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Earnings Management Persists, CFOs Tell Researchers

Tammy Whitehouse | August 29, 2012

Earnings management is alive and well within U.S. public companies, according to recent academic research polling nearly 170 CFOs of public companies. They say perhaps up to 20 percent of companies misrepresent economic performance by managing earnings.

Four professors at Emory University and Duke University polled nearly 170 CFOs and found “a large majority” believe earnings are managed in an attempt to influence stock price because of pressure from within and outside the company to hit earnings targets. They say earnings also are managed to avoid adverse compensation and career consequences for senior executives, according to the four professors' recently published paper, Earnings Quality: Evidence from the Field.

The paper says more than 99 percent of CFOs agreed that at least some companies find some wiggle room within Generally Accepted Accounting Principles to report earnings that misrepresent the economic performance of the company, and 40 percent said they believe the figure is greater than 15 percent. Nearly half of CFOs believe that less than 10 percent of EPS is typically managed, but 23 percent believe more than 10 percent of EPS is managed. The Securities and Exchange Commission launched on attack on earnings management beginning in the late 1990s when then-Chairman Arthur Levitt targeted the practice for enforcement, leading to a wave of restatements in the early 2000s.

“CFOs believe that earnings manipulation is hard to unravel from the outside,” researchers wrote, but they found CFOs willing to suggest red flags that might help identify when a company is managing earnings. The three most common indicators that a company is managing earnings are persistent deviations between earnings and underlying cash flows, deviations from what other companies in the same sector are reporting, and large unexplained accruals or changes in accruals, the study says.

CFOs also have some advice for the Financial Accounting Standards Board that would improve the quality of reported earnings in financial statements: impose fewer new rules (65 percent), converge U.S. GAAP with International Financial Reporting Standards (60 percent), allow more reporting choices to evolve from a company's practices (54 percent), and issue more detailed implementation guidance (48 percent). Earnings quality also would improve, according to 40 percent of CFOs, if FASB reduced the prevalence of fair value in financial reporting.

The authors said their findings suggest CFOs believe that high quality earnings are sustainable, are backed by real cash flows, result from consistent reporting choices over time, and are not heavily based on long-term estimates. CFOs show a clear preference for converging GAAP and IFRS over adopting IFRS in the United States or having a choice between the two systems, the paper says. They believe reporting discretion has diminished considerably over the past 20 years, and that today's rules constrain rather than promote quality earnings reporting. “There is a strong feeling that financial reporting has hardened into a compliance exercise rather than acting as a vibrant means of innovating and competing for better access,” the authors wrote.