The Securities and Exchange Commission (SEC) is experimenting with a list of warning signs that may signal a need for additional investigation. These red flags include a pattern of narrowly meeting or exceeding the earnings estimates of securities analysts.
Charles Niemeier, chief accountant of SEC's enforcement division, reportedly told the Wall Street Journal a company that consistently met earnings expectations would be of special interest to the SEC, if it also showed revenue increases while cash flow was falling. ("Meeting Expectations Used to Draw Favor, Now It Invites Scrutiny," August 5, 2002.)
A study by the Journal based on earnings data provided by Multex.com shows that 43 of the companies, or 9%, in the Standard & Poor's 500-stock index consistently have met or beat estimates by a penny or two for the nine quarters through the first quarter 2002, and several have patterns of rising revenues and falling cash flow from operations.
Of course, experts caution there can be good and valid reasons why a company consistently makes its numbers, such as good management and the fact that some industries are relatively predictable. Then, too, some companies attribute their track records of matching or just beating estimates partly to good communication channels with analysts. But skeptics may see this as evidence of overly cozy relationships between analysts and the companies they follow.
Some experts argue that most companies manage their earnings to some extent. For example, a company could legitimately sell an asset, such as a plant, at the end of a period and report a gain on that sale. However, the practice may go too far, giving the phrase "earnings management" a negative connotation. Former SEC Chief Accountant Walter Schuetze has said, earnings management is "like dirt, it is everywhere. . . I saw companies regularly making their earnings estimates by all kinds by earnings management," he says, pointing to recognition of premature or fictitious revenue as a common abuse.