At Marcellus, a big part of our job is forensic analysis of Indian annual reports. Hence we are always interested to hear about advances in this field elsewhere in the world. In this article, Julie Segal begins by saying that “Harvard Business School and MIT’s Sloan School of Management claim to have found the first empirical evidence that public companies are using information buried in footnotes to manipulate earnings.”
The methodology used in this Harvard-MIT research piece – titled “Core Earnings: New Data and Evidence” seems to be as follows: “Professors Charles Wang of HBS, and Eric So and Ethan Rouen of the Sloan School, used data from research firm New Constructs to analyze disclosures in regulatory filings, including information buried in footnotes and in the “management discussion & analysis” section. The data includes revenues, expenses, gains, and losses that reflect the hidden adjustments, according to the professors…The paper analyzes 19 years of data on company earnings that are adjusted to add back non-core net expenses related to acquisitions, currency devaluations or revaluations, discontinued operations, legal or regulatory events, pension adjustments, restructuring, gains/losses that companies disclose as ‘other,’ and other unclassified gains and losses that are considered non-operating.”
The main conclusions of Harvard-MIT research piece appear to be:
  • “…public companies frequently disclose non-operating income-statement items and that those adjustments significantly altered the true nature of the economics of the business…these adjustments are increasing over time.”
  • “…the number of income-related line items that management claims to be non-operating has grown over the last 20 years. Between 1998 and 2017, there was a 34 percent increase in the average number of adjustments.”
  • “The study also found that for every dollar of adjustments that increase earnings, only 55 cents are incorporated in Wall Street research earnings and other traditional analyst reports. “The selectivity of adjustments in street earnings appears to be in part driven by manager bias: firms that meet or just beat consensus EPS [earnings per share] forecasts [are] more likely to include income-increasing adjustments or exclude income-decreasing adjustments in their street earnings numbers,” wrote the professors in the study.”
  • ““The rapid rise in earnings distortion since 2015 means that an increasing amount of corporate income is coming from unusual or one-time gains, which is not apparent to investors analyzing press releases or income statements. Corporate managers hide the one-time nature of these gains by only disclosing them in the fine print,” according to the scorecard. New Constructs found that earnings distortion is positive for the first time since 2007. In addition, it’s the highest since 2000.”

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