Timing and Precision of Earnings Forecasts Can Reveal Bad News Ahead

 

Takeaway

  • UT research study lends new insight into earnings reports
  • Companies guilty of accounting fraud often cook the books to meet analyst targets or beat them by a cent or two
  • The earlier a company reveals negative earnings news, the less likely it is to get sued by investors

This is the cruelest time of year for companies with bad earnings news. While most people are viewing basketball playoffs and Texas bluebonnets, investors are watching for first-quarter earnings reports, and boosting or battering stocks in response.

But as with many things financial, there’s more to earnings reports than meets the eye, say two assistant accounting professors at the McCombs School of Business. In two recent studies, Dain Donelson and John McInnis investigated when investors should be suspicious of good earnings news and when companies should fess up to bad earnings news.

In their first study, the two looked at how to detect earnings management, a practice made infamous by Enron that involves using accounting tricks to make earnings appear better than they really are.

“Too many firms report small profits rather than small losses,” says McInnis. “That’s consistent with firms trying to cook their books to avoid reporting a loss. They always want to look good to Wall Street.”

Adds Donelson, “Lots of firms just meet analysts’ forecasts or beat them by a penny. Relatively few miss by a penny.”

Do such signs — barely meeting or beating earnings targets — suggest that a company might be committing accounting fraud? The challenge, say the professors, is that it’s hard to catch a company in the act. So they looked at companies that had already been caught.

They analyzed 329 corporations that had settled stockholder lawsuits over accounting violations, from 1996 to 2005. As part of the settlements, the firms had restated their earnings for a total of 1,284 quarters, stripping away the accounting tricks. That allowed Donelson and McInnis to compare the same underlying sets of financial data, both managed and unmanaged.

“We can measure the amount of earnings management between two pictures, says McInnis, “what it looks like with and without.”

The average effect of earnings management, they found, was to boost reported income by $4.1 million, or five cents per share, among the companies studied.

They also found that managed earnings were more likely to meet or beat analysts’ forecasts: 70 percent, versus 40 percent after earnings were restated. Of managed earnings that beat forecasts, 57 percent did so by a penny or less.

When earnings show that kind of pattern, one quarter after another, investors might want to take a closer look, the professors say. But they caution that it’s only a suggestion, not a proof of fraud. Says McInnis, “It doesn’t mean every firm that’s hitting its targets is cooking the books, like the ones in our sample.”

The Best Times for the Worst News

The pair’s second study looked at firms that aren’t hitting their targets, and asked the question: When should they let Wall Street know? Is a company more likely to get sued by shareholders if it warns them as soon as it knows of the bad news? Or should it wait until the quarter is almost over, hoping the news might improve?

To assess the impact of waiting, the pair looked at 423 firms that had been sued by stockholders over bad quarterly earnings news. They compared each company to another that had reported bad earnings but hadn’t been sued.

“The firms were otherwise similar in every regard,” says Donelson. “The only difference was that one set of firms held onto the bad news too long.”

To measure a company’s timeliness, the professors looked once again at analysts’ earnings forecasts. These days, they reasoned, companies deliver earnings warnings to analysts mostly by word-of-mouth, in conference calls and informal conversations. So, the earlier in the quarter that analysts reduce their forecasts, the more timely a corporation has been in notifying them about its bad news.

What Donelson and McInnis found was that the sooner a company revealed negative news, the less likely it was to get sued. Halfway through a quarter, firms that weren’t sued had already revealed 55 percent of their earnings news, while firms that had been sued had revealed only 25 percent of their earnings news.

The moral, says Donelson, is that CEOs should fight their natural tendency to hide bad news and hope things will get better. “That’s how a lot of firms get involved in fraud, by hoping that things will turn around. Then it looks like they had knowledge of the news for some time before it came out in public. It’s always best to get the bad news out early. Don’t wait for a turnaround.”

 

Faculty in this Article

Dain Donelson

Associate Professor, Accounting

Dain Donelson received his Ph.D. in accounting from the University of Illinois, his M.S. in finance from Boston College, and a J.D. from...

John McInnis

Associate Professor, Accounting

John McInnis received his Ph.D. from the University of Iowa and his BBA and MPA from the University of Texas. He teaches financial accounting in...

About The Author

Steve Brooks

In a quarter-century as a journalist, Steve Brooks has won two Neal awards for excellence in trade reporting and a Press Club of New Orleans award...

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