Company executives have a strong incentive to show steady profit growth every quarter. Their compensation and job security often depend on meeting Wall Street’s earnings expectations. This pressure can lead some companies to use accounting tricks and loopholes to boost their bottom line artificially. Savvy investors know how to spot the warning signs of earnings manipulation in SEC filings.
Key Techniques for Earnings Manipulation
Non-GAAP Metrics: One of the most common techniques is using non-GAAP (non-generally accepted accounting principles) metrics that exclude certain expenses, making earnings look higher. For example, companies may back out stock-based compensation, acquisition costs, restructuring charges, asset impairments, and other items from their non-GAAP earnings number. While companies argue these items are one-time in nature, critics counter that they can be routine costs of doing business. Investors should beware when a company prominently touts a significantly higher non-GAAP metric versus its GAAP earnings. Review the reconciliation between the two numbers and watch for non-GAAP exclusions growing over time.
Shifting Revenues and Expenses: Another method is shifting revenues from future periods to the current quarter or moving up expenses to a prior quarter. This smoothing technique is designed to show steadier earnings growth over time. Warning signs include a spike in revenue near the quarter’s end, dramatic changes in receivables or backlogged orders, and higher than usual inventory. On the expense side, look for spikes in reserves, write-downs, or accruals that allow lower expenses in the current period. Capitalizing operating expenses is another tactic to shift expenses off the income statement.
Acquisitions: Buying companies with recurring revenues can instantly boost earnings. But acquisitions also come with a lot of one-time costs that companies typically exclude from non-GAAP earnings. In some cases, the core business is struggling but masked by acquiring growth. Pore over acquisition-related adjustments and charges both in the quarter of the deal and for years after. Multi-billion dollar deals in particular require close scrutiny. Also watch for suspicious spikes in goodwill that may signal overpayment.
Channel Stuffing: Some companies may inflate sales by inducing their distribution channels to buy substantially more inventory than they can sell. This channel stuffing shows up later as growing inventory levels on the balance sheet and increased discounts or liabilities to customers.
Cookie Jar Accounting: This technique involves stashing excess accruals and reserves during good times and then tapping them later to boost earnings when needed. Watch for large changes in the balances of discretionary accrual accounts like warranty reserves, loan loss provisions, and deferred revenue.
Capitalizing Operating Costs: Some companies push the envelope on capitalizing normal operating costs instead of expensing them. This impacts EBITDA and makes earnings seem stronger. Scrutinize CapEx for unusual spending and charges for “software development” or other vague IT projects.
Pension Assumptions: Many companies still use defined benefit pension plans. Earnings can benefit from overly optimistic assumptions about future returns and discount rates for pension obligations. Review pension disclosures to see if assumptions are aggressive versus peers.
Depreciation Changes: Increasing the useful lives or switching depreciation methods for fixed assets reduces current period expenses. While legal, changes in depreciation assumptions for no good reason could be a red flag.
Phantom Revenue: Watch for unusual jumps in revenue with no specifics on the source, especially involving related parties. This phantom revenue from undisclosed transactions or customers may not be real.
How to Spot Earnings Manipulation
Detecting manipulated earnings takes diligence, but will give investors a huge advantage in finding companies playing accounting games versus those with real performance. Relying too much on headline numbers without deeper analysis leaves investors vulnerable to potential earnings manipulation techniques. Here is how to get started:
Compare GAAP and non-GAAP metrics closely
Seek transparency on exclusions and adjustments
Check for patterns of write-downs or other one-time items
Review changes in balance sheet accounts like inventory and accruals
Analyze growth trajectories with skepticism
Read the whole filing, not just headlines or press releases
Use tools like TheSEC.AI to help in the process
Earnings manipulation stems from the intense pressures executives face to meet expectations. By focusing on non-GAAP metrics, large one-time items, and changes in accounts like inventory and accruals, investors can better detect accounting gimmicks and understand the business’ true performance. Analyzing SEC filings takes time but is one of the best defenses against fancy accounting tricks.
Stay informed by regularly checking SEC filings from the companies in your portfolio and subscribe to TheSEC.AI today!