Earnings management is a quietly accepted, but it is not openly acknowledged. One way to attempt to assess the prevalence of earnings management is to compare estimated earnings versus actual earnings. Between July 20, 2011 and August 19, 2011, a total of 2,649 earnings per share releases were compared to the associated earnings estimate from a wide range of randomly selected publicly-held companies. The estimates were based on the latest analyst consensus estimate prior to the release of earnings, and the actual earnings were based on company presented earnings (many were presented in a non-GAAP format).
Of the total data collected, 60.44% exceeded estimated earnings, 9.23% were exactly the same as estimated, and 30.33% were below estimate. Further, 11.57% of the total earnings per share exceeded its respective estimate by exactly one cent per share, while only 5.39% missed its estimate by exactly one cent per share.
Consistent with expectations, a majority of actual earnings exceeded estimate. This was to be expected since managers have a vested interest in establishing earnings’ benchmarks they would likely surpass. Many managers are compensated based on exceeding pre-determined earnings’ objectives so they would likely set a level that is reasonably attainable. Further, managers are intimately aware of the adverse impact on share price if an estimate is missed. Many management teams exert considerable effort toward influencing estimates developed by “independent” analysts, as well.
Since many financial analysts and even novice investors believe that most publicly-held companies manage earnings to some extent, it is no surprise that 11.57% of results netted actual earnings per share results that exceeded estimate by exactly one cent per share. Over 20% of actual earnings per share either met estimates or exceeded estimates by exactly one cent. Surpassing estimates by exactly one cent per share raises the perception (rightfully so) that managers are using accounting discretion (or presentation through non-GAAP adjustments) to manufacture or manipulate its earnings number, i.e., manage its earnings.
Earnings management can lead to more lenient interpretations of generally accepted accounting, which could reach levels considered fraudulent. To avoid the continual pressure to increasingly manipulate its accounting, management teams sometimes take a “big bath.” This is where a company takes a huge loss or drop in profits in a reporting period to clean up the income statement. The “big bath” is seen as a way to true up a lot of the subjective uses of accounting without having a comparable, adverse impact on the stock, as many investors view “big baths” as a one-time occurrence.
Based on the results of this analysis, there are a number of management teams who are either really good at forecasting, or they are going against the spirit of accounting rules to engineer predictable and consistent results. Companies that regularly meet or exceed estimates by one cent should be viewed with skepticism.
An unexpected outcome was the number of companies that missed per share estimates by just one cent. Missing an estimate by one cent per share will, in most cases, adversely impact the share price disproportionately to the severity of the miss. As a result, management teams have a significant interest in meeting or exceeding estimates, and if it is going to miss, to not miss by a small amount. Further, most companies have enough discretion within their financials to be able to “generate” small improvements (or reductions) in the financial results, which should lessen the number of companies that miss earnings by only one cent per share. However, as this analysis has shown, some companies do miss estimates by a small amount. These companies appear to be much less likely to be managing earnings or manufacturing results.