The evolution of the significance of reported earnings and earnings per share
Our presentation will contain six main topics. The six topics all discuss issues related to the evolution of the significance of reported earnings and earnings per share.
Topic 1: An overview of the historical role of “aggregators” in the growing importance of meeting earnings projections
One of the major roles of aggregators in a financial industry, is to provide their investors or clients with the right form of advice on how to complete and address financial situations or problems in their companies, which includes the daily activities that go on within the firm, however, the aggregators serve as intermediaries in order to meet a firm’s future earnings. Financial advisors use account-aggregation technology to gather position and transaction for investors which helps in the increase of a firm’s productivity.
According to Farlex Financial Dictionary (2009), earning projections is the act or process of using certain data to predict future earnings of a publicly-traded company; which can cause significant changes in share price for companies, since forecasts may influence earnings expectations.
Topic 2: An overview of earnings management and how it is related to the topic of meeting earnings projections
Thomas E. McKee defines earnings management as “reasonable and legal management decision making and reporting intended to achieve stable and predictable financial results”, and he believes that earnings management does not include devices designed by management to alter the financial statement. The practice of earnings management can motivate companies to meet earnings targets that may override good business practices. For example, if a company sells an asset but is still responsible for maintaining it, then reporting this transaction as a sale instead of a secured loan does not faithfully represent the transaction (Alford 2017). When a company has a good growth project it helps the earnings projection visible, therefore, when proper management and procedures stocks in a firm have better growth prospects which tend to be more desirable for the company than those with fewer growth rates.
Topic 3: Arthur Levitt: Who is he? What did he have to say about earnings management?
Arthur Levitt was the former Chairman of United States Securities and Exchange Commission (SEC) from 1993 to 2001. During 1998, Levitt addressed a speech to the SEC titled “The Numbers Game” which describe the practice of “earnings management” where some companies are booking revenues before a sale is recorded/complete. For instance, in his speech, Levitt made a reference to how “sales and income are overstated by recognizing revenue for partially shipped, unshipped or even back ordered equipment. Fiscal years are extended beyond 365 days to record extra sales – and even sales that the company knows don't conform to what a customer ordered”(Levitt, 1998). Also, he talked about how to address the practice of earnings management and how he has gotten responses from CEOs, CFOs, investors, and leaders of the public accounting profession and academics on how to tackle the issue. One of the solutions he stresses on about is the performance of thorough audits and the audit world… He gives suggestions of how every company in America should have an audit committee made up of the right people, doing the right things and asking the right questions, and also the Independent Standards Board created should focus on re-evaluating the rules governing the "independence" of the audit profession. Additionally, he talked about the creation of the Earnings Management task force that would coordinate and focus efforts on detecting and challenging deterioration in financial reporting practices (Levitt 1998).
Topic 4: The significance of “earnings surprises”
What is earnings surprises?
An earnings surprise occurs when a company's reported quarterly or annual profits are above or below analysts' expectations. These analysts, who work for a variety of financial firms and reporting agencies, base their expectations on a variety of sources, including previous quarterly or annual reports and current market conditions, as well as the company's own earning predictions or “guidance” (Investopedia, n.d.).
Why are earnings surprises so important?
Stock markets tend to react in the same direction as earnings surprises—positively to positive earnings surprises and negatively to negative earnings surprises—although a significant proportion of earnings surprises result in stock markets reacting in the opposite direction, which may be a reaction to other relevant information released with the earnings announcement or inaccurate measurement of the earnings surprise (Wikipedia, 2018a). Large negative earnings surprises may have legal and reputational costs to managers.
Topic 5: Earnings patterns at Microsoft and General Electric in the 1990s; are you suspicious?
Microsoft’s cookie jar:
Starting around the unveiling of Windows 95 in August 1995, Microsoft has followed a uniquely conservative method of accounting for the software it ships–deferring recognition of large chunks of revenue from a product until long after the product is sold. The reasoning is that when somebody buys software in 1996, they're also buying the right to upgrades and customer support in 1997 and 1998. If it hadn't been for the new accounting technique, the company would have had to report a sharp rise in profits in the latter half of 1995, then a sharp drop in the first half of 1996–a turn of events that might have sent its stock price reeling–instead of the smoothly rising earnings that it did post. By the end of 1996, Microsoft had taken in $1.1 billion in "unearned revenue" that it had yet to recognize on its income statements (Rao, 1997).
GE’s culture:
Kidder Reports Fraud
Kidder, Peabody & Co. was established in April 1865 by Henry P. Kidder, Francis H. Peabody, and Oliver W. Peabody. The firm was formed via reorganization of its predecessor company, J.E. Thayer & Brother, where the three founders had previously worked as clerks (Wikipedia, 2018b).
Kidder Reports Fraud and Ousts a Top Trader
Kidder, Peabody & Company said yesterday that it dismissed its chief government bond trader during the weekend after it had uncovered fraudulent trading apparently intended to inflate the brokerage firm's profits and the trader's 1993 bonus. As a result, Kidder said $350 million in profits it recorded in the last year never existed (Hansell, 1994).
To rectify its accounts, Kidder's parent, the General Electric Company, will take a $210 million charge to its first-quarter earnings, which will be announced this week. Kidder said no customers lost money because of the fraud (Hansell, 1994).
Jack Welch was the Chairman and CEO of GE during 1981~2001
Straight from the gut:
“The response of our business leaders to the crisis was typical of the
GE culture. Even though the books had closed on the quarter,
many immediately offered to pitch in to cover the Kidder gap.
Some said they could find an extra $10 million, $20 million, and
even $30 million from the businesses to offset the surprise. Though
it was too late, their willingness to help was a dramatic contrast to
the excuses I had been hearing from the Kidder people.” (Welch, 2003)
Topic 6: The presentation of the components of earnings in the income statement (for example, the distinction between components of earnings that impact operating income and those that do not, the distinction between recurring and non-recurring items). Why are distinctions within earnings presentations important?
What are recurring and non-recurring items?
A non-recurring item is a gain or loss found on a company's income statement that is not expected to occur regularly. Examples of non-recurring items are litigation fees, write-offs of bad debt or worthless assets, employee-separation costs, and repair costs for damage caused by natural disasters.
A recurring item is a revenue or cost that is highly likely to continue in the future, they are predictable, stable and can be counted on in the future with a high degree of certainty.
Managers disaggregate information strategically, and their strategies reflect a variety of underlying motives. Users rely on the information produced through disaggregation to improve their judgments and decisions and to reduce the amount of information they would otherwise acquire through private sources. However, users may struggle to fully extract the information produced through disaggregation when that information is not presented cohesively across the financial statements. Overall, the research reviewed suggests that disaggregation directly affects information content, and therefore likely shapes market prices and other important non-valuation activities.