Quarterly Earnings and the Addiction to Lying: Can Mattel Show the Way Out?

If you lie, the best time to ‘fess up is immediately. “Immediately” is the only time that “oops” can constitute a full apology.

The longer you wait, the more “oops” looks like a dot in the rear-view mirror. Soon, to make amends, you have to confess. And probably explain. And the longer you wait, the more you have to express remorse, do penance (or pretend that you are) and other forms of disaster recovery.

No wonder CEOs have a hard time with quarterly earnings: the more quarterly earnings increases they show, the harder it is for them to show a quarterly loss; the more they’ll lie to keep the string going.

That’s the conclusion of a very clever study in the spring 2007 issue of the Journal of Accounting, Auditing and Finance. Its authors are James N. Myers and Linda A. Myers, and reported by Mark Hulbert, in the September 22 NY Timess, How Many Quarters In A Row Can Quarterly Earnings Grow? (Hulbert is a rarity—an analytical finance type who speaks completely in common English).

The profs analyzed the heck out of tons of data to answer the question: “absent manipulation, how many companies over a 42-year period would have been expected to put together a 20-consecutive quarter string of increased earnings?”

The professors calculated that no more than 46 companies during that 42-year period should have had earnings-per-share growth for 20 consecutive quarters. But 587 companies actually reported such strings of growth, so the professors conclude that their findings constitute “prima facie evidence of earnings management.”

Additionally: companies that had increased the same percentage over five years but in less linear fashion showed six percentage points less in stock appreciation.

Finally, the longer the string of positive earnings reports, the sharper the plunge in stock price on announcement of a losing quarter. As the professor says:

Together, these various findings paint a picture of extraordinary pressure on corporate management to sustain strings of consecutive earnings increases for as long as possible.

When I was in b-school, we talked about volatility of earnings—basically, a straight line is better than jagged. But we also talked about “quality of earnings,” which suggested that cooking the books (I don’t mean illegal, just, you know, cooking) was worse than not.

I don’t recall realizing there was a tension between those two goals, but it’s clear to me in retrospect that the more powerful of the two in the market was the appearance of low volatility.

In other words, cooking the books is rewarded by Wall Street; and the more you cook them, the more you’d better keep on cookin’.

Is that yet more proof for the cynics? It certainly sounds that way.

Then again, just because everyone’s lying doesn’t mean truth-telling doesn’t work; it could just mean no one’s willing to really try it.

Which brings us to Mattel, whose CEO apologized to China on Friday, September 21, saying China had gotten a bum rap for manufacturing flaws, when design was at fault.

Mattel’s stock price gapped up Friday about 4%, and stayed up on the day. A vote for quality of earnings? One day proves nothing, but as Rick Newman at US News and World Report says,

Mattel messed up, but now the company is bringing a welcome degree of transparency to an issue that seems complex and murky to most of us. So hurry up and pay attention, before the politicians and fearmongers muddle it up.

Was Mattel’s apology genuine, or forced by the Chinese?  I suspect the markets couldn’t care less.

 Could transparency actually be worth financial returns? Now there’s a thought.