A new survey of 400 chief financial officers raises serious questions about the veracity of earnings reports. According to the Financial Analysts Journal, on average, CFOs believe 20% of public companies intentionally misrepresent earnings.
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And, it’s not that they are doing something illegal, not necessarily. GAAP accounting gives corporate financial engineers wide latitude, what it calls “discretion” in interpreting results. That ambiguity, however, makes it difficult for individual investors to sort out which companies are most deserving of their investment dollars and which are not. How big is the earnings distortion? As much as 10% of earnings.
According to the survey, problems are most likely to be found in acquisition accounting, pension accounting and the use of subsidiaries and off balance sheet entities. Accounting at private companies is believed to be even worse with 30% of private companies expected to have misrepresented earnings, according to the survey.
Distorting results is generally associated with an attempt to raise a public company’s stock price. Importantly, though, misrepresentation isn’t only used to make results look better and earnings higher, in fact, one-third of earnings misrepresentation goes the other way, to make results look less impressive. The survey authors surmise a company might make results look worse than they actually are in order to, say gain a leverage in labor negotiations.
The survey was conducted by four business schools professors, with the results supplemented by in-depth interviews with 12 CFOs from high-profile companies.