What Accounting Conservatism Means To Investors
Most people know that financial analysts and accountants have different functions. Accountants record transactions over a given period and create summaries (backward-looking) in the form of financial statements. Financial Analysts use these statements to project future performance using a variety of ratios, models, growth rates, etc. This is, essentially, the Art of Valuation. However, valuations are only as useful as the statements on which they stand, meaning the accountant’s accuracy and faithfulness in representing the business’s true financial results are vital.
Now, if we only had to worry about the accountants, this would be a non-issue. Accountants are trained to operate within the stringent guidelines of the U.S. G.A.A.P. or IFRS procedures, and as such, always work to minimize the probability of a negative restatement. This is why line items like revenue and accounts receivable have allowances built-in, so as to minimize or eliminate any overstating of performance. X% of products sold will have an adjustment or defect, and Y% of accounts receivables will go uncollected. The trouble is that accountants do not determine the X’s and Y’s of the allowances; firm management does. These managers have every incentive to manipulate short-term performance, whether it’s to hit earnings estimates, receive higher financial compensation, or boost stock price.
Accounting Conservatism provides investors with two-fold protection from this manager manipulation. The first is minimizing the probability of a negative restatement, mentioned previously. The revenues found on the financial statement are, according to accounting procedures, most likely not lower, and the costs are most likely not higher. This means that we should be able to trust that MOST financial statement values are ‘close enough’ approximations of performance. However, whether investing is your profession, hobby, or retirement, ‘close enough’ is not what you want.
The second form of protection considers this: accountants must record all calculations and managers’ expectations in the footnotes of the financial statements. Footnote analysis is a useful tool in an investor’s arsenal to combat manipulation. It’s also quantitatively painless; all investors must do is read the footnotes. However, footnotes do not have strict regulations, so they can be numerous, long-winded, and technical. But there is great value to be found in them.
Here’s a highly simplified example. Let’s say managers allowed for 5% of accounts receivable (A/R) to go uncollected in 2016, just as they had for the previous 30 years. This figure is the historical average over the period, and tracks very closely to the annual value (minimal variance). However, only 2% of A/R was not collected in 2016. So, these managers issue their financial statements the next year with a new accounting policy. Now, they only allow for 2% of A/R to go uncollected. An astute financial analyst will question this. Why do the managers believe this one year is more representative of the future than all years preceding it? What do Accounts Receivables and A/R turnover look like using the old allowable policy? How does it affect their Cash Conversion Cycle? This singular change could affect the entire stock recommendation. Footnotes will rarely be this drastic (generally) or easy to read (never), but the concept is what’s important here.
In addition to footnote analysis, there are several quantitative measures financial analysts developed to examine the quality of earnings reports, primarily the Balance Sheet Accruals Ratio and Cash Flow Accruals Ratio. It’s worth noting again, that they are an “addition” to footnote analysis and not in any way supplementary. However, these two tools are quantitatively rigorous, and require both a deeper understanding of financial statements and a greater number of steps than I can impart to you in a paragraph or two. If this sort of calculation appeals to you, I recommend going to Investopedia or cracking open a Financial Statement Analysis textbook. What can be discussed, though, is how to interpret these figures (since you may be able to find them online from analyst reports).
Both should be calculated for a period of years (5 or more is best) to provide a historical firm context. If the company is mature, the ratios should seldom change, be very small, and stay the same sign. Frequent sign changes can be a sign of manager manipulation. Industry context is also very important, as some industries tend to have larger accruals. Accrual size can allow for larger movements in the ratios due to asymmetric shocks and firm-specific troubles. Suspicious looking accrual ratios should support odd movements on the financial statements and align with suspect changes in accounting procedures. They can also indicate to investors that earnings quality is low.
Lastly, in 1999, Dr. Messod Beneish created a measure called the M-Score, which calculates the probability of manager manipulation. It indicates earnings manipulation if the figure is greater than -1.78 (i.e. an M-Score of -1 indicates earnings have been manipulated). The primary model contains 8 variables, and can be constructed from a company’s 10-K. In addition to being academically rigorous, this equation was used to predict the Enron scandal, one of the largest scandals in business history. While many might be hesitant to wade through the calculations required for the M-Score, there is a greater incentive than simply knowing the probability of manipulation. Dr. Beneish created a portfolio of stocks, wherein he bought-and-held high M-Score stocks (lower than -1.78) and shorted low M-score stocks, re-balancing annually. The test portfolio returned 2.14% monthly from 1993-2009, with 90% of the returns coming from the short position. This means that firms with low earnings quality performed exceptionally poorly, and that earnings quality can be an effective stock screener.
Investors want their accountants to be conservative. It makes for more trustworthy financial statements, and allows people to fact-check the manager assumptions that influence statements. What’s more, the relationship between negative returns and low earnings quality is significant, demonstrating that opaque firms are likely to be poor investments, especially in the long-term.
Beneish, Messod Daniel, and D. Craig Nichols. “Identifying Overvalued Equity.” SSRN, 21 May 2008, papers.ssrn.com/sol3/papers.cfm?abstract_id=1134818.
Beneish, Messod Daniel, et al. “Fraud Detection and Expected Returns.” SSRN, 5 Feb. 2012, papers.ssrn.com/sol3/papers.cfm?abstract_id=1998387.
“How to Detect Earnings Manipulation Using the Beneish M Score.” The Value Investing Blog of Old School Value, 16 May 2017, www.oldschoolvalue.com/blog/investment-tools/beneish-earnings-manipulation-m-score/.
Red Team Analytics. “The M-Score Explained.” Seeking Alpha, Seeking Alpha, 30 June 2015, seekingalpha.com/article/3293805-the-m-score-explained.