Are investors really fooled by earnings manipulation?

November 08, 2006

There are times when cash flows just don't line up with economic transactions. For example, the cash from a consummated sale may not show up until the following period. Knowing this, standards setters have made provisions for accrual accounting, which allows firms to adjust cash flow from operations. Their intention in allowing flexibility is to provide enough latitude so that financial statements can be made more informative.

Nevertheless, managers may instead use the flexibility to mislead stakeholders about the underlying strength of the company. This is the crux of an ongoing debate in the financial community. Does earnings management affect investors' perceptions?


The extent to which stakeholders are misled by earnings manipulation is at the heart of recent research by a team from the W. P. Carey School of Business. W. P. Carey finance professors Michael Hertzel and Jeffrey Coles, and Swaminathan Kalpathy, a professor at Washington State University who worked on the project while a W. P. Carey Ph.D. student, were motivated by evidence from earlier studies that painted a woeful picture of the ability of market participants to see through the manipulation.


In particular, earlier studies found evidence that managers aggressively managed accruals prior to initial public offerings and seasoned public offerings. The market overprices these accruals, those studies reported, and as a result the firms are able to issue overvalued equity. One study suggested that analyst "credulity" played a significant role.


"The results are consistent with the hypothesis that analysts are more overoptimistic about firms with pre-issue accruals and investors are not aware of this bias," the W. P. Carey paper states. "In other words, around equity issues investors rely on analysts who, in turn, are misled by accruals manipulation."


What is particularly troubling, Hertzel says, is that many of these offerings under-perform for years after the issue, in part because analysts and investors "are slow to recognize and unravel these accounting manipulations."


"If you look up 'credulity' in the dictionary you will find 'gullible,' 'swallow whole,' 'taken in' and 'born yesterday.' If this is truly an accurate description of analysts, then our financial markets are in a pretty sorry state," Hertzel comments. "We were curious just how 'born yesterday' the market might actually be."


Reissuing employee stock options


To get at the extent of analyst and investor rationality the team looked at earnings management in a unique experimental setting in which the incentive to opportunistically manage earnings should be obvious to market participants: the period surrounding the cancellation and subsequent reissue of employee stock options. A firm that restructures compensation using this method first cancels the outstanding option and then after a clearly specified period of time, typically 6 months and 1 day, reissues new options, with the strike price set at the then-current (reissue day) market price. Since managers of firms benefit from a lower strike price, the incentive to manipulate earnings to drive price down prior to the reissue date should be apparent to analysts and investors.


According to the paper, this is exactly what happens in many cases. "Based on a sample of 159 issues, we find strong evidence of abnormally low accruals leading up to the option reissue date," the paper reads. Thus, even in this most transparent setting, the evidence suggests that managers still attempt to manage accruals to their own benefit.


The good news, and in sharp contrast to the IPO and SEO studies, is that investors are not duped by these machinations; i.e., the low pre-issue discretionary accruals do not lead to a lower stock price on the reissue date. An analysis of analyst’s forecast errors suggests that analysts get it as well.

One interpretation of these findings is that analysts and investors are reasonably discerning, but that the incentives and accounting manipulation around SEOs and IPOs are not particularly transparent. There is less support for the view that analysts and investors are gullible and can be misled by simple accounting manipulations.

Fool me once…

Several interesting questions remain. Why do managers bother to try to manipulate the strike price on cancellation and reissues when they know that every move they make is on display before an attentive audience? Perhaps a lesson for managers is not to waste time, effort and resources on this activity. Furthermore, if they are successful in manipulating they could get sued. Earlier studies have shown that aggressive accruals manipulation is often cited in shareholder lawsuits related to IPOs and SEOs and affects both the likelihood of a lawsuit and the size of the judgment.

Another question is what these results suggest for corporate governance. "We are currently in the midst of an option backdating scandal that has roiled corporate boardrooms across the country" says Hertzel. Backdating refers to the practice of allowing executives who receive new option grants to go back in time and choose a past date when the market price was particularly low, thereby inflating the value of their options. "Of course, the managers in our study can only look forward and do not have this device at their disposal … that they still appear to attempt to manipulate in the bright light of day does give one pause."

 Meantime, investors would do well to be mindful of the potential for accounting manipulation, and that even in the most transparent settings, managers may still try a sleight of hand.

 Bottom Line:

  • Managers may use the flexibility provided by accrual accounting to attempt to manipulate the price of a company's stock.
  • The extent to which this earnings management affects investors' perceptions about the underlying strength of a company is the subject of an ongoing debate in the financial community.
  • Previous studies have suggested that investors rely on analysts who, in turn, are misled by accruals manipulation.
  •  This study found evidence that managers did indeed attempt to manipulate earnings to drive stock prices down prior to option reissue dates, but that investors and analysts were not fooled.