'Camouflaging' earnings management

Tricks to disguise deceptive accounting games have gotten trickier in the post-Sarbox era, a study suggests.

CFOworld –

The stringent accounting and board standards introduced with the 2002 Sarbanes-Oxley are widely thought to have resulted in higher quality earnings. But by increasing the cost of earnings management, Sarbox has also become part of some companies' efforts to hide improper earnings management.

Columbia Business School's Nahum Melumad and Itay Kama of Tel Aviv University analyzed over 120,000 financial disclosures of some 6,000 publicly traded companies for several years both pre- and post-Sarbox and found that companies have increased the use of what they call "accruals conversion cash management" in order to disguise their efforts to manage earnings.

Two common red flags that indicate possible earnings management are (1) cash that does not follow earnings and (2) accruals (the difference between earnings and cash) that don't correspond to either earnings or revenues. Some companies try to mask accruals-conversion cash management red flags by converting accruals into cash to mimic the impact of a true sales increase or expense decrease on cash and accruals.

Melumad and Kama point out that there are two types of earnings management: accrual-based manipulation and real earnings management. The latter involves manipulation of real transactions --- for example, pulling in sales to the current period, or postponing or cutting discretionary expenses like advertising and R&D.

"Real earnings management is costly to employ," Melumad tells the publication Columbia Ideas at Work. "If a company wants to manage earnings in a manner that is difficult to detect, it is more likely to resort first to another available, often less costly, method of disguising earnings management: managing cash to replicate the impact of a true improvement in performance."

The professors show that the forward variation of key financial variables like cash flow from operating activities relative to sales increases significantly over the next several quarters when companies try to disguise their post-Sarbox earnings management efforts.

Melamud and Kama also say that while their work was prompted by questions raised by Sarbox, the research has broader implications. They argue that the delayed effects on the key financial variables that they identify could help analysts, regulators and other market participants in detecting suspected earnings management. Relying exclusively on more commonly analyzed indicators, they say, could result in misleading inferences about the scope of earnings management activity.

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