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Rice University research finds market outliers at risk of misreporting

Research shows that some corporate executives skew earnings to influence the market and inflate share price. Photo via Pexels

Say a company called CoolConsumerGoodsCo has just released its quarterly earnings report, revealing significantly higher profits than its consumer goods industry counterparts.

That result might spur analysts to slap a buy rating on the stock and investors to snap up shares. In an ideal world, the market wouldn't have to consider the possibility that the numbers aren't legit — but then again, it's not an ideal world. (Enron, anyone?)

Rice Business professors Brian R. Rountree and Shiva Sivaramakrishnan, along with Andrew B. Jackson at UNSW in Australia, studied what makes business leaders more likely to engage in fraudulent earnings reporting. Specifically, they focused on the relationship between this kind of misrepresentation and the degree to which a company's earnings are in line with the rest of its industry — a variable the researchers term "co-movements."

Many people are familiar with a similar variable, calculated using stock returns often referred to as a company's beta. The authors adapted the stock return beta to corporate earnings to see how a company's earnings move with earnings at the industry level.

The researchers hypothesized that the less in sync a company's earnings are with its industry, the higher the chance a company's leaders will manipulate earnings reports. They started with the well-accepted premise that corporations try to skew earnings reports to influence the market. The primary motive is typically to raise the company's stock price, as when an executive tries to "choose a level of bias" that balances potential fallout of getting caught against the benefits of a higher stock price.

To test their prediction, the professors analyzed a sample of enforcement actions taken by the U.S. Securities and Exchange Commission against companies for problematic financial reporting from 1970 to 2011 — although they noted that given the SEC's limited resources, the number of enforcement actions probably underestimates the actual amount of earnings manipulation in the market.

Their analysis revealed that firms with low earnings co-movements (meaning their earnings were out of sync with industry peers) were more likely to be accused by the SEC of reporting misdeeds. They concluded that the degree of earnings co-movement determines the probability of earnings manipulation. Put another way, earnings co-movements are a "causal factor" in the chances of earnings manipulations — and to a significant degree. The researchers found that firms who don't co-move with the market are more than 50 percent more likely to face an SEC enforcement action, compared with firms who are perfectly aligned with the market.

The researchers drilled deeper into the data to study whether the odds changed depending on the industry, since past research has indicated that the amount of competition in an industry works to constrain misreporting. That premise seems to hold true, the researchers concluded. In industries with more competitive markets, the impact of low co-movement on earnings manipulation is moderated.

They also studied whether the age of a firm played a part in the likelihood of earnings manipulation. Newer firms often rely more on stock compensation, which could be a motive for manipulating earnings reporting to drive up share price. Indeed, younger firms were more susceptible to misreporting when their earnings were out of whack with the rest of the marketplace.

Every firm faces some risk of misreporting, however. Even for public companies under analyst scrutiny, low co-movement proved to be a driver of earnings manipulation. But companies known for conservative reporting tend to be less likely to exaggerate their earnings, in general; these firms typically recognize losses in a more timely manner, the professors found.

These findings suggest a number of future lines of research. For example: When do executives underreport earnings? And can analyzing patterns related to cash flow reporting help better isolate earnings manipulation?

In the meantime, if you come across a company like CoolConsumerGoodsCo with an earnings report that's widely out of sync with the rest of its industry, you might think twice before rushing to buy in.

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This article originally ran on Rice Business Wisdom and is based on research from Brian R. Rountree, an associate professor of accounting at the Jones Graduate School of Business at Rice University, and Shiva Sivaramakrishnan is the Henry Gardiner Symonds Professor of Accounting at Rice Business.

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Building Houston

 
 

Vanessa Wyche, director of the Johnson Space Center, gave the keynote address at this year's State of Space event. Screenshot via houston.org

Is the Space City poised to continue its reign as an innovative hub for space exploration? All signs point to yes, according to a group of experts.

The Greater Houston Partnership hosted its annual State of Space this week. The virtual event featured a keynote address from Vanessa Wyche, director of NASA Johnson Space Center, and a panel moderated by David Alexander, chair of aerospace and aviation committee at the GHP and the director of the Rice Space Institute.

The conversations focused on the space innovation activity happening in Houston, as well as an update on the industry as a whole has space commercialization continues to develop. All the speakers addressed how Houston has what it takes to remain a hub for the sector.

"The future looks very bright for Houston that we will remain a leader in Houston spaceflight," Wyche says in her address.

Here are a few other memorable moments from the event.

"Houston, I feel, is poised to be a leader. We have led in human space flight, and we will a leader in commercialization."

— Wyche says in her keynote address, which gave a thorough overview of what all NASA is working on at JSC. She calls out specifically how startups are a driving force in commercialization. JSC is working with local accelerator programs at The Ion and MassChallenge.

"These startups help us to connect to tomorrow's space innovation leaders, and gives our team the opportunity to mentor these entrepreneurs as we work to advance both our scientific and technical knowledge," she says.

"The ability to have a place where government, academia, and industry can come together and share ideas and innovation is incredibly powerful."

​— Steve Altemus, president and CEO of Intuitive Machines LLC, specifically talking about the Houston Spaceport, where Intuitive Machines has signed on as a tenant. Altemus adds that a major key to leading space commercialization is a trained workforce, which the spaceport is focused on cultivating.

"We shouldn't discount the character that Houston has from the standpoint as a great place to build a business."

— Tim Kopra, vice president of robotics and space at MDA Ltd., says, adding that Houston is a big city that feels like a small town. "We need to incentivize companies to come and stay," he says.

"Great cities — like great companies — understand that if you're still, you're probably moving backwards. ... I think Houston gets it in that regard."

— Todd May, senior vice president of science and space at KBR, says, adding that Houston realizes it needs to be on the offensive side to bring innovation to the game, positioning the city very well for the future.

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