Earnings management in stressed firms

The Reserve Bank of India’s (RBI) expanded mandate for faster resolution of non-performing assets (NPA), correctly or incorrectly, requires it to provide guidance to banks at very granular level. These guidance ranges from deciding which of the defaulted corporates are sustainable, thus the bank must take a haircut with or without change of the company management, to identifying the subset of corporates to be referred for insolvency proceedings under the new bankruptcy code. Another equally disturbing area that concerns our central bank is “wilful defaults” which are difficult to identify. As such, the RBI has advised all banks to design early warning signals to identify bad debt including those due to wilful default. Most early warning systems (EWS) tend to focus almost exclusively on reported financials. However, if the financials themselves are manipulated, such corporates will bypass most EWS, currently in use. It is in these instances that a novel earnings management score (EMS) developed by this team could help. In fact retrospectively running the EMS may help the stakeholders in identifying corporates that have been “managing” their financials all along.

It is well known that capital markets hate earnings surprise. While the intention of the regulator in seeking frequent financial information from listed firms was to protect investors, markets have become increasingly unforgiving of companies that miss their estimates. For example, annual earnings (profits) of Dr Reddy’s Laboratories Ltd. (DRL) for 2016-17 was reported on May 12, 2017, at Rs 72.61 per share compared to an estimate of Rs 82.88 for the same period, resulting in an earnings surprise of -12.4 per cent. Market reaction was severe — the share price tumbled from Rs 3,097 in early February 2017 to Rs 2,414 on May 26, 2017 — a fall of 22 per cent. This kind of market reaction may create undue pressure on the management to “perform”.

A popular way to avoid such severe market reaction is to manage earnings in such a way that the earnings surprise is limited and at the same time disclosures are within regulatory limits.

The market’s undue focus on quarterly earnings pushes some firms to manage earnings apart from inducing strategic myopia in management.

Earnings a matter of opinion, cash a fact

Earnings management, per se, is not illegal. Accounting principles allow a firm’s management to use its discretion in financial reporting. Historically, accountants have argued that reporting earnings on accrual basis enables a firm to report financials, which are a more realistic representation of their economic performance. Specifically, it refers to the management’s discretion to recognise earnings, which may not be in sync with actual cash flows. However, some firms tend to abuse this discretion by reporting earnings that have very limited, if any, synchronicity with their underlying cash flows. Globally regulators are worried about earnings management. For example, the Securities and Exchange Commission (SEC), USA, periodically reviews companies’ filings and monitors compliance with regulatory disclosure and accounting requirements.

Look beyond window-dressing

Despite the shortcomings of the reported earnings number (PAT, PBT or EBITDA) equity investors and lenders tend to focus on such accrual earnings or ratios such as price-to-earnings or debt-to-EBITDA. A slippage on these numbers or on these ratios will either create an adverse stock movement or will cause the company to breach a loan covenant such as leverage level. Clearly there is ample motivation for firms to manipulate so that the earnings remain in line, or help them avoid loan covenant breaches.

The EMS as the one proposed by us can help regulators, investors and lenders identify companies that are managing their earnings. It is easy to define the concept of earnings management. But it is extremely difficult to identify a suitable proxy for it. Experts have so far used total accrual or more popularly, discretionary accrual, as a proxy for earnings management.

We have developed a proprietary earnings management score (EMS) where a higher number indicates greater earnings management. The score is calculated using six variables for each firm — balance sheet and cash flow total accruals, balance sheet and cash flow discretionary accruals, the correlation between net income (profit after tax) and balance sheet and cash flow total accruals. Our study uses data of 1,691 non-financial companies, covering 37 industries, for which complete information is available from 2005-06 through 2015-16. EMS above 2000 indicates high earnings management and more than 50 per cent of firms in our sample have an EMS of greater than 2000 (see table: Keeping track). Thus, earnings management is rampant in India.

Bad business manage more

Some firms with higher debt levels and low cash generation ability have often stated higher accrual earnings (EBITDA, PBT, PAT) using extensive earnings management so as to “delay” the violation of their leverage levels stated in debt covenants.

Our EMS clearly distinguishes financially distressed companies from the healthy ones. Median EMS of AAA rated firms in our sample is 1450 while median EMS of D rated firms is 2340. Corporates identified as stressed but not yet tagged NPA tend to have score above 3000. There appears to be a case where some corporates used earnings management techniques to continue hiding their inability to generate cash. Remember, servicing debt requires cash and not mere accounting entries, which accrual earnings such as PBT/PAT reflect.

(This is an abridged version of an article that appeared in Artha, an IIM Calcutta e-zine)

Banerjee is professor and Mukherjee is visiting faculty at IIM Calcutta. Mandi is a consultant with PwC