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How to identify earnings manipulation?

Mar 11, 2013

Stock prices are slave of earnings. Hence, there is a strong incentive for the management to manage earnings as it will lead to higher stock price. By managing earnings, we mean taking advantage of accounting flaws and inflating earnings. In this article, we look at various ways in which management can inflate earnings. Subsequently, we will look at measures on how one can identify earnings manipulation. This can help investors in identifying companies with strong managerial ethics.

Here are the various ways in which management can manage earnings:

  • Depreciation policy: This is the most basic tool in the hands of the management to manage earnings. Changing depreciation policy can help inflate earnings. For instance, resorting to straight line depreciation policy from an accelerated depreciation policy followed earlier increases earnings.

    Solution: Change in depreciation policy is often reported in notes to accounts section. Investors should specifically look out for change in policy when the company is in a down cycle. In a down cycle, the earnings are on a decline and thus there is an incentive to tweak the policy to report better earnings. Often the useful life of the asset is extended as management has discretion over it. Increasing useful life reduces depreciation expenses and increases earnings. Thus, investors should look out for sudden and massive changes in useful life of an asset.

  • Goodwill policy: Goodwill can either be amortized or is impaired. Amortization results in equal write off every year. However, in impairment there is more of a management discretion involved as to when the intangible asset should be expensed in the income statement.

    Solution: Investors should look out for situations when the policy is changed from amortization to impairment. While the change in policy itself does not indicate manipulation, higher discretion involved with impairment charge should be viewed with caution.

  • Revenue recognition: Generally, revenues are recognized when the risk and reward of the goods in question is transferred to the buyer. However, some companies engage in aggressive revenue recognition practices. By doing so they recognize the revenues before the transfer of risk and reward to the buyer. Thus, reporting revenues earlier increases earnings for that period.

    Solution: Increasing revenues is accompanied by increasing debtors. But if the company continuously faces problems to liquidate its debtors on time it could well indicate that revenues were recognized too soon. Piling up of debtors when there is no liquidity issue in the markets should be viewed with caution. It could be that the revenue recognition practices are aggressive.

  • Pension expense: This is the most complicated tool employed by the companies to manage earnings. Every company that offers a defined benefit plan reports pension expense in its income statement. And that pension expense is dependent upon age of the employees, their mortality rate, salary increases etc. Management can tinker with these heads to inflate earnings. For instance, assumption of lower growth in future salary expenses reduces pension expense and increases earnings.

    Solution: Investors should look out for frequent changes in pension assumptions. This is particularly true for PSU companies where pension component is a major part of employee expenses.

  • Exchange variations: Companies have flexibility to report exchange losses/gains in either income statement or balance sheet (adjustment to reserves) depending upon the nature of the forex transaction (We are not getting into the exact knitty gritty of such transactions. The idea is to understand the importance of flexibility in reporting) For instance, some losses can be adjusted in reserves eschewing the income statement all together. This can inflate earnings.

    Solution: Reasonable understating of the accounting standards is required to identify the earnings manipulation that can happen through this tool. And this is a difficult task for an average investor. Thus, investors should be careful while investing in companies that have significant forex exposure.

Apart from the above shenanigans, there are various other means that companies can resort to for managing earnings. One such instance is lowering the provision for doubtful debts despite increasing debtors in a tight liquid environment. Delaying cost recognition and reducing inventory write downs even if it has turned obsolete are other examples.

As there is lot of management discretion involved in reported earnings investors should focus on balance sheet strength and cash flow generating capability of any company before investing in it. That's because manipulating cash flows is a difficult task. And analyzing balance sheet helps in understanding the various financial aspects of the business. Focusing on earnings alone is a recipe for disaster.

Jinesh Joshi

Jinesh Joshi (Research Analyst) holds a masters degree in Finance and has over 8 years of experience in tracking equities. He has a keen affinity for number-crunching and is often sought after for his valuable insights on financial modeling and valuations. He has a keen eye for spotting emerging growth opportunities across sectors and market caps. Jinesh contributes to our Megatrend investing service The India Letter.

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