For a listed company, a late filing is a violation of the listed rules which would raise great negative result, the worst of which is delisting from that exchange. I have asked one auditor, “If the management would not intend to manipulate earning, say all the auditor adjustments are completely accepted, then the audit can be completed in the planned time schedule and late filing would not happen. Is it true? “. “Absolutely”, the auditor said.
However, the management would not give up the efforts to manipulate earning. As a result, the audit is doomed to be a battle between the management and the auditors, and the result (the audit report) is a compromise between them.
When I was a student in one business school, I was taught that the management's earning manipulation is a “bad” behavior. But why management would manipulate? The prior reason is the stress from the investors, especially the institutional investors. I have heard a story from an IR that one day when their financial information released, the unexpected loss made the share price crush, one investor phoned the IR, crying. However, the emotional pressure is not the most difficult thing the company faced, the investors would vote by foot, meanwhile they have other arms, such as selling short. The battles between the investors and the management are frequent games in the capital market.
As a result, management has great motivation to manipulate the earnings. There are two directions to earning manipulation. One is borrowing income from future (increasing current revenue or decreasing current expenses); the other is banking income for the future (decreasing current revenue or increasing current expenses).
To better analysis the earning quality, so as to recognize the possible earning manipulation, you should follow the following advices:
• Understand the business
• Understand the accounting policy
• Understand the business areas where accounting quality is most doubtful
• Understand situations in which management are particularly tempted to manipulate
Under some Institutional Situations where Manipulation is More Likely, I list some below:
• The firm is in the process of raising capital or renegotiating borrowing. IPO; SEO
• Debt covenants are likely to be violated
• A management change
• An auditor change
• Management rewards (like bonuses) are tied to earnings
• A weak governance structure: inside management dominate the board; there is a weak audit committee or none at all
• Management buyout
• Transactions are with related parties rather than at arm's length
• Special events such as union negotiations and proxy fights
• The firm is "in play" as a takeover target
• The firm engages in exotic arrangements (structured off-balance-sheet vehicles)
Finally, I would like to say that, for an auditor, earning manipulation is the greatest challenges in their career life. They must seek the balance between GAAP and the clients' demand. They should know clearly when they should insist, and when to compromise. It's both art and science.
For an analyst, the existence of earning manipulation puts great difficulties on their analysis; but it‘s just the recognition of the earning manipulation and the proper treatment in their financial analysis tells who is a better financial analysts. To read the financial data more effectively, the analysts need a pair of wise eyes, and years of experiences.
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