The Earnings Game

All public firms have the opportunity to "game" or mess with, distort, misrepresent, lie about or in any way alter the earnings they report each quarter. Why can companies game their earnings? Well, lets face it, our accounting system isn't perfect... to say the least. But none is. There are multiple ways to report various items, companies can use these options to change their expense structure in order to give earnings a boost when they need it, or even when things are great, to create a reserve that they can draw on when they do need a boost to earnings. Why would companies go through all this trouble for an extra couple cents of EPS? Well because remember those earnings estimates that analysts have are priced into stocks, and not meeting those expectations, or exceeding those expectations has a huge effect on the stock price.

I was planning on writing a long article on this for a while but then today I was reading Buffett's annual letter to shareholders (in class of course) which went out a couple weeks ago. Besides from hearing what the richest man in Amerca's company is up to, and gaining a true genius' insights to the economy, there are a couple pages of borderline academic education that is laced with his unique and hilarious (in a nerdy way) sense of humor... it's classic. In this year's he talks about just this topic, gaming earnings. He addresses it from two ways managers can achieve this: stock option expensing and manipulating pension funds. Of course there are more, but instead of me rambling, below is what Buffett has to say.

Bottom line: watch out for gaming earnings, it's one reason why going through a company's footnotes to their financials is so crucial.


Below is the option expense manipulation part from Warren Buffett's 2007 Annual Letter to shareholders, I encourage you to go here and read it in its entirety... as well as the one from each year.

Fanciful Figures – How Public Companies Juice Earnings
Former Senator Alan Simpson famously said: “Those who travel the high road in Washington
need not fear heavy traffic.” If he had sought truly deserted streets, however, the Senator should have looked to Corporate America’s accounting.

An important referendum on which road businesses prefer occurred in 1994. America’s CEOs had just strong-armed the U.S. Senate into ordering the Financial Accounting Standards Board to shut up, by a vote that was 88-9. Before that rebuke the FASB had shown the audacity – by unanimous agreement, no less – to tell corporate chieftains that the stock options they were being awarded represented a form of compensation and that their value should be recorded as an expense.

After the senators voted, the FASB – now educated on accounting principles by the Senate’s 88 closet CPAs – decreed that companies could choose between two methods of reporting on options. The preferred treatment would be to expense their value, but it would also be allowable for companies to ignore the expense as long as their options were issued at market value.

A moment of truth had now arrived for America’s CEOs, and their reaction was not a pretty sight. During the next six years, exactly two of the 500 companies in the S&P chose the preferred route. CEOs of the rest opted for the low road, thereby ignoring a large and obvious expense in order to report higher “earnings.” I’m sure some of them also felt that if they opted for expensing, their directors might in future years think twice before approving the mega-grants the managers longed for.

It turned out that for many CEOs even the low road wasn’t good enough. Under the weakened rule, there remained earnings consequences if options were issued with a strike price below market value. No problem. To avoid that bothersome rule, a number of companies surreptitiously backdated options to falsely indicate that they were granted at current market prices, when in fact they were dished out at prices well below market.

Decades of option-accounting nonsense have now been put to rest, but other accounting choices remain – important among these the investment-return assumption a company uses in calculating pension expense. It will come as no surprise that many companies continue to choose an assumption that allows them to report less-than-solid “earnings.” For the 363 companies in the S&P that have pension plans, this assumption in 2006 averaged 8%. Let’s look at the chances of that being achieved.