Something's Fishy in Many Earnings Reports

Something strange happened last month, when Apple (Nasdaq: AAPL) reported its quarterly earnings: They fell short of Wall Street's expectations. That has rarely happened in recent years, and the stock sank on the news, down about 7% initially. The episode was a good reminder that many companies have set us up to expect them to beat expectations -- and that bad things can happen when they don't.

The technology realm includes many frequent exceeders. For example:

Data: AOL / Thomson Reuters.

Something fishy
It might seem unsurprising that some companies tend to exceed expectations in earnings seasons, and that other companies don't. It might seem natural. Research last year by Joseph Grundfest and Nadya Malenko of Stanford suggests, though, that something fishy might be going on.

They studied about half a million corporate earnings reports released over 27 years, examining earnings not down to the penny, but to the tenth of a penny. And they discovered that there wasn't a very even distribution of numbers. The number least represented: four-tenths of a cent.

As The Wall Street Journal noted, "Computer maker Dell didn't report earnings per share with a '4' in the 10ths place between its 1988 initial public offering and 2006. The likelihood of that happening by random chance is 1 in 2,500."

Think about the odd paucity of four-tenths, and you might see the most obvious explanation: If a company can get its earnings to hit 0.5, then that number will be rounded up to the next highest penny. In other words, earnings of $0.264 are less desirable than $0.265, because the former will be reported as $0.26, while the latter will become $0.27.

Why fiddle?
That little penny of a difference can be a big deal in a system that rewards companies that beat expectations. Such companies draw the admiration and interest of investors, while companies that disappoint can lose supporters.

Many have long suspected that companies may be fudging their earnings a bit, but this research makes it more than mere speculation. At his respected blog, The Big Picture, noted market observer Barry Ritholtz found it interesting that The Wall Street Journal chose to report on this kind of important study on a Saturday, when its readership isn't at its highest. The corporate world would probably prefer that we not think about this topic too much. Ritholz opines, "[M]any firms manage their earnings, pulling all manner of shenanigans to beat the street."

Managing earnings or cooking the books?
"Managing earnings" is a classy way to refer to how companies turn those fours into fives or beat expectations. In some cases, "cooking the books" is more fitting.

One simple way for companies to improve their lot is with the "guidance" they provide to Wall Street analysts. After all, the expectations to beat are ones that these analysts come up with based on projections from the companies themselves.

Another way is to tweak the actual earnings, which can be done in ways consistent with Generally Accepted Accounting Principles (GAAP) or in more shenanigan-like ways. For example, companies can choose from several different ways of depreciating assets, which affect earnings in different ways. How revenue is recognized is another opportunity for creativity. Revenue is supposed to be recognized when it's earned, but some companies have put it on the books as soon as a contract is signed and long before any deliverables are delivered. To smooth out earnings, some companies have kept a sum of them in a reserve account, drawing from it as needed. There are many possibilities.

What to do
If all this is alarming you, take a deep breath. It needn't derail your investing. In particular, just because companies consistently beat expectations, that doesn't automatically mean they're doing anything shady or otherwise questionable.

Here are some key points to keep in mind:

• You can avoid this whole issue by just ignoring earnings estimates. Focus instead on how a company is doing and how its reported numbers are improving or declining. Look at actual numbers, not estimates.

• Understand that earnings can be manipulated, not only in unacceptable ways, but also acceptable ones. Consider focusing more on other numbers, or at least adding other numbers to your mix -- such as revenue, free cash flow, operating income, cash from operations, and so on.
  
• Remember that even though a company may take a hit for missing its estimate, it may recover soon after that, unless there are major problems. In addition, as long as you're invested in a company for the long haul, how its stock moves over a particular week or quarter isn't too meaningful. What matters is where the stock price is some years down the road.

Companies that manage earnings aren't necessarily to be avoided -- many have been terrific wealth-builders for many years. Just invest with your eyes open.

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