Earnings Management: Short Term Gains, Longer Term Costs
Public companies using interest rate swaps and stock repurchases to “avoid the torpedo” do so at a cost
Let’s say you’re a large, publicly traded corporation. You’ve borrowed $10 million at a fixed rate of 6%. Now, sometime later, you’re concerned that you may fall just short of your quarterly earnings estimate. Your stock price is at risk of being hit by an “earnings torpedo.”
But you have a plan. You’ll convert part of your remaining debt to a floating rate position— which, at the moment, is lower than the 6% fixed rate. By reducing your current interest expense, you realize an immediate increase in earnings. And through this bit of “earnings management” you will meet those all-important analysts’ expectations.
There’s just one catch. Depending on the yield curve — based on the expectations of future interest rate— your conversion to a floating rate position could actually wind up costing your company more money and lower future earnings over the longer term than had you remained locked into your fixed rate.
That’s what seemingly happened to Wal-Mart. A study of that case piqued Professor Nicole Jenkins’ interest in practices, such as interest rate swaps and stock buybacks, through which public companies sometimes may “manage” their quarterly numbers.
Before she entered the academic realm, Professor Jenkins served as a senior auditor for Price Waterhouse. “My experience made me comfortable with complex financial transactions,” she says. “It also made me curious about how firms use reporting rules to their advantage.”
Both her students and her colleagues now benefit from that real-world experience, upon which she has drawn in producing two papers and a Harvard Business School Case on different facets of this subject. Her work on interest rate swaps is currently under review. Her earlier work on stock repurchases appeared in The Journal of Accounting and Economics in 2006.
Interest rate swaps are nothing new. For years, companies have relied on them as a way of managing their risk. In the first half of 2007 alone, the notional amount of interest rate swaps exceeded $347 trillion. That was a 38% increase from 2006, when $900 billion were involved in interest rate swaps each day. According to a 2003 survey, 85% of the world’s 500 largest companies use interest rate swaps to manage risk.
Nor is earnings management a recent invention. But most research into this practice, Jenkins notes, involves accrual manipulation. Other tactics, such as stock repurchases, have received less attention. And, until now, no one had examined the extent to which companies utilize the flexibility in by Generally Accepted Accounting Principles to generate earnings through interest rate swaps.
In Wal-Mart’s case, Professor Jenkins says, between FY 2001 and FY 2003, the company took advantage of a rising Treasury yield spread (the yield on 10-year Treasury notes minus the yield on 1-year Treasury notes), which made floating rates significantly lower than fixed rates. Through rate swaps, Wal-Mart increased the share of its exposure to floating rates from less than 20% of its total debt to more than 40%. As a result, the company reported interest expenses that was $269 million lower than the prior year. The resulting earnings exceeded analysts’ annual consensus forecast by three cents per share. By the end of FY 2005, however, short-term interest rates had risen considerably—as predicted by the yield curve--prompting Wal-Mart to issue an earnings warning that its interest expenses could rise as much as $500 million that year.
Why would the company trade a near-term gain for a higher long-term cost? The answer, suspected Professor Jenkins, lay in a desire to avoid an earnings torpedo that might have resulted had Wal-Mart’s earnings failed to live up to analysts’ projections in 2002. “Clearly,” she says, "interest rate swapping is ripe for exploitation by managers with significant debt who are in need of additional earnings.” So she and two colleagues —Sergei Chernenko of Harvard Business School and Professor Michael Faulkender of Northwestern — decided to investigate the extent, if any, to which companies might be using this practice to increase short-term earnings.
They also probed for answers to another key question: How does the market respond to this behavior? “The lion’s share of interest rate swapping is to hedge corporate exposure,” Jenkins says. “The stock market actually rewards companies for reducing their risk.” But if interest rate swapping is done to improve earnings, it was less clear how the market would react.
Professor Jenkins and her colleagues examined a large sample of firms over a 10-year period. They found that 29% of the companies made use of interest rate swaps.
They also found that managers were significantly more likely to engage in interest rate swaps that increased their amount of floating debt when (a) their earnings were closer to analysts’ consensus forecast (b) when short-term earnings gained by moving interest expense into the future allowed them to meet market expectations. The group also found that interest rate swapping was higher among firms that were unable to use the more traditional earnings management tool of accrual management. Finally, they found that interest rate swapping is more prevalent among firms that “walk down” their analyst earnings forecasts. All of these findings, Professor Jenkins says, support a conclusion that the use of interest rate swaps to manage earnings is a common practice.
When they examined how the market responds to this tactic, Jenkins and her colleagues came up with one answer: “It depends.” On the one hand, she explains, companies that meet earnings projections using interest rate (but otherwise would have missed their numbers) avoid the negative stock-price reaction to firms who fall short of expectations. On the other hand, the market does not appear to reward companies that rely on interest rate swaps to meet or beat expectations in the same way that it rewards those that meet expectations through operating earnings.
It appears, Professor Jenkins says, “the market is not only able to see through the manipulation of earnings using interest rate swaps but actually assesses a penalty of sorts” to firms that reach their quarterly earnings targets only because they deferred interest expenses by switching from fixed to floating rates. There’s one more wrinkle, Professor Jenkins discovered. When firms swap floating rates for fixed ones, incurring higher short-term costs as a long-term approach to managing risk and interest exposure, the market appears to reward them.
In her earlier research, Professor Jenkins found some similar dynamics at work in the practice of stock repurchases as an earnings management tool. She and two colleagues — Professors Paul Hribar and Bruce Johnson of the University of Iowa — noted that, little research had been done on the use of stock repurchases to increase earnings per share (EPS) in spite of the fact that this is the number one consideration of CFOs when repurchasing shares.
Perhaps one reason for the relative lack of research is the opacity of the rules themselves. Most stock buybacks occur through open-market repurchase programs that must be approved by the company’s board of directors. Yet, until new SEC rules took effect in 2004, open-market programs hardly offered an open view of repurchase activity. Firms were not required to provide any details about the number or shares repurchased, the price per share, or even the timing. Typically, analysts and investors learned about these transactions only from a company’s quarterly or annual reports.
Jenkins and her colleagues recognized that the great flexibility and limited visibility offered by such stock repurchases naturally would make them an attractive tool for managers seeking to boost their EPS. So they investigated a sample of firms listed on the NYSE, NASDAQ or AMEX over a 13-period between 1988 and 2001.
They found a disproportionately large number of accretive stock repurchases occurring among companies that otherwise would have narrowly missed market expectations. Here, too, as with interest rate swaps, the market does not bestow the same rewards enjoyed by firms that meet estimates entirely through operating earnings. Instead, investors appear to discount the portion of accretive EPS that resulted from the repurchase.
So why, given this reaction by the market, would a company attempt to manage its EPS through stock repurchases? One answer, says Professor Jenkins, may be that the alternative would be far worse if the company failed to meet analysts’ forecasts. Even if investors do not reward them for making their numbers through EPS management, managers might reason, they can avoid the stock price “torpedo” by merely meeting expectations. In fact, Professor Jenkins’ findings that the market’s response to EPS generated from stock repurchases supports just such a conclusion.
But the research also helps illuminate how much remains to be learned. For example, says Jenkins, “there’s the question about what insiders — top management — are doing when companies repurchase their stock. What happens if companies buy back stock, but the insiders are selling?" There is currently no research on that issue, but the research is moving in that direction.
And where do business ethics enter this picture? As Professor Jenkins points out, when companies engage in interest rate swaps or stock repurchases for the sake of earnings management, they are operating well within the guidelines set forth by the SEC and Generally Accepted Accounting Principles—“I’m not trying to change the rules,” she says. “My goal is to make investors aware so they can be better informed and make better decisions.”
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Reported by Randy Horick
Published 6/25/08 in OWENintelligence
© 2008 Vanderbilt Owen Graduate School of Management