Handling earnings management

Earnings management refers to the practice of manipulating a company's financial results to meet or exceed market expectations, often by using accounting methods that may not accurately reflect the company's true financial performance.

Earnings management can take many forms, such as manipulating revenue recognition, delaying expenses, adjusting reserves or provisions, and using one-time or non-recurring items to boost earnings. The goal of earnings management is to make a company's financial results appear better than they actually are.

Since the bulk of fundamental investing decisions are based on the financials of a Company, it is important for any quantitative platform to be able to accurately reflect the “true” financials and not just what is being reported.

This is where our use of a global data vendor like FactSet comes in truly handy. All financial items in FactSet are standardized to International Financial Reporting Standards (IFRS). Standardization to IFRS ensures that a lot of (not all) “accounting juggleries” are caught and adjusted.

One example is “cash flow from operations”. Consider a highly indebted company with a large interest outgo. In India, generally, this interest outgo will be part of “cash flow from financing” activities. This could make cash flow from operations (and free cash flow) look deceptively high. In our system, cash flow from operations considers interest payments and thus provides a closer representation of cash flows.

Another example is net income (and EPS) calculation. Net Income and EPS numbers can be inflated by one-off extraordinary items. Again, in our system, net income and EPS (wherever used as metric) are always before extraordinary and non-recurring items.

At the same time, we do accept that not all accounting jugglery and earnings management can be caught. For that, we fall back on work done by investors and researchers. We have several earnings quality metrics to help investors check if a company is managing its earnings:

• Cash flow accrual ratio - Cash flow accrual ratio is a metric to detect if accrual earnings (net income) are significantly different from cash earnings. It can be used to assess a company’s earnings quality and reliability.
• Beneish M-Score - This is a metric developed by Prof. Messoud D. Beneish and is used to detect potential earnings manipulation by companies. M-score is calculated using 8 different variables to arrive at a single score.
• Proprietary earnings quality score – Combining various earnings quality metric, we have developed our proprietary earnings quality score which scores a company’s earnings quality between 0 and 100 (higher being better).