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At this point, it’s nearly impossible to argue with the notion that earnings manipulation is prevalent throughout the ranks of publicly-traded companies. We know that CFOs have admitted to manipulating earnings and the ongoing Valeant Pharmaceuticals (VRX) scandal continues to expose the creative ways companies can artificially boost results.

While most earnings manipulation is not as blatant as Valeant, the fact remains that investors have to be on the lookout for earnings management at all times. To be properly vigilant, it’s important to understand why executives misstate earnings. When you understand the why, you’ll have a better sense of what you need to look for.

  1. Their Bonuses (And Jobs) Depend On It

Ever since “performance-based” bonuses were made tax-deductible in 1993, an increasingly large portion of executive compensation has been tied to hitting certain performance targets. In many cases, these are “adjusted” non-GAAP metrics that are designed for CEOs to always hit those incentive targets. In other cases, the targets are simply so low that it would be almost impossible to miss them.

Still, occasionally executives will see their bonuses get cut if they miss targets for metrics like revenue and EPS growth, so there’s an incentive in place for them to do whatever it takes to meet that target. That could mean things like channel stuffing to boost revenue at the end of a quarter, lowering reserves to artificially boost EPS, or even lumping regular expenses into one-time items such as “restructuring” so that they’ll be excluded from the earnings calculation.

There are almost too many options to count. In 2014, Caleres (CAL) hit an adjusted EPS of $1.72, 11% above the target threshold to receive their full bonuses. However, this number was inflated by:

  • A $2 million decrease in the company’s inventory reserve
  • Unrealistic pension plan assumptions, which included an expected return on plan assets of 8.25% and a discount rate of 5%, which allowed the company to earn $10.7 million in net periodic benefit income.

Together, these two non-operating items boosted CAL’s income by $0.29/share. Removing that impact, the company would have had an adjusted EPS of $1.43, which would have fallen short of the performance target. Boosting earnings to hit those targets helped the five highest paid executives earn record compensation of $18 million last year, or 15% of after-tax profit (NOPAT)

Of course, the risk for executives who miss earnings targets can be even greater than just losing money from their bonuses. Studies have shown that simply missing targets can increase a CFO’s chance of getting fired, even if they just barely miss and the stock still does well!

With the extreme focus on these quarterly and annual targets, it’s no wonder that executives give in to the pressure because those that don’t earn less in compensation and are at a higher risk of getting fired.

  1. They Want To Lower The Bar

One of the most interesting details from the CFO survey linked above is the fact that roughly 1/3 of the cases of earnings misrepresentation actually involve companies decreasing their earnings. Decreasing earnings seems counterintuitive at first, but it makes more sense when you remember that it’s more important to the executives whether or not they hit their targets rather than by how much.

Therefore, if an executive is on track to beat their target by a wide margin, they might actually want to decrease their earnings, thereby setting up an easy comp the following year. One of the most common tactics for accomplishing this goal is to increase reserves. Executives can decrease earnings by inflating reserves. Then, if the company is struggling to hit their target in a later period, the executive can always decrease those reserves back down and book the decrease as positive income.

Figure 1 shows the results of the work we did on reserves in 2013. In 2012, the companies that increased their reserves the most—thereby decreasing reported income—were Capital One Financial (COF), Caterpillar (CAT), Walgreen’s (WBA), Chevron (CVX), and Kroger (KR). The next year, three of those five companies significantly decreased their reserves, while the other two increased them by a much smaller amount.

Figure 1: 5 Companies With The Largest Increase In Reserves In 2012

Sources: New Constructs, LLC and company filings.

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