Why red flags in financial reports are found in both the narrative and the numbers

We’ve all been there… it’s the morning of a company’s financial results and the pressure’s on to get the gist of the update. It could be a personal holding already, or a stock you’ve been stalking for a while. Either way, it’s important to find the good news (and any bad news) to anticipate how the share price might respond. Yet what you’re faced with is a complex narrative that leaves you with more questions than answers.

Companies and their advisors are skilful at managing how and what they communicate to the market. Many work hard to do it clearly. Some will admit when things aren’t going to plan, but it’s also true that there is considerable scope in these announcements to smooth over bad news. Especially if that means meeting market expectations.

There is evidence that investors are prepared to put up with a degree of earnings ‘manipulation’ by management if it keeps the results stable and predictable year in, year out. But it’s still something that auditors and regulators take seriously. Not least because earnings manipulation can be the start of a slippery slope towards fraud and even corporate collapse.

Certainly when it comes to presenting accounts, the use of ‘adjustments’ and other (albeit legal) methods of presentation - both in the numbers and the narrative - can make it difficult to understand how well a company is really performing or where the risks are. It creates a grey area where investors are at risk of being mislead or just left downright confused.

This is a particular problem for individual investors. Because without accounting experience, a direct line to management or a team of analysts on hand, you’re on your own when it comes to interpreting earnings reports.

With all this in mind, it would be easy to think that companies can act at will to bury bad news and use complexity to present results in their best light. Yet research suggests that clarity and readability in these reports is rewarded by the market.

Plain English pays off

Researchers in Chile and Spain have dissected the relationship between firms that meet (or slightly beat) their previous year’s earnings performance with how their share prices behave over the following month. There were two main findings:

• Meeting or beating the previous year’s earnings results in lower stock return volatility over the following month
• This connection is even stronger when the actual announcement is clear and readable

The first point doesn’t come as a surprise: meeting or beating previous year’s earnings is a generally positive signal. But the important point here is about how that news is conveyed.

When firms reveal it with clear, well-written financial reports it makes it easier for the market to value them quickly and confidently. In essence it makes them more believable. That makes their share prices better protected from near-term volatility (which is often caused by post-announcement uncertainty).

This specific research covered what are known in the United States as 10-K filings - which are essentially detailed annual reports. There were two measures of complexity under review:

• one was the size of the document (as measured by the size of the digital file)
• the other was whether it was presented in plain-English (with the complexity measured using the ‘Bog Index’ - a standard calculation of how badly the writing bogs down the reader)

They found that complexity of language wasn’t the main problem. Rather it was the length of the reports that made the difference - with companies finding it easier to hide their ‘earnings management’ in lots and lots of repetitive text and data.

Importantly, from this, the research suggests that structural and textual characteristics of financial reports are themselves an important signal to investors that helps them detect differences in earnings quality, particularly among firms they suspect might be guilty of earnings manipulation.

The researchers went as far as to suggest that policy makers should rethink their efforts to encourage firms to improve their report readability - because where you do get needless or suspicious complexity, it can be a signal to investors.

Overall, there’s an argument here that a company’s earnings quality can be measured not just by financial quality checklists but also by the nature of their financial reports. Too long, badly written, complex explanations? It could be a red flag.

Screening for earnings quality

Of course, at Stockopedia our earnings quality checklists focus on the accounts side of financial reports. If you want to take a more quantitative approach to detecting the red flags of earnings manipulation, you could start with the Beneish M-Score checklist.

The checklist was developed by finance professor Daniel Beneish, and uses accounting data to detect potential problems. It looks at the year-on-year change in eight different ratios that can be worked out from a company’s financial statements. It looks for these red flags:

• Inflated revenues
• Declining gross margins
• Capitalised and deferred costs
• Excessive sales growth
• Lengthening depreciation periods
• Rising sales expenses
• Increasing leverage
• Higher accruals

Ideally, you would want stocks to be passing these checks with ease. But when a company fails one or more of them, it might be time to dig deeper into the accounts to find out why.

Generally, a score greater than -1.78 (i.e. a less negative or positive number) indicates an increased likelihood of a firm being an earnings manipulator.

We have the M-Score as a ‘short’ screen in the Guru Screens area of the platform, as well as a risk meter on all StockReports, which looks like this:

In addition, to use the Beneish rule in a Screen or Checklist, go to Screens and click Create a New Screen. From there, click Add Rule and find the Beneish M-Score in the Quality > Earnings Quality section of the rule picker.

The rule can be used to find a stock’s M-Score based on results from its last financial year, or the year before that. Here’s how those rules can be used in the Screener:

As a shortcut, you can use this screen - Beneish M-Score Screen - as a guide (don’t forget to click Copy at the top of the page and then Save the screen to save it to Your Screens list).