One of the most important elements that Warren Buffett mentions while choosing an investment is of management quality. The incentives given to the management usually tell a lot about where the company policies might be headed in the future, e.g. suppose management receives a lot of stock options expiring 5 to 10 years down the line. Then management is incentivized to increase the long-term earnings and make sure they hit the target. But keep in mind, this does not mean that there would be long-term value created. The management could very well manipulate earnings in order to manage the stock price for a short period.
I’ll detail a few ways how companies manipulate earnings.
a) Big bath accounting
Usually when a new CEO or management comes into power due to problems within a company, they undo the policies set by the old management and undergo a very big write-off of assets on the books. Good projects which do not fit in the long-term strategy of the new CEO are written off; divisions are shut down and liquidated and/or spun off. All these charges are written off as a loss.
Once these charges are written off, the company stock price takes a hit since the earnings for that period fall and due to the other turmoil at the company, i.e. restructuring. This sets the stage for the stock to outperform the market a few years down the line. There is usually no cash change on the balance sheet. Big Bath accounting is just an earnings management technique.
Here are examples of asset write-downs.
Ten dollars of inventory is written down to $5 on the books, and a few years down the line is sold for $8, which would imply an earnings jump in the future years.
Real life example:
HP recently wrote down $8 billion in goodwill from its EDS acquisition in 2008 and reduced assets on the balance sheet, while HP services still maintains 28% of HP’s revenue, and there is a possibility that the value created by EDS is much greater than what was written off. These practices need to be watched out for before choosing an investment. All of these are examples of Big Bath accounting.
b) Valuation of investment assets
Investment assets are reported in the comprehensive income statement area of the income statement. The regulatory bodies allow three different categories of valuation for assets: L1, L2 and L3. They determine how the valuation of assets' underlying value takes place. The L1 and L2 assets are usually not to be worried about. If a company has a lot of L3 assets, then that’s a concern for worry because the true price of these assets is very hard to determine and is based mainly on management input. This could possibly lead to a huge write down of assets in the future.
What are L3 assets?
Financial assets and liabilities whose values are based on prices or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement. These inputs reflect management’s own assumptions about the assumptions a market participant would use in pricing the asset or liability (examples include certain private equity investments, certain residential and commercial mortgage related assets (including loans, securities and derivatives), and long-dated or complex derivatives including certain foreign stock exchanges, foreign options and long dated options on gas and power). Level 3 assets trade infrequently; as a result there are not many reliable market prices for them. Valuations of these assets are typically based on management assumptions or expectations – from wikinvest.com.
Real life example:
During the year 2007, these assets came under heavy scrutiny because they made up mortgage backed securities on the balance sheets of the banks and firms were not adjusting the value downward since it was difficult to determine their price. Finally after the write down took place, many companies ended up triggering their covenants and were forced to go bankrupt by the debtors.
c) Tinkering with depreciation salvage value and time
Depreciation helps determine the useful life of an asset and how it hits the company’s earnings. Companies tinker around with this value and can have a more than average salvage value, which would increase the reported earnings and hence decrease the P/E ratio. Companies also tinker around with the useful life of an asset, but now there is guidance provided on the range of useful life, so there is less manipulation using the “useful life” method.
Usually comparing the depreciation methods with peers helps prevent this problem. The depreciation method manipulation has been a lesser and a lesser problem these days because of disclosure.
If a company tweaks its accounting principles very frequently it would need deeper inspection and it would save you a lot of time to avoid that company unless you have a very compelling reason.
There are a lot of other ways to manipulate earnings, such as capitalizing versus expensing, etc. Being aware that earnings can be legally manipulated will help you keep an eye out for them.
How to see through earnings manipulations
Read, Read and read. Especially all the footnotes, the devil is in the details.
To get started:
I recommend learning financial statement analysis as much in detail as you can. One excellent book that I have found on the same topic is "Financial Statement Analysis" by KR Subramanyam.
Here is a link to a short tutorial as well:
I will detail this out in a future article on ways to detect earnings manipulation risk.