SunPower is set to report financial results, as well as the results of its investigation, after Thursday's market close. In the meantime, here's a question I'd like to ponder: Was the restatement predictable?
Pressure to please the Street
In 2002, a paper by Richardson, Tuna, and Wu titled "Predicting Earnings Management: The Case of Earnings Restatements" explored this topic. The authors operated on the assumption that, "earnings restatement firms can be characterized as firms who knowingly and intentionally engaged in earnings manipulation." Such firms are "on average high growth firms, have more frequent external financing needs, and raise larger amounts of cash."
Does that sound like a sector you know? This is one reason I've long been wary of the capital-intensive solar space. Equity raises by the likes of ReneSola
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Does earnings management mean flat-out lying about your sales in a given period? In the most egregious cases, sure. But beyond such flagrant fudging, there's a whole world of wiggle room when it comes to earnings reporting. That's because public companies report on an accrual basis, rather than a cash basis.
For those who skipped or snored through Accounting 101, accruals are used to recognize economic events during the period in which they occur, rather than when cash changes hands. This method of accounting, while potentially most reflective of economic reality, involves a lot of estimation. During the 1990s, Waste Management
Getting back to that academic paper, one of the key findings was that, "restatement firms have very large accruals in the years of alleged manipulation." This makes intuitive sense, as the more accruals you take, the further you're getting away from actual cash earnings. With estimated income and expense figures constituting a larger part of the earnings pie, you have more leeway.
No clear warning
So were there warning signs in SunPower's accrual figures through the first three quarters of 2009? Actually, no. While accruals were prominent in past years, they made up only a small fraction (generally below 10%) of reported earnings in 2009. That's true whether you use the balance sheet or cash flow-based method of calculating accruals. By this measure, you would conclude that SunPower's quality of earnings was quite high. First Solar
While it certainly is a high-growth firm that's active in the capital markets, SunPower doesn't appear to quite fit the classic profile of an earnings manipulator. While this accruals ratio wouldn't have alerted us to SunPower's reported irregularities, it may lend itself to Foolish forensic analysis in the future. I'll be sure keep it in my back pocket and occasionally survey the land for potential earnings manipulators.
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