Winning Investors Over. Baruch Lev
TCF's conference call, and analysts are likely to participate in subsequent calls.
My specific operating instructions for managers' communications are:
HARDEN SOFT INFORMATION. When possible, replace or augment narrative with numbers that are comparable across companies and computed the same way by your competitors, like earnings or order backlog. The numbers should be verifiable and audited, or aligned with subsequent facts. For example, TCF's CEO succinctly quantified the major reason for the disappointing year thus: “Big impact for the year for us was the 44 million dollars that we spent in debt cancellation, mostly in the third quarter, which impacted on an after-tax basis about 41 cents per share for the year.”46 Not exactly Shakespearean, yet straight to the point.
PAY ATTENTION TO TONE AND STYLE. Most managers focus on the subject matter of the communication, or what the message is, and leave to an afterthought its tone and style, how it is communicated. The evidence is unanimous: tone and style—pessimism or optimism, certain or wavering, crisp or foggy—count in changing investors' perceptions and their actions. In particular, frankness enhances credibility.47 Here is Warren Buffett in a 2007 shareholder letter discussing a table showing that Berkshire's pretax EPS rose from 1965 to 2007 from $4 to an astounding $4,093: “Berkshire's past record can't be duplicated or even approached. Our base of assets and earnings is now far too large for us to make outsized gains in the future.” (p. 4) Typical no-hype Warren.
FOSTER INTERACTIVE COMMUNICATION. I documented earlier that the effectiveness of conference calls increases with the number of participants and the number of questions asked. It's important, therefore, to engage analysts and investors as much as possible in interactive discussion. Ex cathedra preaching is better left to the clergy.
ENHANCE COMPANY RECOGNITION (VISIBILITY). Investors' limited attention adversely affects their demand for small and mid-cap companies' shares and lowers their prices. Effective investor relations and positive media exposure mitigate investors' limited attention, positively affecting IPOs' outcomes and companies' capitalization.48 Feed the business press interesting stories about exciting products and business ventures; don't be coy about important social responsibility initiatives; and turn the usually dull shareholder meetings into media events.
AND, YES, LIGHTEN UP. The somber, sometimes grim atmosphere of investor communications is contagious and counterproductive; lighten up the discussion. Here are several vignettes from Warren Buffett's 2007 letter to shareholders:
John Stumpf, CEO of Wells Fargo, aptly dissected the recent behavior of many lenders: “It is interesting that the industry has invented new ways to lose money when the old ways seemed to work just fine.” (p. 3)
A footnote: We paid the IRS tax of $1.2 billion on our PetroChina gain. This sum paid all costs of the U.S. government—defense, social security, you name it—for about four hours. (p. 16)
(I've reluctantly discarded the notion of my continuing to manage the portfolio after my death—abandoning my hope to give new meaning to the term “thinking outside the box.”) (p. 18)
But note, no humor is better than lame humor (this writer exempted).
AND, DON'T PLAY GAMES. Angela Davis and Isho Tama-Sweet examined fourteen thousand quarterly earnings releases and report that managers' pessimistic tone in the widely watched preliminary earnings release, concerning declining earnings or missing analysts' estimates, was substantially tamer than their pessimistic tone in the subsequent, less followed management discussion and analysis (MD&A) section in the financial report.49 Obviously, managers tried to soften the blow in the earnings release and protect themselves against litigation in the subsequent MD&A. Shareholders generally wise up to such games, and when they do, your integrity is seriously hurt.
Chapter 3
To Manage or Not to Manage Earnings?
Why You Shouldn’t Even Think of Manipulating Financial Information
In This Chapter
Surprise, there is no “truth” in accounting information.
GAAP to the rescue of truth, sort of.
Why do managers manipulate financial information and how do they do it?
The harsh consequences of manipulation for investors and managers.
Just don’t manipulate; there are better alternatives.
On September 12, 2007, the SEC charged former top executives of Nortel Networks, a Canadian telecommunications equipment maker, with accounting and reporting fraud aimed at beautifying reported earnings.1 Specifically, the SEC alleged that in 2002 Nortel executives created accounting reserves, in violation of GAAP, by artificially lowering the company’s earnings, which happened to be higher than internal and analysts’ estimates. These reserves were quickly put to good use: nearly $350 million of them were reversed and credited to income to inflate reported earnings—magically turning losses in the first two quarters of 2003 into profits—to impress investors and generate executive bonuses.
You will see in this chapter that Nortel is far from an aberration. In fact, financial reporting manipulation, ranging all the way from small tweaks of accounting estimates to beat analysts’ consensus forecasts by a penny to egregious multibillion-dollar frauds, is quite common. Manipulation is perhaps even increasing, as indicated by the frequency of corporate restatements of previously reported information, mostly, corrections of previous misreporting: from 614 restatements in 2001 to a whopping 1,795 in 2006, decreasing gradually thereafter to 1,217, to 923, and to 674 in 2007, 2008, and 2009, respectively.2 The total number of restatements from 2006 to 2008, a staggering 3,935, indicates that over half of public companies corrected previously reported earnings during those years. That’s seriously disturbing. The number of annual SEC Accounting and Auditing Enforcement Releases is rising too—from 134 in 1997 to 180 in 2009. You will see later that the incentives to manipulate reported information are strong and varied, making “earnings management”—an elegant euphemism for manipulation—an issue that most managers face. Yet, the costs of manipulation to investors, employees, society at large and, not the least, to managers are onerous. I focus in this chapter on the most critical circumstance leading to manipulation—a business slowdown causing managers to miss the consensus estimate or report decreasing earnings—discuss the means and consequences of manipulation, and conclude with operating instructions.
Truth in Accounting?
Lying in financial reporting as elsewhere is universally condemned. An absolutist rejection of lying, on moralistic grounds, has a long-standing tradition. The ninth of the ten commandments delivered by Moses from Mount Sinai states emphatically: “You shall not bear false witness against your fellow.” St. Augustine adds: “Now it is evident that speech was given to man, not that men might therewith deceive one another, but that one man might make his thoughts known to another. To use speech, then, for the purpose of deception, and not for its appointed end, is a sin.” Fast-forward fourteen centuries to hear Immanuel Kant declare that a lie is “a crime of man against his own person and a baseness which must make a man contemptible in his own eyes.” When asked if a lie is permitted to save a life, Kant answered: “To be truthful (honest) in all declarations, therefore, is a sacred and absolutely commanding decree of reason, limited by no expediency.”3
Realists, keen observers of life and human nature, have taken a more pragmatic and nuanced approach to deception. Plato “had allowed that in his ideal Republic, rulers, the very topmost executives of the state, might find it ‘necessary’ to lie for the good of the community, and Machiavelli most wholeheartedly agreed with him.”4 Iris Murdoch sarcastically noted: “We have to mix a little falsehood into truth to make it plausible.”5 In a competitive environment, marked by the struggle to survive, lies and deceptions are often a part of life. Jeremy Campbell notes the following:
In the world of life, even fairly primitive life,