There are arguments that favor such behavior because shareholders stand to benefit from the resulting low volatility earnings, or the clear view of what earnings would have been if, for example, the U.S. dollar had not strengthened over the past year or oil prices had not declined. On the other hand, there are arguments that suggest that earnings management only benefits the managers, at the expense of the creditors and shareholders. Of course, both sides of the issue claim to have supporting evidence. But this begs the question: when does earnings management become earnings manipulation, and when does earnings manipulation become outright misrepresentation? This is an important question, especially in light of the most recent reported earnings of many leading publicly traded companies in the U.S.
Is Earnings Manipulation Good or Bad?
Management has several reasons for managing or smoothing earnings. The decision to smooth earnings may result in multiple benefits for shareholders. For example, smoothed earnings (i.e. earnings streams with low volatility) are thought to produce desirable share-price effects. Some of these effects include:
- Wide spread agreement among analysts and favorable coverage,
- A lower cost of equity capital,
- Higher share prices, and
- Higher firm values.
Low volatility earnings may also enhance a firm’s ability to borrow by producing:
- Enhanced credit quality,
- Higher debt ratings,
- More flexibility in financial covenants, and
- A lower cost of borrowing.
Earnings management may also help mangers successfully operate in difficult political and regulatory environments. For example, petroleum companies may want to conceal the correlation between rising pump prices and rising profitability to avoid political pressure to impose price controls or levy additional taxes on the industry. Similarly, firms with unionized labor forces may want to manage earnings downward in an effort to facilitate labor contract negotiations and to better control labor costs.
Finally, corporate executives have a personal reason for engaging in earnings management. From their perspective, earnings management may favorably affect their compensation through:
- Increased profit-based bonuses,
- Increased stock option values.[1]
However, these compensation-based incentives can and do give rise to potential conflicts of interest between management and shareholders (and creditors). That is, because management’s total compensation may be dependent on favorable earnings results and higher share prices, management has an incentive to attempt to manipulate both earnings and share prices in order to capture the associated payouts. But this short-term focus may be detrimental to long-run wealth creation; and shareholders may be compensating their managers for transitory, rather than permanent, economic gains.
The methods used to report executive compensation has given some investors pause. For example, while Warren Buffett was lamenting the application of GAAP accounting rules to acquisition goodwill in Berkshire Hathaway’s 2015 letter to shareholders, he made the following observation:
“I suggest that you ignore a portion of GAAP amortization costs. But it is with some trepidation that I do that, knowing that it has become common for managers to tell their owners to ignore certain expense items that are all too real. “Stock-based compensation” is the most egregious example. The very name says it all: “compensation.” If compensation isn’t an expense, what is it? And, if real and recurring expenses don’t belong in the calculation of earnings, where in the world do they belong?
Wall Street analysts often play their part in this charade, too, parroting the phony, compensation-ignoring “earnings” figures fed them by managements. Maybe the offending analysts don’t know any better. Or maybe they fear losing “access” to management. Or maybe they are cynical, telling themselves that since everyone else is playing the game, why shouldn’t they go along with it. Whatever their reasoning, these analysts are guilty of propagating misleading numbers that can deceive investors.”[2]
What are Quality Earnings and Why Do They Matter?
Dichev, Graham, Harvey, and Rajgopal survey approximately 169 CFOs of U.S. publicly traded companies and 206 CFOs of large private companies in an attempt to better understand how these CFOs characterize quality earnings—or earnings that investors can trust and use in determining the value of publicly traded companies. These CFOs tell us that:
- Above all, high-quality earnings are sustainable and repeatable and these two characteristics manifest themselves through consistent reporting choices, high correlation to actual cash flows, and absence of one-time items and long-term estimates;
- In any given period, about 20 percent of firms manage earnings to misrepresent economic performance, and for such firms 10 percent of EPS is typically managed;
- The primary consequence from reporting poor quality earnings is investor confusion and lack of trust in the company’s management;
- About 50 percent of earnings quality is driven by non-discretionary factors such as industry and macro-economic conditions; and
- Earnings manipulation is hard to unravel from the outside but peer comparisons, lack of correlation between earnings and cash flows, the liberal use of accruals, the presence of serial “one-time charges,” and consistently beating analysts’ forecasts provide helpful red flags.[3]
This study also indicates that 80 percent of the CFOs surveyed ranked, in order, the following uses of earnings as “very important”:
- Valuing the company,
- Establishing and maintaining debt contracts,
- Internal management decisions, and
- Use in executive compensation contracts.
Furthermore, it is worth noting that approximately 90 percent of the CFOs indicated that motivation behind earnings management was to:
- Influence the stock price,
- Meet outside pressure to hit earnings benchmarks,
- Meet internal pressure to hit earnings benchmarks, and
- Influence executive compensation.
Notice that rewarding executives is one use of reporting earnings that is considered to be very important, and 90 percent of CFOs believe executive compensation is a primary driver of earnings management (or manipulation). Investors should also take note of the point made about the difficulty related to detecting earnings management and manipulation. Based on this insider perspective, one can expect to find approximately 1 in 5 publicly traded companies managing or misstating their earnings by as much as 10 percent—but it will be hard to detect. The job becomes even more difficult as companies become more innovative in their reporting practices and presentations; providing owners, creditors, and markets with financial performance metrics with GAAP-sounding labels such as Adjusted EBITDA, Adjusted diluted earnings per share from continuing operations, Adjusted earnings, Pro-forma earnings, and Adjusted free cash flow.[4]
But the problem could actually be more pervasive. FACTSET recently reported that of the 30 blue chip stocks that comprise the Dow Jones industrial Average (DJIA), 21 companies reported both GAAP earnings and non-GAAP earnings in their formal earnings announcements for Q3 2016. Average (median) year-over-year non-GAAP earnings growth was positive 10.8 percent (5.1 percent). However, average (median) GAAP earnings growth was -3.7 percent (-1.2 percent). So are earnings growing or not? Similar outcomes for these 30 companies were also reported for Q3 2015, except for the average difference between the two GAAP measures, which was 17.1 percent.[5]
Earnings announcements by companies that constitute the S&P 500 indicate similar reporting practices. For this broader group of companies, the 2015 non-GAAP earnings indicated year-over-year growth of just 0.4 percent. But the 2015 GAAP earnings show a very different picture, posting a year-over-year decline of 12.7 percent. Moreover, the pro-forma earnings figures were 25 percent higher than the GAAP earnings. This difference, easily seen in Figure 1, is as wide as it has been since 2008.[6]
For many investors and analysts, the P/E ratio is used as a simple model to compute a fair price for a market index or a firm’s stock. Furthermore, because earnings are the denominator in P/E ratios, the different measures give very different pictures of market index values and overall market relative value. Using non-GAAP earnings, the market’s P/E ratio at year-end 2015 was a reasonable 16.3 times. However, using GAAP earnings, the market was trading at an extended 21.2 times earnings. The difference in these outcomes may result in very different investment approaches and portfolio allocations because the first outcome suggests the market is fairly valued, while the latter indicates that the market may be overvalued.
Figure 1: GAAP versus Pro-forma earnings for the S&P500
Source: Wall Street Journal
Reading Between the Lines
Distortions in metrics intended for evaluating the relative value of a market index are one thing, but what about the incremental effects, and potential added confusion, of reporting various financial performance measures when it comes to valuing an individual company?
Consider Twitter’s recent presentation of its financial performance. Its website offers interested parties at least four documents containing accounting and operating data related to their Q3 2016 performance. Contained in each of these presentations are GAAP earnings, free cash flow, and something called Adjusted EBITDA. To be fair, Twitter provides a reconciliation of the Adjusted EBITDA to GAAP earnings (typically in an appendix), and a note to the reader alerting them to the non-GAAP metric. But what they do not provide is an explanation for the inclusion, or the interpretation, of the Adjusted EBITDA figure.[7]
Furthermore, in its Q3 2016 earnings press release, Twitter reports something called non-GAAP net income. This figure is defined as: non-GAAP net income as net loss adjusted to exclude stock-based compensation expense, amortization of acquired intangible assets, non-cash interest expense related to convertible notes, non-cash expense related to acquisitions, the income tax effects related to acquisitions, and restructuring charges.[8] Of these, stock-based compensation and depreciation and amortization are the two largest adjustments. These figures, along with GAAP earnings, Adjusted EBITDA, and free cash flow are presented in Figure 2.
The data clearly show that the negative GAAP earnings in 2014 and 2015 are entirely due to the amount of stock-based compensation. This is almost true for 2013 as well. Additionally, Adjusted EBITDA far exceeds GAAP earnings each year.
Figure 2: Reported Financial Performance – Twitter
Source: Presentation at TWITTER annual meeting, May 25, 2016, San Francisco, CA.
Taking a closer look at the Adjusted EBITDA figures, one has to wonder about the true purpose for their inclusion. Often EBITDA is used as a proxy for cash flow calculations, but Twitter includes the statement of cash flows in their presentations. Additionally, Twitter’s version of EBITDA, Adjusted EBITDA, excludes the value of the stock-based compensation. Finally, when most firms provide guidance, they offer revenue and earnings per share estimates. Twitter provides revenue and Adjusted EBITDA guidance. The company seems to be suggesting to its shareholders and potential shareholders that stock-based compensation should not be considered an important component of understanding the firm’s current and potential operating and financial performance. But the real reason just might be that over the past year Twitter’s stock-based compensation has been approximately 26 percent of revenues while similar companies such as LinkedIn, Facebook, Alphabet, and Amazon report comparable figures are 17 percent, 15 percent, 7 percent, and 2 percent, respectively.[9]
Analyzing stock-based compensation gives us additional insight into the motives behind the purposeful confounding of the reported financial performance. One of the strongest arguments for stock-based compensation is to incentivize the management team, and to align those incentives with favorable outcomes for shareholders. That is, if you want management to act in the shareholders best interests, make them shareholders. Therefore, well-designed plans include incentives based on logical goals such as sustained growth in revenues, profit margins, returns on capital (e.g. ROA, ROIC, book ROE, and shareholder returns) and other non-financial goals such as increasing market share and customer or client retention rates. However, creating well-designed plans is easier said than done, but poorly designed plans are easy to identify. Twitter’s plan seems somewhere in between, but it helps us to better understand why it might report Adjusted EBITDA and Adjusted non-GAAP earnings.
In their most recent Schedule 14A filing, Twitter provides an explanation of their 2016 Equity Incentive Plan. The plan involves the potential distribution of 6,814,085 shares of the company, all of which are offered by Co-Founder and CEO Jack Dorsey from his trust. Because the company is not issuing new shares, the plan will not dilute shareholders. However, one has to wonder if these shares will incentivize Twitter employees, or simply be viewed as a generous gift.
Skepticism is justified based on the structure of the incentive plan and the lack of detail. The plan indicates that some shares will be awarded to management and employees based only on the passage of time. Other shares, or Performance Awards, can be earned. However, this is where the plan structure gets confusing. There are 31 performance benchmarks listed in the plan ranging from cash flow and cash balances to revenue growth, economic profit added and “innovation.” All benchmarks are applied at the administrator’s discretion. Furthermore, performance can be measured under U.S. GAAP, International Accounting Standards Board (IASB) accounting standards, or adjustments made to the accounting outcomes derived from either of these standards—that is Adjusted EBITDA and Adjusted non-GAAP earnings.
This implies that using Adjusted EBITDA as a benchmarking standard (which tends to be loaded with special non-GAAP assumptions) encourages a favorable evaluation of the management team because Adjusted EBITDA values are likely artificially high and positive, even if GAAP earnings are negative. If a rational firm wants to award bonuses only for superior management performance, then the firm needs high EBITDA targets before a bonus can be earned. Finally, stock-based compensation in this plan may be granted in cases where there is no improvement in the benchmark metric. For example, stock options can be granted where the exercise price of the award is equal to the market price—the stock price does not have to go higher to award compensation. Is this really incentive compensation, or is Twitter simply substituting options grants for cash compensation to manipulate its cash flow, EBITDA, and earnings measures?
That is, without a meaningful incentive in the stock compensation plan, Twitter seems to be converting an ordinary two-step process into an artificial one-step process. In an ordinary two-step process, Twitter would first pay cash compensation to a manager. In the second step, the manager uses the cash to purchase Twitter stock. Collapsing the two steps looks like the distribution of stock to the manager with no cash compensation. But in this instance, there may be no meaningful managerial achievement to support the distribution of the stock based on an incentive plan. The purpose of the collapse appears to be a reduction in reported cash compensation.
Another troubling aspect of Twitter’s stock-based compensation relates to the compensation for the members of the Board. Traditionally, the Board of Directors is viewed as a monitor of managerial behavior, serving on behalf of the shareholders. However, as part of their annual compensation, Twitter’s directors receive $225,000 in restricted stock units (RSU). The RSU’s vest quarterly and do not require any action by the board member—just the passage of time. There are no incentives to monitor the management team, oversee the strategy, or adjust management compensation contracts downward for poor performance. Again, it appears that Twitter may be using stock-based compensation in place of cash compensation without any long-term incentives attached.
Conclusions
Twitter is not the only company creating confusion for their shareholders and the market; recent earnings seasons are replete with other companies providing the same kind of unclear, or even misleading financial performance reports. However, one thing is clear. Investors should be paying attention to all the information in the earnings disclosures so they can better understand the motives behind the presentation of the results. Ignoring this information may lead to large losses. Feng, Ge, Luo, and Shevlin[10] provide evidence from a sample of firms that were subject to SEC enforcement actions related to accounting manipulations that the CFOs involved in material accounting manipulations are likely to be pressured by their CEOs, who stand to materially gain from incentive based compensation contracts.
[1] Note that there are two forces at work here. Reducing volatility in the earnings stream, and presumably in the stock price, will reduce the value of compensation options because the value of a call option is inversely related to the volatility of the underlying asset. However, by increasing the predictability of the earnings stream, and therefore the stock price, compensation committees may be able to increase the likelihood that the compensation options will finish in the money.
[2] Warren Buffett, Berkshire Hathaway 2015 Annual Letter, http://www.berkshirehathaway.com/2015ar/2015ar.pdf, accessed November 1, 2016.
[3] Dichev, I., Graham, J., Harvey, C., Rajgopal, S., “The Misrepresentation of Earnings,” Working paper, Goizueta Business School, Emory University, June 2, 2015.
[4] McKenna, F., Linnane, C., Kilgore, K., “Here’s how investors are duped each earnings season; Made-up numbers are creating confusion and misery,” Market Watch, http://www.marketwatch.com/story/earnings-season-is-an-unrelenting-misery-it-doesnt-have-to-be-2016-05-13, accessed August 20, 2016.
[5] Butters, J., FACTSET Earnings Insight, November 18, 2016, https://www.factset.com/websitefiles/PDFs/earningsinsight/earningsinsight_11.18.16, accessed November 19, 2016.
[6] Lahart, J., “S&P 500 Earnings: Far worse than advertised; http://www.wsj.com/articles/s-p-500-earnings-far-worse-than-advertised-1456344483, accessed August 20, 2016.
[7] Twitter Q3 2016 Earnings Report, http://files.shareholder.com/downloads/AMDA-2F526X/3265546172x0x913986/54A7EF6C-F9C3-44C7-BF3C-D4A921452DFA/Q3_16_Earnings_Slides.pdf, accessed November 22, 2016. The note contained in this document reads: In addition to U.S. GAAP financials, this presentation includes certain non-GAAP financial measures. These non-GAAP financial measures are in addition to, not a substitute for or superior to, measures of financial performance prepared in accordance with U.S. GAAP. As required by Regulation G, we have provided a reconciliation of those measures to the most directly comparable GAAP measures in the Appendix.
[8] Twitter Earnings Press Release, http://files.shareholder.com/downloads/AMDA-2F526X/3265546172x0x913984/36DC5767-AF54-496B-93D7-8437630D5DFA/TWTR_Q3_16_Earnings_Press_Release.pdf, accessed November 22, 2016.
[9] Kretzmann, D., “Stock-Based Compensation and You!,” http://www.fool.com/investing/2016/09/14/stock-based-compensation-and-you.aspx, accessed November 20, 2016.
[10] Feng, M., Ge, W., Luo, S., Shevlin, T., “Why do CFOs become involved in material accounting manipulations?,” Journal of Accounting and Economics, 51 (2011): 21-36.
