If you just looked at reported income, it would have seemed like Capital One grew steadily in 2012 and 2013. In reality, by reversing the impact of change in reserves, we see that it grew NOPAT by over 100% in 2012 and then declined in 2013. By changing reserves, executives managed to show two years of growth rather than one great year and one struggling year where their bonuses would get cut.

  1. Everyone Else Is Doing It

Since measures of executive performance are so often based on comparisons to a company’s peer group, it creates a sort of arms race of financial manipulation. As soon as one company in an industry starts manipulating their numbers, everyone else has to follow suit or get left behind.

A recent study looking at restatements from over 2,000 companies found that there was a strong tie between whether one company manipulated earnings and the percentage of firms in its region or industry that had announced restatements in the past year. Simply put, when executives see their competitors engaging in accounting trickery, they tend to follow suit.

The good news? The study found that when there was significant enforcement action, shareholder litigation, or negative press, the copycat effect didn’t occur. When executives are held accountable for manipulating earnings, their peers don’t tend to follow them. The bad news is that…

  1. Executives Face Very Little Accountability

Executives rarely face much blowback when they misstate earnings, either from regulators or the investing public. On the regulatory side, enforcement is so weak that they rarely even have to give back the bonuses they earned from false earnings.

How crazy is that? Executives get paid massive bonuses for hitting growth targets, and then when it’s revealed they didn’t actually hit those targets, they get to keep the bonuses anyway! So much for being aligned with shareholder interests.

Investors and analysts don’t do much better. Sell-side analysts, who have a vested interest in maintaining a good relationship with the companies they cover, don’t tend to probe too deeply into reported earnings.

“The sell side has no incentive to detect earnings quality,” said one anonymous CFO who was interviewed for the survey on earnings misrepresentation.

Buy-side analysts and short-sellers tend to be better at detecting these red flags, but too often they get shouted down when trying to raise the alarm. Take the blowback Andrew Left of Citron Research has faced for calling out Valeant. As the stock has fallen, the executives and large investors with a vested interest in supporting those misleading earnings have accused him of “playing on the fears of investors”.

This has led to a bizarre culture where executives manipulate earnings to reward themselves with bigger bonuses, and everyone knows this is happening, but when anyone tries to call them out on it they get accused of being greedy and self-serving.

The activist investors who might be best positioned to curb executive bonuses rarely do anything about them. Pershing Square founder Bill Ackman actively encouraged the aggressive acquisition accounting at Valeant that helped executives nearly triple their compensation in 2014, and he has been a staunch supporter of the executive team at Jarden (JAH) that uses an exec friendly form of adjusted earnings to help executives boost their own pay at the expense of shareholders.

Ideally, this situation will change at some point, and the correct enforcement mechanisms will be in place to prevent earnings manipulation. Until that time, investors need to be aware that the reported results they’re looking at are not necessarily an accurate indication of the underlying economics of the business. It takes a lot of work to reverse all the loopholes that executives exploit to serve their own purposes.

Disclosure: David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, style, or theme.