Companies can play lots of games, even with cash. Some businesses designate certain stocks they hold as trading instruments to inflate operating cash flow when the securities are sold. Many lead and lag payments to raise short-term cash flow. Others lowball customers' bad debts to increase earnings and artfully adjust estimates of old inventories, receivables, and pension fund profits.
Ironically, it doesn't do companies any good in the long run. Research by Richard G. Sloan of the University of Michigan Business School and Scott Richardson of the Wharton School shows that companies making the largest estimates and reporting the most exaggerated earnings initially do well. They attract lots of investors, and their stocks soar. But later, when the estimates prove overstated, their stocks tank. Indeed, the shares of companies that overstate their estimates, on average, lag the stocks of similar-sized companies by 10 percentage points a year. This costs investors more than $100 billion in market returns. These too-aggressive companies also have more earnings restatements, Securities & Exchange Commission enforcement actions, and accounting-related lawsuits.
What to do? Companies should make sure all the estimates and judgments in reported earnings are transparent. They should simplify their financial statements to make them clear and comparable. And at the least, they certainly need to report income and cash flow for the same time periods. Clarity and honesty in accounting would not only make the financial markets more efficient but also might head off a second round of corporate scandal and regulation. Does anyone want Sarbanes-Oxley, Part II?