A survey of 375 chief financial officers (CFOs) from both publicly traded and privately held companies unveiled widely held suspicions of earnings manipulation.

CFOs of public companies believe 20% of companies misrepresent earnings. Private company CFOs put the number even higher, at close to 30%.

On average, public company CFOs believe about 10 cents on every dollar of earnings is manipulated, with private company CFOs believing the amount is even higher.

Given these responses, the logical question is: How can investors determine whether or not a company they are investing in is manipulating earnings?

An understanding of accounting, a willingness to look at the footnotes of earnings releases and regulatory filings, and allowances for discretionary decisions on the part of a company’s management are all required. The surveyed CFOs further listed specific actions and items to focus on.

• A lack of correlation between GAAP earnings and cash flows: Though earnings and cash flow may not always flow in the same direction for a particular quarter, if they move in different directions for six to eight quarters, suspicions should be raised. Be wary of strong earnings and weakening cash flows, and pay particular attention to cash flow from operating activities.
   
• Accruals: Lots of accruals and/or large changes in accruals and reserves warrant suspicion. CFOs suggest trying to tie accruals back to cash over several years, while acknowledging that growth “muddies the picture.”
   
• Acquisitions: Acquisitions are viewed as a common setting for managing earnings. The balance sheet may be used to set reserves and accruals, only to take charges against them in the future.
   
• Varying from industry norms: Questions should be asked if a company’s financial ratios and/or trends are notably different than its peers. Cash cycles, the volatility of results, average profitability, revenue growth, accounts payable, pension adjustments and level of disclosure should all be reasonably similar to industry norms.
   
• Large or frequent one-time earnings: Companies that routinely take one-time charges or report one-time adjustments may be using accounting procedures to hide bad news or trends.
   
• Consistently beating earnings: Companies that routinely exceed earnings by a similar amount may be attempting to manage their earnings.

Source: “The Misrepresentation of Earnings,” Ilia Dichev, John Graham, Campbell R. Harvey and Shiva Rajgopal, SSRN, June 2, 2015.