Companies sometimes use accepted accounting techniques to pump up their earnings just before they sell their first shares of stock to the public, a new University of Washington study found.
That can mislead investors, the study suggests.
Investors who buy stock in companies that inflated their earnings rarely get the returns they expected, and companies that were particularly aggressive in their accounting practices were more likely to get sued, the researchers found.
“Firms that manipulate their earnings prior to stock offerings deceive investors, who in turn form overly optimistic expectations regarding future post-issue earnings,” said Paul Malatesta, a UW Business School professor who was involved in the study.
Companies that do so also are more likely to be sued by angry shareholders, the study found.
Malatesta and colleagues Steve Sefcik and Larry DuCharme studied more than 10,000 stock offerings by companies from 1988 through 1997. Their paper, titled “Earnings Management, Stock Issues and Shareholder Lawsuits,” was published in a recent issue of the Journal of Financial Economics.
Their study zeroed in on the accrual method of accounting, which reflects the difference between a company’s reported earnings and its actual cash flows.
Generally Accepted Accounting Principals allow companies some leeway in when they report revenues and expenses. Some rules allow companies to delay reporting expenses, for example. Other rules allow companies to engage in “channel stuffing,” or shipping products to businesses early so they can be recorded as sales, even if the products never end up in the hands of consumers.
Juggling these things can make a company’s earnings look better, and there is a temptation to do that just before a company makes a stock offering, because stronger earnings typically result in better stock prices, the professors wrote.
But companies run a risk doing this, they warned.
The problem is that companies that push up their earnings typically can’t keep them there, they wrote. The earnings “tend subsequently to revert back to normal.”
Investors, however, have already formed “excessively optimistic expectations at the offer date regarding future earnings growth,” based on the inflated earnings.
And disgruntled investors are more likely to sue, the professors said.
“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.
The research does not prove that companies deliberately raise their accruals in order to get inflated prices on their shares. But it does underscore the importance of reading the fine print in financial statements, Malatesta said.
“These findings strongly suggest that investors should consider the quality of reported earnings and not just their magnitudes,” he said in a statement. “They should read the footnotes to the financial statements, and pay attention to cash flows as well as earnings.”
The study predates the Sarbanes-Oxley Act, which was passed by Congress in 2002 in an effort to crack down on companies that mislead investors. Malatesta said he thinks the law will help reduce the use of questionable accounting methods.
Reporter Bryan Corliss: 425-339-3454 or corliss@heraldnet.com.
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