The words “accounting manipulation” usually conjure up images of executives inflating income to pump up their company’s share price, or to earn a bonus based on higher profits. What investors often forget are the other reasons for fudging the numbers: to keep earnings as low as possible.
The practice of understating earnings is well known to private enterprises and small businesses, where the primary reason to keep profits down is to reduce the amount of income tax payable. Executives do so by simply reversing the techniques used to overstate earnings. Instead of, say, booking revenue too early, managers might delay revenue to a later period, and do so continuously to always keep earnings as low as possible.
Investors tend to disregard the motivation to depress earnings in public companies because of the reigning assumption that executives want to maximize profits in order to maximize share price. Yet management is sometimes motivated to smooth profits in order to generate a more stable picture of the company.
Companies with steady earnings growth tend to be more prized by the market than those with unexpected swings in income. In order to smooth income, executives hold back profits during one period in order to recognize them in a subsequent quarter, when income might otherwise be too low.
A multibillion-dollar example of earnings smoothing took place at U.S. government-sponsored mortgage lender Fannie Mae just prior to the company being placed in conservatorship during the depths of the credit crisis.
Reporting on the official post-mortem of the scandal issued by the Office of Federal Housing Enterprise Oversight in 2006, Associated Press noted, “From 1998 to mid-2004, the smooth growth in profits and precisely hit earnings targets each quarter reported by Fannie Mae were ‘illusions’ deliberately created by senior management using faulty accounting.”
Spotting smooth operators
So how do you recognize accounting manipulation used to smooth earnings? For starters, look for companies with an almost uncanny ability to consistently beat analyst expectations by a penny every quarter.
It’s rare to have industries and companies unscathed by at least some influence outside of management control, be it currency swings, commodity trends, raw material prices, consumer spending, or unseasonable weather.
Companies that consistently beat estimates by a slight margin every quarter may get some help from the accounting department. Especially when it comes to quarterly results, it’s easy to hold back something for later in the year.
While investors are likely to understand earnings smoothing, it can be difficult to understand why management would decimate its own share price through earnings manipulation. The primary motivation in such cases is to drive away minority shareholders, convincing them to sell the stock of an otherwise good company.
In such cases, management is often looking to go beyond simply scooping up the shares at a discount price. If executives are intent on stealing from shareholders, they tend to want some bang for their buck.
And the greatest leverage for management usually comes in the form of options. You might see examples of executives receiving large option grants (or the re-pricing of existing options) once untoward accounting has brought down the share price.
Insidious insiders
Insider theft can also occur when insiders lend money to the company during its so-called troubled times (caused by accounting manipulation). The terms of the loans made by the insiders might be considered overly generous even if the company’s results were not being manipulated.
The loans might have excessive interest rates, or inappropriate covenants that allow the insiders to seize control of the company after more poor results have been fabricated.
Manipulative insider loans might also be in the form of convertible debentures, or death spiral financings, where the conversion rate is continually reset as the stock falls due to accounting manipulation. Before long, the excessive dilution of the convertibles results in the insiders owning the company outright. Such an approach works hand in hand with accounting manipulation since it drives away other potential lenders or white knights.
The common factor in such cases is always the existence of controlling insiders who own large share blocks in the company.
There’s always greater risk in being a minority shareholder than in owning shares of a company where there is a large public float. Given the need for insiders to control the situation, troubling cases are often found among the smaller-cap names in the market.
Recognized cases of minority oppression tend to be rare in Canada, not because they don’t occur, but because they are kept from public view by lax securities regulation, less detailed accounting prohibitions compared to the U.S., and out-of-court settlements kept under wraps by confidentiality agreements.
When vetting investments for undue risk of accounting manipulation, it often helps to come at the situation from several directions. Accounting games are just one of the tools a manipulative executive team might use to cheat minority investors.
Insiders often make unfair profits on the purchase and sale of assets between the public company and insider-owned entities, on overly generous management contracts, and on regular sales of goods and services between the company and executive-controlled subsidiaries.
Deferring revenue
Detect it by looking for:
The approval of these transactions can easily circumvent board oversight, and be carried off at unfair prices that unduly compensate the insiders (for more details see “Stealing the Crown”).
Double whammy
Most sinister of all, though, might be the dual levers of accounting manipulation and related-party transactions used in concert to create a double dip for insiders. Take the case where a public company is already dealing with an insider-controlled entity.
An agreement might be in place where the insider entity sells goods or services to the public company through a contract that allows for cost escalations. The insiders might use weak accounting rules to inflate the costs before passing the goods and services to the public company.
In turn, this creates greater cash expenses in the public entity. The insiders reap additional profits through their company, and concurrently put pressure on the stock of the public firm, which reports declining results.
The insiders then use any of the means described above to unfairly seize a larger stake in the public company, creating a win-win situation for themselves.
It goes without saying who the losers in these scenarios tend to be. So it pays to view insider-controlled small and mid-cap companies as high-risk given the potential interplay of accounting manipulation and related-party transactions, and how both are poorly regulated in the Canadian markets.
Dr. Al Rosen, FCA, FCMA, FCPA, CFE, CIP and Mark Rosen, MBA, CFA, CFE, run Accountability Research Corp., providing independent equity research to investment advisors across Canada.