Finding the tipping point of stock collapses

This article appears in the February 2022 issue of Advisor’s Edge magazine. Subscribe to the print edition, read the digital edition or read the articles online.

It’s difficult for advisors to know the extent to which accounting issues should impact the value of equities. On one hand, we’ve reported about accounting issues leading to share price collapses, as with Carillion Group, Wirecard AG, Luckin Coffee and Maxar Technologies. On the other hand, we’ve described in detail over the years how management’s ability to manipulate earnings reports means that nearly all companies possess accounting issues, not all of which have a significant effect on share price.

A recent study (“Do Firms Time Changes in Accounting Estimates to Manage Earnings?” to be published in the journal Contemporary Accounting Research) found that companies use changes in estimates to manage earnings in many different ways, including to meet consensus expectations, to show year-over-year growth or simply to post positive income. An example is slowing the depreciation rate on assets at an opportune moment, thereby boosting earnings enough to meet analyst earnings-per-share estimates.

The authors noted that companies will also time accounting changes to lower earnings, either to lump bad news together (known as a “big bath”) or to smooth out earnings because the market favours less volatility in reported income.

While the study confirmed that companies manipulate the timing of accounting changes, it did not explore the quantum of the changes, which is an entirely different way to manage earnings. The authors noted that “accounting estimates are a necessary component of accrual accounting that are by their nature forward-looking, often subjective and difficult to quantify with precision.” Unreasonable or unsupported estimates are a common way for management to achieve the same goal of meeting earnings benchmarks. There is also an area known as discretionary accruals, which are one-time adjustments made by management (either positive or negative) that can be used to shift reported income.

With so many ways to manage earnings, where is the tipping point for accounting to have a major impact on share prices?

Microsoft made a recent accounting estimate change that boosted earnings. The company extended the estimated life of the servers and network equipment it uses in its cloud business. Through lower annual depreciation expenses, income was raised by an estimated $2.3 billion in fiscal 2021. While the impact is material, the company addressed it in a forthright manner.

With sudden accounting collapses, however, the information tends to be revealed in other ways, such as through a whistleblower, the need for financial restatements via regulatory investigation, or a cash crunch that reveals manipulated financial statements to the board.

In commonplace situations (like Microsoft), the study noted that the market tends to punish companies that meet earnings benchmarks through changes in accounting estimates, meaning that published accounting information tends to find its way quickly into share prices. Therefore, accounting-focused equity research that simply republishes known information (such as highlighting how changes to accounting estimates impact income) has no value to the market.

So where should advisors turn for information that will make a difference? While the study was not groundbreaking — merely adding to the academic literature about companies using flexible financial reporting standards to manage earnings — there were takeaways that advisors can use to lower overall accounting exposure risk in portfolios.

The study found that changes in accounting estimates occurred disproportionally in the construction and manufacturing sectors; the services sector was about average, while finance, transportation, utilities and retail were lower than expected.

The segments that tended to skew toward more income-increasing adjustments were retail and agriculture, whereas finance was again found to be most balanced.

These insights can be incorporated into an investment approach that addresses accounting risks in a proactive manner. While advisors can’t avoid owning companies with accounting concerns, they can make sure that sector weightings reflect the study’s findings. The market tends to think of retail companies as having less accounting risk and financials as having more. Advisors can take comfort in knowing that financials don’t carry as much risk as the market tends to believe, and therefore shouldn’t unduly underweight the sector. Retail, on the other hand, may carry more risk than previously believed, and advisors should think twice about overweighting the sector.

This approach is of far more value to advisors than backwards-looking analyses that dwell on the historical accounting results of individual companies. While time and patience is needed to glean such data, doing so pays off over the long term and avoids the analysis paralysis that advisors often feel when assessing the impact of accounting issues on share prices.

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.