4 Reasons Executives Manipulate Earnings

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At this point, it’s nearly impossible to argue with the notion that earnings manipulation is prevalent throughout the ranks of publicly-traded companies. We know that CFOs have admitted to manipulating earnings and the ongoing Valeant Pharmaceuticals (VRX) scandal continues to expose the creative ways companies can artificially boost results.

While most earnings manipulation is not as blatant as Valeant, the fact remains that investors have to be on the lookout for earnings management at all times. To be properly vigilant, it’s important to understand why executives misstate earnings. When you understand the why, you’ll have a better sense of what you need to look for.

1. Their Bonuses (And Jobs) Depend On It

Ever since “performance-based” bonuses were made tax-deductible in 1993, an increasingly large portion of executive compensation has been tied to hitting certain performance targets. In many cases, these are “adjusted” non-GAAP metrics that are designed for CEOs to always hit those incentive targets. In other cases, the targets are simply so low that it would be almost impossible to miss them.

Still, occasionally executives will see their bonuses get cut if they miss targets for metrics like revenue and EPS growth, so there’s an incentive in place for them to do whatever it takes to meet that target. That could mean things like channel stuffing to boost revenue at the end of a quarter, lowering reserves to artificially boost EPS, or even lumping regular expenses into one-time items such as “restructuring” so that they’ll be excluded from the earnings calculation.

There are almost too many options to count. In 2014, Caleres (CAL) hit an adjusted EPS of $1.72, 11% above the target threshold to receive their full bonuses. However, this number was inflated by: