The temptation to artificially boost short-term earnings can be too much for some CEOs. Tim Bennett explains what sceptical investors should look for.

Earnings manipulation: 3 warning signs

The CEO’s of public companies are often obsessed with achieving “earnings beats”, whereby the published profits of their firm beat analysts’ expectations and forecasts. The reason is simple – the reward is usually a boost to the share price, not to mention their own personal reputation for over-delivery. The risk, however, is that in a quest to keep up this pattern they may resort to ever more desperate measures, including bending the rules when it comes to earnings. So what are the warning signs that a firm is turning from being a genuine earnings generator to an earnings manipulator?

A high profile example – Coca Cola

Some years ago, no less a brand than Coca Cola was accused of resorting to “bottle-stuffing”;

The incentive for doing so is pretty clear – earnings beats are addictive and once a firm starts to over-deliver the pressure to continue doing so only mounts as investors start to demand more of the same.

The danger signs

As a retail investor, you clearly can’t stop a firm’s directors from doing whatever it takes to maintain these beats – it might start with something that bends the rules and end in some quite dubious accounting practice, as Tesco’s 2014 accounting scandal woes illustrate. However, what you can do is keep an eye out for the warnings signs.

The checklist above is not fool-proof but it is a good starting point for further investigation. The three points here are also symptomatic of another problem – overly dominant CEOs.

When it comes to outright earnings manipulation, there should be safeguards built into the fabric of most listed companies to prevent a problem. These include;

·         A strong executive board

·         A strong, independent non-executive board

However, where a firm is dominated by one very strong individual, these controls can break down as executives succumb to a mixture of carrot (the promise of financial rewards) and stick (outright threats for not following the party line). Spotting weaknesses in a firm’s corporate governance structure isn’t easy – some of the warning signs include vacancies in top positions, frequent changes of senior management and any hint that top managers have been the subject of previous investigation by key regulatory bodies (such as the FCA, or what used to be called the Department of Trade and Industry).

The moral of the story

Too many investors hope for a free lunch. It is all too easy to sit on a stock that is delivering and never ask any difficult questions about how a strong share price performance is really being achieved. Whilst spotting potential candidates for earnings manipulation isn’t easy, you should be at least a little sceptical where certain factors combine;

To sum up, in investing, as in other aspects of life, if something looks too good to be true, don’t bury your head in the sand.