This article comes from Ryan Maxwell of FirstRate Data.
During economic booms, weak companies are often able to flatter their financial performance by manipulating (or managing) their earnings. Strong financial markets allow such companies to repeatedly tap debt and equity funding sources and deploy the funds to create the illusion of current profits instead of productively investing in projects to create future profits.
The sudden downturn in the economy and funding sources will restrict this availability of funds and likely imperil companies which were manipulating or aggressively managing their earnings.
At FirstRate Data we typically service high-frequency traders with short time horizons who typically ignore fundamental company information, however, in light of the recent economic shock many short-term investors are now adding screens for corporate distress into their investing process.
There are several key financial metrics which are indicative of earnings manipulation:
Operating Cash Flow / Operating Profits
Revenues reported on the Income Statement are not cash sales but rather sales based on accruals which provides flexibility in how a company chooses to recognize revenue. Companies with over-aggressive revenue recognition policies may book multiple periods of future revenue in the current period by claiming it has already been earned. For example, Enron booked all revenues for multi-year service contracts in the current period falsely claiming the revenue had already been earned.
Alternatively, companies struggling to maintain sales growth will often offer customers more and more favorable terms – such as longer payment terms or generous rights or return or cancellation.
It is difficult to directly test for these activities from the information reported on financial statements and 10-Ks. However, these activities will usually result in less cash being collected from the sales made. Whilst revenue can be easily managed, cash flows are very difficult to manipulate as there is no flexibility in reporting cash flow and auditors will reconcile cash flow balances directly to bank statements. As such, the cash flow statement can be very helpful as a source of accurate information if there is a suspicion on the validity of reported revenues and profits.
The Cash Flow From Operating Activities figure in the Cash Flow Statement is probably the most useful cash flow metric and is essentially the cash profits earned in the period. Thus the ratio of Cash Flow From Operating Activities to Operating Cash Flow is the proportion of companies profits that are earned in cash. This ratio should be compared over time to see signs of aggressive or manipulative accounting practices, a significant decline in this ratio over time indicates that the company is increasingly resorting to malpractice to maintain its earnings.
Exceptional items on the Income Statement are one-off expenses incurred outside of the normal operation of the business. For example, a single large legal judgment against a company would be considered as a one-off expense outside the scope of a company’s operations.
Although exceptional items are charged as an expense prior to arriving at the operating profits figure, they are routinely discarded by investors assessing the company’s financial performance as they are not expected to recur. Similarly, the company will often publish its own performance metrics such as Adjusted Operating Profit which excludes exceptional items.
Companies struggling to maintain profitability will often resort to declaring regularly occurring expenses in exceptional items and thus flatter their adjusted profits.
To detect this a useful metric is to look at the Exceptional Items to Revenue ratio. If this ratio over time is persistent then it is evidence that the company is manipulating its profits by reducing expenses.
Bad Debt Provisions
Most companies will not collect cash immediately on sales and give customers credit terms. Through either default or fraud, not all customers will pay and the company will be forced to book a loss.
In anticipation of such losses, the company will allocate a portion of the creditor balance (ie amount due from customers) as a provision against future bad debt.
The mechanics of this are that an expense is incurred (reducing profits) and a provision liability on the balance sheet is created. When the bad debts are confirmed, the provision liability is netted against the Creditor balance. However, if the bad debt provision is higher than the bad debts actually incurred, then the balance is credited back to the Income Statement.
Thus, an over-provision for bad debts reduces profits in one period and increases them in another period. This can be abused by companies looking to smooth erratic earnings or bank earnings in a good period for release in periods when earnings are under pressure.
To test for this form of earnings manipulation, the bad debt provision to revenue ratio should be reviewed over time. In general, this ratio should increase during times of economic stress and decrease during economic booms, ratios which change counter to this natural cycle are an indication that the company is manipulating earnings.
Earnings manipulation is a very challenging subject and difficult to test for, however, these three metrics can provide a useful first screen as it is unlikely a firm engaging in aggressive manipulation will not be flagged on one of these metrics.
About the Author
Ryan Maxwell is currently a Director at FirstRateData. He formerly worked in Financial Risk Management at Deutsche Bank