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.
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.