Publicly Reported Earnings May Not Tell Whole Story

"Our research shows that accruals are unusually large before a sale," said University of Washington accounting professor Steve Sefcik, who conducted the study with Business School colleagues Paul Malatesta and Larry DuCharme. Accruals reflect the difference between reported earnings and cash flows, and generally accepted accounting principles (GAAP) allow firms some discretion. Under GAAP, earnings numbers that corporations report to investors can differ in both magnitude and timing from the actual net cash flows that companies experience.

"Firms that manipulate their earnings prior to stock offerings deceive investors, who in turn form overly-optimistic expectations regarding future post-issue earnings," said Malatesta. "These findings strongly suggest that investors should consider the quality of reported earnings and not just their magnitude. They should read the footnotes to the financial statements, and pay attention to cash flows as well as earnings."

GAAP allow firms discretion in calculating the accrual component of earnings. Malatesta, Sefcik and DuCharme's research focused on these accruals around the times when firms make initial public offerings (IPOs) and seasoned equity offers (SEOs), stock offers made by already publicly traded companies.

"Our research shows these accruals " or increased reported earnings " tend to quickly and quite dramatically revert to lower levels after stock offers, which challenges the notion that stock market prices correctly reflect publicly available information," said Sefcik.

Their research, however, does not prove if companies deliberately raise their accruals in order to obtain more than fair value for their shares.

Malatesta added that the Sarbanes-Oxley Act, designed to improve corporate governance and imposed upon publicly traded companies by Congress in 2002, has some stern guidelines that pertain to accounting practices and disclosures. He said that while this study was conducted before Sarbanes-Oxley was enacted, he predicts the law could help crack down in the future on questionable accounting methods.

"The bottom line is, while only a small percentage of firms making stock offers ultimately get sued by disgruntled investors, top-level corporate executives should understand that if they play games with earnings, they could easily get sued later," Malatesta said.

Their paper, "Earnings management, stock issues, and shareholder lawsuits," appeared in the January issue of Journal of Financial Economics.