Uncovering accounting irregularity

December 11, 2012 | Last updated on December 11, 2012
4 min read

An anonymous survey by professors from Emory and Duke Universities in the U.S. found 20% of companies manage their earnings reports by using wiggle-room within accounting rules.

This number seems light. In fact, when we informally asked several of our colleagues, most laughed off the 20% as being grossly underestimated.

The survey result is likely low because 169 U.S. CFOs were questioned about what percentage of public companies they thought employed such tactics. They weren’t asked directly about whether they personally engaged in distorting the books.

The authors either didn’t want to offend anyone, or they knew respondents would likely lie about their own actions, even when questioned in secrecy.

Despite these results, there is an ongoing risk for advisors.

Advisors be wary

Accounting rules are vague, not designed with investors in mind, and thus open to misinterpretation, fraud, and manipulation by legal means.

With the means and opportunity established, what might be the motive to fudge results? As examined in Deception of a Different Kind (AER March), companies are sometimes motivated to artificially depress earnings instead of boosting them. In fact, the U.S. study claimed 40% of suspected manipulation was to manage income to the downside.

Holding something back from results is most often intended to smooth earnings, creating a picture of greater stability that usually leads to a higher share price. Therefore, it pays to look for companies with an uncanny ability to beat estimates by a few cents every quarter.

But what about the bulk of cases, where executives are focused on boosting results? Some pundits place the blame for accounting malfeasance on the use of quarterly earnings guidance by companies. They argue that without the desire to meet pre-set expectations, management would not bemotivated to play with the numbers. While there might be some truth to that, it ignores the most lucrative reason for executives to manipulate the accounting.

By meeting expectations instead of missing them by a few cents, executives will avoid some grief, and maybe a temporary dip in share price. But they’re hardly making out like bandits. Keep in mind we’re talking about the bulk of executives who manage earnings to a certain degree, not by an amount that would cover up a major earnings miss.

Examining the numbers

This is why advisors should look for torque in the numbers. A couple of cents won’t do much to boost the value of an executive’s shareholdings, options or other equity-linked instruments. But, much better leverage and opportunity can be found inmanagement bonus agreements.

The accounting scandal that engulfed Nortel almost a decade ago centered on executives allegedly manipulating earnings in order to trigger “return to profitability” bonuses. By simply releasing liability reserves, executives can increase profits, and push past predefined performance hurdles.

Nortel executives received millions in bonuses based on results released in the first half of 2003, which were later restated by the company. Prosecutors in the recent fraud trial claimed executives first delayed a return to profitability in late 2002 because it was too early to trigger a bonus.

Next, it was argued, they over-reached in their scheme, producing an unexpected profit of $100 million in 2003, which was then deliberately scaled back to $35 million—just enough to trigger the bonus. Much of the trial (a decision is expected mid-January 2013) focused on whether the release of the reserves was acceptable under the accounting rules.

But executives don’t have to push the envelope of the accounting rules. Sometimes, they receive bonuses based on adjusted figures they create. A few years before the accounting scandal, Nortel shelled out lucrative executive bonuses based on an ill-conceived measure called “net earnings from operations,” which was designed to sound legitimate but really ignored billions of dollars in otherwise standard accounting expenses.

Unfortunately, management bonuses based on problematic results are not a relic of the past. A current example can be found in Just Energy Group. As described in Portfolio Torpedoes (AER October), the company produces its own earnings measure known as Adjusted EBITDA, which excludes a significant portion of marketing expenses, as well as other adjustments.

What most investors don’t realize is the annual bonuses of the company’s top three executives are determined by a formula that is 40% based on whether the company meets a pre-set target for Adjusted EBITDA. Last year, they were able to beat the target by 1%. Remember, management comes up with the definition of Adjusted EBITDA on its own. There is no standardized approach, and as a non-GAAP measure, the figure is not audited.

It seems hard enough for advisors to keep track of executives that manage their reported results, never mind those who calibrate the measuring stick as well. Just Energy stated this year the formula will be the exclusive means on which executive bonuses are based.

The easiest way to avoid similar situations is to monitor the composition of executive bonus plans. Unfortunately, it’s not that easy. Just Energy’s disclosure, for instance, was found on page 33 of its 96-page Management Proxy Circular—which is hardly at the top of most reading lists. A shortcut, therefore, is to not ignore the obvious clues. Any advisor that has read some of Just Energy’s disclosures before knows that management pushes its Adjusted EBITDA metric on the investment community with vigour.

In fact, the company even calls it “the best measure of operating performance.” Experience told us that there was probably more to the story, and to look for where there was potential motive and torque in the numbers.

Dr. Al Rosen, FCA, FCMA, FCPA, CFE, CIP and CIP and Mark Rosen, MBA, CFA, CFE run Accountability Research Corp., providing independent equity research to investment advisors across Canada.