A group of accounting professors from the US and Singapore looked at accounting errors that came to light over the course of 12 years. In all, they examined over 2300 restatements, and found a curious pattern. When a prominent firm in an industry admits it has mismanaged its books, many of its competitors will start to overstate their own earnings in the same way—usually for about two years, until they get caught. These episodes of contagion only happen if the company that commits the initial fraud doesn’t get punished in some way.
The pressures to inflate income are legion: management could be under pressure to deliver earnings growth; executive compensation is often tied to the stock price; bank credit—and the firm’s solvency—may be on the line. Accounting involves a lot of estimation and judgement calls. There are many ways that companies can dress things up. Warren Buffett was once at a company’s loading dock on September 30th. During the lunch break, he asked the foreman how the quarter had gone. “I don’t know,” the worker replied. “It’s only noon. The quarter’s only half over.”
Source: Audit Analytics
Channel-stuffing, early revenue recognition, failure to write off unsold inventory—these are just a few of the ways that earnings can be manipulated. When a firm admits they have padded the bottom line, their peers learn both the details of the fraud, and whether the fraudsters are subject to SEC sanctions or shareholder lawsuits. It effect, they get to see both the costs and the benefits. If that equation looks attractive, it’s far more likely that a competitor will start to inflate its own bottom line in the same way—using the first firm’s financial restatements as a crib sheet.
Financial markets are aware of this danger, however, and tend to discount the share prices of similar firms after a significant restatement, especially those companies with weak accounting practices—companies without an independent audit committee, or who recently changed audit firms. Still, the financial danger of “accounting contagion” to investors is real—and can add up to hundreds of billions of dollars.
Because it looks like when companies want to cook their books, their accountants end up sharing recipes.
Douglas R. Tengdin, CFA
Chief Investment Officer