many managers strive for. But companies that consistently meet or exceed Wall Street's consensus earnings estimates are often gaming their company's earnings to do so. Be especially wary of managers who publicly tout their earnings-guidance track record. At the very least, it illustrates the short-term approach they're taking with the business.
2. Boosting income or lowering expenses using one-time events
You might be used to seeing management make statements-of-issues releases with words like "adjusted earnings" or "earnings before one-time charges or expenses." Companies will periodically experience one-time or non-recurring changes to their business: perhaps the sale of a factory, a large gain on an investment, a charge to restructure the business, or a large write-off of obsolete inventory.
Your job is to figure out when management is making appropriate adjustments to the income statement, and when it's inappropriately shifting line-items around to simply paint a prettier picture of the business. The difference between right and wrong lies in how companies classify these one-time events, and where they show up on the income statement. For example:
- Some companies will include one-time gains from asset sales or investments in the operating section of the income statement, as a way to boost operating profits. Obviously, if these activities aren't normally part of the ongoing operations of the business, they shouldn't be there.
- On the other hand, restructuring charges, which aren't normally included in operating expenses, should be there if the company keeps reporting regular restructuring expenses. You could call these "recurring nonrecurring" charges.
- Finally, a large write-off of bad inventory or uncollectible debt should also be included in operating expenses. Often, it's not.
3. Inappropriately capitalizing normal operating expenses
One of the classic ways companies boost short-term earnings involves capitalizing certain expenses that should normally be included on the income statement. In essence, a company treats normal operating expenses as an asset, shifting them to the balance sheet to be amortized (depreciated) over many years, instead of in the current quarter.
WorldCom, the famously bankrupt telecommunications giant, reported billions in inappropriate profit by capitalizing a significant portion of its line costs -- the fees WorldCom paid to other telecom companies to access their networks, a perfectly normal part of its everyday business.
Watch for big increases in capital expenditures on the cash flow statement, with corresponding reductions in operating expenses on the income statement. That might give you a clue that a company is suddenly shifting normal operating expenses to its balance sheet.
4. Unusual changes in reserve accounts
Computer and car manufacturers normally bundle warranty plans with their products. These plans cover any potential problems you might experience, with the promise to fix or replace any defects over a predetermined number of years.
Manufacturers are required to record an expense and a liability reserve on the balance sheet for expected future warranty costs at the time the product is sold. Similarly, most companies set aside reserves to cover a portion of their accounts receivable -- the amount their customers owe them -- that they don't think they'll collect. And banks, when they have to, set aside certain amounts to cover expected loan defaults.
But management can exercise considerable discretion about how much money to mark for future liabilities. Reserve too little, and profit margins get a nice short-term boost, at the risk of higher expenses -- not to mention lower profits -- down the road.
In 2007, computer maker Dell (DELL) was required to restate its earnings for several years, because it improperly accounted for warranty liabilities. Investors should monitor changes in reserve items relative to revenue. If reserves decline relative to revenue, it could signal that a company is inflating earnings by not properly accounting for future costs.
Next in this series, we'll help you spot cash flow red flags.
Motley Fool senior analyst Matthew Argersinger does not own shares of any of the stocks mentioned in this article. You can click here to see his holdings and a short bio.