Ok, before we get into the topic at hand, let me ask you a question. You might think it is off topic, but it will all make sense at the end.
Why do accountants make good lovers?
To answer this burning question, we must first understand why accounting is important. As investors,
WE DEPEND UPON ACCOUNTING
for many reasons, not least of which is the financial transparency this discipline requires provides insight into the value of companies. Financial transparency suggests all transactions are tracked, and reported. This allows us to make informed decisions about investing or not investing in a company. Ultimately financial transparency increases investor confidence. Financial transparency also allows the management of a company to make informed business decisions. The performance of business operations can be tracked, quantitatively, and financial health measured in a consistent manner. This provides a historical record of a firm’s financial activities. From this record, comparisons over time can be reliably made. This transparency also allows a company’s scarce resources to be allocated in an efficient manner, and helps with the budgeting problem. Accounting will help insure businesses have complied with relevant tax laws, and provides legal protection in the case of audit. Finally, accounting helps both internal management as well as external investors to easily compare a company’s performance, since information is consistently collected and tracked for all businesses. However
ACCOUNTING DOES HAVE ITS FAULTS
which investors must be aware of to insure they properly use and interpret information. For example, most accounting is not real time and, in fact, looks back in time. This limits the applicability of the results of accounting measures when making forward looking decisions. And although quantitative, there is a measure of subjectivity in accounting, specifically when making estimates or judgements about how to classify transactions or related data. Also, some metrics used in accounting are relatively complex and difficult to understand by non-specialists; this has been known to lead to misinterpretation; dangerous when management makes this mistake. Accounting is somewhat myopic, in the sense that it focuses on financial data, and as such fails to capture non-financial drivers of a company’s performance. And many have criticised accounting as a tool allowing companies to manipulate financial statements, and present a more favourable picture of a company’s health.
At first glance this criticism appears baseless. Given all the positive aspects of accounting — its rules based transparency and insistence upon quantitative data — this certainly could not be true! But, as it turns out researchers discovered
THERE ARE TIMES WHEN COMPANIES DO
manipulate parts of their financial statements, allowing them to easily round up their earnings. The reason why is obvious: higher earnings makes management look better. While
THIS PAPER WAS PUBLISHED IN 2009
it’s only recently started making the rounds in my circle of finance buddies and colleagues, raising two points1) Yes we know we’re slow! 2) How many hedge funds used this as their “edge”
Let’s look a little deeper. A link to the full paper is at the end of this article. Consider a case where you are calculating earnings per share (EPS) for your business. By convention, earnings per share are rounded up or down to the nearest full cent. The author’s hypothesis is
YOU ARE INVENTIVISED TO NOT REPORT EARNINGS
ending in the digit ‘4’, simply because earnings of (their example) of 13.4 cents are rounded down to 13 cents, while earnings of 13.5 cents are rounded up to 14 cents. Yes, it is simple, but
HOW CAN WE PROVE THIS?
Pretty easily actually, given adequate computing power. The authors analysed the earnings of all publicly traded firms for the period 1980 to 2021. Statistically, in such a large sample, all of the digits zero through should appear with the same frequency, in a earnings per share calculation. However they found
“the number four is significantly underrepresented”
in the reporting of EPS,
“particularly among firms that are covered by analysts.”
The called this phenomenon “quadrophobia” and calculated what they termed a “Q-Score” for all companies analyzed. A simple rule emerged, the higher the Q-Score the less often a company reported a number four in their earnings per share calculation.
The Q-Score has severe implications: lots of attention is focused on a businesses results on the day of reporting, these are often reported in the media, perhaps on the front page, no less. But few media outlets pay attention to REVISIONS TO EARNINGS, which take place later.
Finally, the author’s found that
“companies with high Q-scores are significantly more likely to … be named as defendants in SEC Accounting and Auditing Enforcement”
actions. These are problems as they may lead to securities fraud litigation, with the expected impact on share price.
So this is a fascinating paper, one that can be applied with tangible results. We just need a service to incorporate Q-scores, then we can use it in our stock screening exercises.
Oh and the question I asked earlier — why do accountants make good lovers?
They’re great with figures!
So great they can make some figures disappear.
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