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Corporate earnings: Facts and fiction

Corporate earnings: Facts and fiction. By Team 3. Introduction. Importance of earnings Input of investors’ valuation model Managers ' compensation and wealth E nterprise performance measurement. Overview. An Anatomy of Earnings Manipulation True Earnings and GAAP Earnings

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Corporate earnings: Facts and fiction

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  1. Corporate earnings: Facts and fiction By Team 3

  2. Introduction • Importance of earnings • Input of investors’ valuation model • Managers' compensation and wealth • Enterprise performance measurement.

  3. Overview • An Anatomy of Earnings Manipulation • True Earnings and GAAP Earnings • Classifying Manipulated Earnings • Why Manipulate Earnings? • How Much Earnings Manipulation Occurs? • The Social Costs of Earnings Manipulations • A Proposed Procedure to Curb EM

  4. An Anatomy of EarningsManipulation • Ex. Case of Enron • Left bar • Analyst forecast • Middle bar • Original report • Right bar • Subsequent restated

  5. True Earnings and GAAP Earnings • What are true earnings? • Correspond to reality, or facts. • Confirmed by bank and custodians’ statements. • What are GAAP earnings? • High-quality earnings following the GAAP framework. • A measure of a company's overall earnings performance.

  6. Classifying Manipulated Earnings • Accounting Manipulation • No effect on cash flows. • Real Manipulation • Involve a change in the firm's level of investment with an intention to affect reported earnings. • GAAP-Consistent Manipulation • Attempt to affect investors' perceptions. • GAAP-Violating Manipulation • Include clear deviations from accepted rules

  7. Why Manipulate Earnings? • Personal gain • Very high executive compensation. • Maximization of multiyear bonuses. • Continuation of investor/supplier support • Operation with adequate funding. • Satisfying contractual arrangements

  8. How Much Earnings Manipulation Actually Occurs? • Direct earnings manipulation • Fraud litigation • Corporate earnings restatements • SEC enforcement actions

  9. Securities Fraud Litigation

  10. Earnings Restatements • A study of 1,068 cases of reinstatement during 1977-2000 • 232 firms faced securities class action lawsuits. • 193 firms had their management replaces. • 108 companies replaced their auditors.

  11. SEC Enforcement Releases • The Account and Auditing Enforcement Releases indicates that approximately two thirds of the recorded manipulations lasted for one to two years.

  12. How Much Earnings Manipulation Actually Occurs? • Indirect earnings manipulation • Discontinuities in earnings distributions. • Deviations from expected accruals. • Earnings patterns around suspicious circumstances.

  13. Discontinuities in earnings distributions • Examine Past earnings and Analysts’ forecasts • Distributions should be fairly smooth with a hump in the center.

  14. Deviation from Expected Accruals • Many accruals require estimates • An inflation tend to boost expected accruals

  15. Suspicious Circumstances • Managers are especially tempted to inflate earnings reported when: • A manager's performance is challenged. • Prior to a stock offering.

  16. The Social Costs of Earnings Manipulations • Increase in firms’ cost of capital. • The losses caused to pension funds, university endowments, and insurance companies. • Cost of unwise investments. • Cost of auditing. • Cost of legal systems and public institutions.

  17. A Proposed Procedure to Curb Earnings Manipulation • Accounting rules have to reflect economic reality. • Shift accounting standard. • Mandatory revision of companies’ annual earnings.

  18. Conclusion • Earnings manipulation is prevalent, but it is hard to detect for very bad cases. • Change the incentives for earnings manipulations. • Make corporate financial reports more truthful and revealing.

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