In Today’s Financial Times, John Authers explains companies’ motivations behind manipulating earnings. With plenty of companies “managing” their earnings, it’s a concern that your portfolio may be sitting on what Authers calls an “earnings torpedo.”
“Within GAAP” manipulation involves dipping further into accruals than they would otherwise do, without resorting to outright fraud. After a while, even this will not work, and so they move on to fraud. In part this is driven by the asymmetric pressure from the market — the longer a company takes to come clean, the bigger and more damaging the “earnings torpedo” that hits its share price and its reputation once the true numbers come out.
The sample of companies includes only those who fell foul of accounting and auditing enforcement releases by the Securities and Exchange Commission, and therefore excludes a number of companies who were notorious for earnings management but managed not to progress beyond “within GAAP” manipulation. The list does, however, include names such as Coca-Cola and Microsoft, as well as more obvious miscreants like Enron.
What conclusions can we draw? For investors, the research should be yet another reminder of the importance of corporate governance. If your company allows too much power to reside in the hands of the chief executive, do not be surprised if they abuse that power.
Read more here.
Jeremy Jones, CFA
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