Research Says Disclosure Offers Cover for Questionable Accounting

Public financial reporting involves an inherent tension between accurately portraying the condition of a company and the pressure to meet the expectations of investors. Adjustments and footnoted disclosure can help companies put the best spin on their results, avoiding damaging headlines . . . at least for the time being.

That short-term orientation in financial reporting has become an area of concern at the Securities and Exchange Commission, where chairman Jay Clayton has gone so far as to ask if investors would benefit from ending quarterly reporting. The thinking goes that the frequent filings encourage executive teams to manage for the short run to appease investors, rather than making decisions in the best long-term interest of their companies.

Similarly, a new study from academics at the Harvard Business School (HBS) and MIT’s Sloan School of Management appears to lend credence to concerns about “short-termism” in Corporate America. Based on nearly two decades of data from research firm New Constructs on disclosures in regulatory filings, professors Charles Wang and Ethan Rouen of HBS and Eric So of MIT concluded that “disclosures of non-operating and less persistent income-statement items are both frequent and economically significant.” Also, they found that “Street earnings for firms that meet or just beat analyst expectations are more likely to selectively exclude these items.” In other words, companies are using the selective disclosure of non-operating line items to massage their quarterly numbers.

Moreover, the researchers determined that such disclosures have increased over time. The average number of adjustments for income-related line items claimed to be non-operating grew by 34%. The professors attributed the expansion in part to so-called manager bias to help the companies meet or exceed earnings forecasts. That typically entails adding adjustments that raise income or excluding adjustments that reduce it.

Publicly traded companies that are pushing the limits on earnings-management strategies should take heed of the latest news from the SEC. In recent months, the Commission has gone after apparel company Under Armour Inc. and Marvell Technology Group for pulling in sales from future quarters to the current period. In the case of Marvell, the agency specifically said the semiconductor company was attempting “to close the gap between actual and forecasted revenue and to meet publicly-issued revenue guidance.”

Additionally, the SEC has pushed ahead with its effort to amend its rules for earnings releases and quarterly reports. The regulatory initiative was recently moved to the agency’s short-term agenda. Of course, it’s important to remember that even if companies find themselves reporting their financial results less frequently, it won’t free them from the burden of investor expectations.

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