How to spot companies that manipulate earnings
It’s earnings season once again, and that means stock prices can move up or down depending on how investors react to earnings results.
If earnings exceed market expectations, investors may react positively that will lead to higher stock prices, but if earnings are disappointing, investors may anticipate lower valuation, causing stock prices to decline.
Because investors rely on earnings on how they will pay for stocks in the future, companies are always pressured to make their financial situation look better.
It is not hard to imagine that companies can possibly use accounting techniques to show consistent earnings growth to support their stock prices.
Through a combination of earnings guidance, accrual accounting, and changes in accounting policies, companies could actually inflate their earnings to meet market expectations.
In 1999, an accounting professor from the Kelly School of Business of Indiana University by the name of Messod Beneish theorized in his research that companies were more motivated to manipulate their earnings if they have decreasing sales growth, deteriorating gross margins, rising operating expenses and increasing leverage.
Beneish said that companies under this situation were likely to manipulate their earnings by accelerating revenue recognition, increasing cost deferrals, raising accruals and reducing depreciation expenses.
Based on this theory, Beneish developed a quantitative scoring model, known as the Beneish M-Score, that could determine the likelihood that a company had manipulated its earnings.
According to Beneish, companies that score greater than -1.78 are considered earnings manipulators, while those that score lower than -2.22 are non-earnings manipulators.
Companies that have scores in between -1.78 and -2.22 are regarded as possible earnings manipulator but they have more reliable reports than those with scores higher than -1.78.
The formula for the Beneish M-Score, which uses eight financial ratios, is expressed as M-score = −4.84 + 0.92 × DSRI + 0.528 × GMI + 0.404 × AQI + 0.892 × SGI + 0.115 × DEPI −0.172 × SGAI + 4.679 × TATA − 0.327 × LVGI, where:
DSRI stands for Days’ Sales in Receivables Index. An increase in receivables that is disproportionate to the volume of sales may indicate revenues are artificially inflated.
GMI stands for Gross Margin index. Deteriorating gross margins mean lower profits in the future, which motivates companies to window dress.
AQI stands for Asset Quality Index, which we have discussed in this column last week, “How does asset quality affect stock prices?” An increase in noncurrent assets, other than fixed assets, means the company has potentially increased its deferred costs to increase earnings.
SGI stands for Sales Growth Index. High growth companies are more likely to manipulate their earnings because of their need to achieve their sales targets.
Depi stands for Depreciation Index. A decrease in depreciation levels relative to net fixed assets indicates the possibility that the company has revised upwards the estimated useful life of assets to boost earnings.
SGAI stands for Sales, General and Administrative Expenses Index. Rising operating expenses relative to sales indicates poor operating efficiency.
LVGI stands for Leverage Index. An increase in leverage motivates a company to overstate its earnings to comply with debt covenants.
Tata stands for Total Accruals to Total Assets, which is similar to the Sloan Ratio that we have discussed previously in this column. A higher level of accruals indicates a higher likelihood of earnings manipulation.
Better earnings quality
If we will apply this model to detect earnings manipulation in the Philippine Stock Exchange (PSE), we will find that the number of manipulators has increased from 23.8 percent in 2018 to 25.4 percent in 2020.
Companies that are classified as potential earnings manipulators have the largest increase from 17.6 percent in 2018 to 28.5 percent last year.
Interestingly, if we compare this to PSE Index stocks, the trend is different. There are only two index stocks that are regarded as earnings manipulators in 2020 and this number has not changed from 2018.
The number of potential earnings manipulators also declined from 12 stocks in 2018 to 10 in 2020, indicating that blue chip companies have better earnings quality compared to non-index stocks.
Although the Beneish M-Score is a probabilistic model and as such its results are not 100 percent, the model is useful in selecting stocks that generate sustainable growth. INQ
Henry Ong is a registered financial planner of RFP Philippines. Stock data and tools provided by First Metro Securities. To learn more about investment planning, attend the 93rd batch of RFP program this January 2022. To register, email [email protected] or text at 0917-6248110
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