Accounting rules allow considerable scope for company management teams to nudge earnings in a particular direction (typically upward!). With this in mind, it is interesting that that U.S. federal prosecutors are investigating firms that had a notable absence of the number “4” in their reported financials.
It was recently reported that the U.S. Securities and Exchange Commission (SEC) was investigating more than 10 companies and the various accounting adjustments they had made in their financial reports. These adjustments may have potentially boosted the earnings per share (EPS) of these companies by improperly rounding up their EPS to the next highest cent.
This investigation follows an academic paper which looked at how the number “4” appeared an unusually low number of times relative to what would be expected based on chance, a phenomenon dubbed “quadrophobia”. The worrying thing for investors is that these adjustments may be perfectly legal and within the ambit of accounting rules.
This isn’t the first time companies have tried this nifty trick; in 2010 it was reported by the Wall Street Journal that Dell, the computer maker, did not once report the number “4” in the tenths place between its IPO in 1988 and 2006. Researchers concluded that the chance of such an occurrence was 1 in 2,500. It was later found that Dell had manipulated its earnings via “cookie jar” reserves and was forced to pay a $100 million fine.
What the above cases reveal is that investors must always be on guard as to whether management teams are being unscrupulous in their treatment of accounting items. While picking up the absence of the number “4” in decades worth of financial statements is not practical, there are certainly other indicators investors can search for to reveal accounting malfeasance: a divergence between earnings and cash flows, the removal of items from reported earnings that are not truly non-recurring, changes in accounting methods or segment reporting, amongst others.
It is not enough to take reported earnings, or worse still, adjusted earnings, and use these numbers as the foundation for an analysis on a company. Investors must be discerning when poring over a company’s financials, approaching the exercise with a healthy dose of scepticism. The aim should be to make any necessary adjustments to derive an earnings estimate that best reflects the goings on of the underlying business. Failing to do so could result in using overstated earnings in a valuation analysis, thus inflating the resulting value estimate.