Accounting games happen in plain sight

A constant struggle plays out in the market between those hunting and those being hunted. As an advisor, you’d be wrong to assume that you’re one of the hunters. You’re huddled with the rest of the prey trying to avoid financial cons.

The battleground is unfair, tilted toward the hunters by weak legislation, poor regulations and deficient accounting rules. You arm yourself with the best tools, which include knowledge of how, why and when executives will manipulate earnings reports to their advantage.

We regularly explain the “how” in this column, highlighting the gaps in financial reporting and the areas open to judgment and exploitation. We’ve also touched on the “why,” which usually comes down to human nature and common greed. This time, we’ll explore the “when.”

Investors know that accounting shenanigans occur frequently, and most assume that more chicanery exists in companies where the market is paying less attention. Turns out that last part isn’t true.

A new study from professors at the Massachusetts Institute of Technology and the Wharton School at the University of Pennsylvania confirms that fewer accounting games are played in companies that receive more analyst coverage, enjoy greater media coverage and have higher institutional ownership. That was as expected given the increased attention and greater likelihood of being caught.

Yet what happens in companies where there is the least scrutiny—in the companies with minimal analyst coverage, less media attention and fewer institutional investors? At the lowest-profile companies, the study found, investors care little about earnings, so there is little incentive to play with the numbers.

This creates a sweet spot where executives are most likely to mess with the numbers. Companies start out small and don’t bother playing around with the accounting to produce better results. They’re focused instead on becoming profitable.

As the companies grow, they attract attention from media and garner analyst coverage from investment banks. This in turn brings in institutional investors who are more likely to dive deeper into the numbers and have direct access to management to ask questions. As media and analyst focus eventually shifts to earnings, executives are tempted to push the envelope on the weak accounting rules.

The researchers determined that “as the quality of the information environment improves, misreporting first increases, reaches an inflection point, and then decreases.” They pinpointed that inflection point at approximately 17 relevant media articles per year and six analysts covering the company.

The purpose of the study was to inform policymaking and not to narrow the focus of where investors should spend their energy digging into financial statements. We can, however, adapt the findings to the Canadian market, if only to get a general sense of where manipulation occurs.

Canada is more concentrated than the U.S. in terms of media, which would lead to less attention, but is relatively over-scrutinized when it comes to analyst coverage and institutional ownership. In the U.S. study, analyst coverage seemed the most correlated to overall results, so we’ll concentrate on that factor.

The study found that misreporting increases in the first three quintiles, peaks in the fourth, and then declines sharply in the fifth. According to Bloomberg, the fourth quintile in the Canadian market includes names like Fairfax Financial, George Weston, Onex, Canfor, Maple Leaf Foods and dozens of other familiar names.

To be clear, we’re not suggesting these companies engage in any kind of deception. But knowing that larger names are susceptible provides a reality check for those who thought accounting gamesmanship only occurred in the dark corners of the market, amongst small-cap unfamiliar names with minimal analyst and media attention.

It’s a worthwhile reminder that more than 70% of companies in the market have an incentive to manipulate earnings because, as the study explains, until they reach a certain level, the benefit of the deception outweighs the risk of being caught. Advisors should recalibrate what they view as risky investments from an earnings quality perspective, and make sure that portfolio holdings match up with their clients’ tolerance levels.

Al and Mark Rosen run Accountability Research Corp., providing independent equity research to investment advisors across Canada. Dr. Al Rosen is FCA, FCMA, FCPA, CFE, CIP and Mark Rosen, is MBA, CFA, CFE.