Although no longer in the daily headlines, the scandals at WorldCom Inc., Enron Corp. and Global Crossing Ltd. are not that far behind us. And although each debacle has a unique script, they all have one thing in common: flawed accounting — specifically, a web of tricks that allowed the companies to appear prosperous when they were generating nowhere near the profits that shareholders expected.

Richard Sloan, an accounting professor at the University of Michigan, was the first to discover that investors habitually overlook the role accounting estimates play in determining a company’s earnings and hence its stock performance. In his initial study several years ago, Sloan looked at the non-cash component of earnings — which accountants call accruals — in search of stock market clues.

Accrual accounting is supposed to give shareholders a more accurate picture of what is going on in a business at a particular time by allowing a company to allocate revenue to a specific period to better reflect when the sales were made, not when the actual sales dollars were received.

Under the accrual method, transactions are
tallied when the order is made, the item delivered or the services provided, regardless of when the money is actually received. Similarly, expenses are incurred when goods are received, even though the bills for them may not be paid until a later date.

The largest variable in accruals is often depreciation, which reduces earnings. Other measures, such as receivables and inventory, have also been used to push reported earnings up or down.

In the hands of honest people, this process
provides an accurate view of a company’s fortunes. Sometimes though, the numbers get a tad fuzzy. Companies can push their estimates to the limits in order to boost earnings, leaving investors to decipher hidden, confusing assumptions. Not creating an adequate bad-debt reserve could boost earnings and drive a stock price higher, even if it means a hit in the future.

A rival that books an adequate reserve and reports lower profits could mean that its lagging shares might be a bargain as a result, Sloan argued.

Looking at the major companies in the Standard & Poor’s 500 index, Sloan sorted through their financial reports and came up with the 10% of companies using the biggest estimates and the 10% using the smallest. He uncovered a link between accruals and share prices, in that those companies with high subjective accruals, (i.e., lots of management decisions that boost earnings) tended to perform poorly, whereas those with low subjective accruals tended to beat the market.

Subsequent research suggests that the shares of companies that overstate their estimates, on average, lag the stocks of similar-sized companies by several percentage points a year.

When Sloan’s ideas were first postulated, critics maintained that the connection between high accruals and management skullduggery was too tenuous. The big accounting scandals eventually proved Sloan right, however. Too many investors had put too much trust in reported earnings.

Several other researchers have explored why this “accrual anomaly” occurs and whether it is predictive. Some think it’s less a matter of earnings manipulation and lazy analysts than executives trying to grow their companies too fast and investors simply jumping on board. They maintain that the key lies not in manipulation but with the wishful thinking of executives and investors alike, all of whom want to believe that their assumptions will drive the stock higher. IE