The WSJ reports today on a study that confirms what everyone has known for years: That many firms manage their earnings, pulling all manner of shenanigans to beat the street.

The way this form of fraud was detected was rather ingenious: The lower than mathematically expected incidences of the digit “4″ in corporate earnings releases. (“X.4″ to be precise) This simple statistical insight was due to an analysis of normal random distribution. “When the authors ran the earnings-per-share numbers down to a 10th of a cent, they found that the number “4″ appeared less often in the 10ths place than any other digit, and significantly less often than would be expected by chance.”


By finagling the 0.4 to a 0.5, accountants then get to round up to the next higher number. Hence, 12.4 cents is “managed” to 12.5, which then becomes rounded to 13 cents per share.

They dub the effect “quadrophobia” — fear of fours.

Here’s the WSJ:

“A new study provides further evidence suggesting many companies tweak quarterly earnings to meet investor expectations, and the companies that adjust most often are more likely to restate earnings or be charged with accounting violations.

The study, which examined nearly half a million earnings reports over a 27-year period, reached its conclusion by going beyond the standard per-share earnings results that are reported in pennies and analyzing the numbers down to the 10th of a cent.

That deeper look showed that companies tend to nudge their earnings numbers up by a 10th of a cent or two. That lets them round results up to the highest cent. Investors often snap up shares of companies that beat earnings expectations, even by a cent, and, likewise, sell off shares of companies that don’t make their numbers.”

I love the euphemism “meet investor expectations” as opposed to the more colloquial “lie cheat and steal.”

It also points out the need for the SEC to develop a Department of Quantitative Analysis filled with math geeks and computers, doing nothing but sifting through data looking for investor fraud. I’d bet they would get more convictions than the rest of the SEC combined. (If someone in the SEC would call me, I’ll help you set it up).

On an unrelated note: The WSJ yet again takes an academic study that proves Wall Street cheats and liars and runs it on a Saturday. Recall the first Option Repricing article they did that that caused quite a ruckus — a Saturday publication as well. If the historical pattern holds, this article will continue to have legs for the next 2 years, eventually leading to resignations and indictments.


Backdating Options Widespread (July 17th, 2006)

Widespread Fraud, Option Backdating, Exec Felonies (August 18th, 2009)

Quadrophobia: Strategic Rounding of EPS Data
Joseph A. Grundfest and Nadya Malenko
Stanford University, 2009-10-14

One Click Download

For Some Firms, a Case of ‘Quadrophobia
WSJ, FEBRUARY 12, 2010

Category: Corporate Management, Earnings, Legal

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

31 Responses to “Mathematical Proof: Companies Manage Earnings”

  1. more proof that the vast majority of our ills, can, in fact, be solved; incompetence is not, nearly, as wide-spread, as advertised.

    or, differently, good thing AG “Bag” Holder is on the Job.

  2. Moss says:

    Isn’t managing earnings a Six Sigma pillar? GE mastered this discipline under the tutelage of Jack. Having a financial arm makes it so much more fluid.

    The WSJ could find enough material to have a newspaper section exclusively dedicated to ‘lie cheat and steal’ . Maybe that is how they can generate revenue. Think of all the cheats that would pay to read such exclusive news.

  3. David Merkel says:

    Barry, on the off chance that you get the call from the SEC, count me in… I have my own bevy of tools for testing earnings quality.

    But then, if we got companies to be honest, value investing wouldn’t work so well… ;) Oh well, it is worth the sacrifice for a better society.

  4. call me ahab says:

    “The WSJ reports today on a study that confirms what everyone has known for years: That many firms manage their earnings, pulling all manner of shenanigans to beat the street.”

    the WSJ- blazing trails- investigative reporting at its finest /snark/

    my opinion- there is not an honest corporation in the world- as you always find beneath the corporate logo a company that will obfuscate, conceal, cheat and lie even if people are “dying” from their products-

    that’s what happens when you get a bunch of folks together under the corporate “banner”- no one person’s at fault and no one person to blame- as the people in charge reject responsibility for corporate actions


    BR: Give the Journal credit for recognizing (and publicizing) what could have been an easily overlooked piece of important research!

  5. John Clarke says:

    Hmmm. Interesting. “The WSJ reports today on a study that confirms what EVERYONE has known for years…That many firms Manage their earnings, pulling All Manner of Shenanigans to beat the street”… Or simply put they “Materially Misstate Information”… otherwise known as FRAUD.
    I guess the SEC, FASB and Public Company Accounting Oversight Board (PCAOB) have known about it too and The Sarbanes-Oxley Act (of 2002– signed by ‘W”orst) isn’t worth the paper it was printed on.
    I presume this article is in light of the fact that Companies can use a number of alternative accounting methods under GAAP (given the considerable amount of ahh ‘Discretion’ that GAAP allows) in how they report their earnings…
    (I would have thought an article like this would have shown up in Barrons or FT).
    Nevertheless, like the article says, Everyone has known about it for years and I seriously doubt it amounts to much from either the Enforcement Standpoint (lack of ‘Resources’/Political Will to pursue it) or Stock Market standpoints.

  6. Marcus Aurelius says:

    BR says:

    “(If someone in the SEC would call me, I’ll help you set it up).”

    Damn, BR, that’s the last thing the SEC wants: proof of criminality among those it regulates. In fact, since you have indicated that you could help obtain proof of criminality, you are arguably a very dangerous person to those ostensibly charged with enforcing our laws and regulations.

    Change your name and move to Paraguay, immediately.

  7. SWMOD52 says:

    The public corporation is messed up. It’s just an ATM for senior management. Empl0yees: F you, get to work. Common stock holders: we will throw you a couple pennies of a divi.

  8. constantnormal says:

    Pretty sad, Barry — you’re showing your roots, in not ever having worked for a publicly-owned American corporation. Managing earnings is the number two job of Bananamerican corporate management (right after managing their own compensation packages).


    BR: I’ve been on the boards of publicly traded companies! Both small tech companies with zero earnings, except for the occasional patent litigation windfall.

    But your point is true — managing earnings was not in either firm’s DNA

  9. seneca says:

    Why coin a new term “quadrophobia” when we already have “four-flusher” : bluffer, cheater?

  10. MayorQuimby says:

    Now THIS is TBP I enjoy reading. Nice catch BR.

  11. farmera1 says:

    I’m shocked, shocked I say. Rounding earnings, that is unbelievable.

    And who is surprised by this latest revelation. I used to graph quarterly earnings/share for several major corporations which resulted in a straight line over say five years. The probability of this happening in “nature” is about the same as getting run over by a horse five times or winning the lotto five times or you get the idea. Admittedly getting a straight line graph for earnings growth isn’t as easy now with the global melt down and all.

    But what else is upper management to do but manage the short term earnings (and hence the stock price) after all that is how they get paid. Just ask them, what their job is and they will tell you to manage the stock price.

    Got to recommend Bogle’s book THE BATTLE FOR THE SOUL OF CAPITALISM, with the take away companies are now manged for the benefit of management vs the old fashioned management for the benefit of the owners.

  12. Mannwich says:

    Excellent post, BR. I’ve been banging this drum for years now. They lie and we pretend to believe them. Wonderful.

  13. globaleyes says:

    Wag of the finger to all CFOs who are reminded: you are entitled to your own opinion but you are not entitled to your own facts…

    That’s especially true when it comes to earnings.

  14. microcap says:

    Fascinating study. Here are three essential facts to remember as to how and why this happens:

    1) Analysts make more money and become prominent when their groups are doing well, not for being bearish [even when correct.] As such, they have a strong incentive to UNDERESTIMATE earnings.

    2) Why does the underestimation matter? Because as other studies show, beating “earnings estimates” does lead to price momentum. For whatever reason, other investors [not regular TBP readers of course] have not figured out that the whole estimates/earnings symbiosis is artificially manipulated. This phenomenon has persisted for a significant period of time.

    3) The companies are not stupid, they know facts one and two. As such, they purposefully a) guide analysts as low as possible, and then b) manipulate the numbers as best they can to either hit or beat the number.

    This is why the bizarre phenomena of whisper numbers came into being–it was the market’s attempt to find some truth. And sometimes it works, that’s why companies can sometimes beat the estimates but drop anyway.

    Is it any wonder why so few of us have faith in the integrity of the system?

  15. MayorQuimby says:

    Yup micro. Lying and cheating gets rewarded ALL OVER the country. Politics, sports (steroids), economics, wall street etc. J6P doesn’t care and so we get the gvmt we deserve. I’m still waiting for ONE prosecution for options backdating.

  16. But then, if we got companies to be honest, value investing wouldn’t work so well… ;) Oh well, it is worth the sacrifice for a better society.

    Think of all the grief/money/time we’d save not having to so diligently preserve capital? Imagine actually investing in a company and not having to worry that you have just sunk your money in a sink hole.

  17. wally says:

    Did you hear about the Rancher who had 99 cows but wanted 100?

    He solved the problem by rounding them up.

  18. constantnormal says:


    “I’m still waiting for ONE prosecution for options backdating.”

    plus Brocade, Broadcom, and a host of others. While not terribly effective in terms of convictions that survive the appeals process, the rampant practice of options backdating seems to have significantly abated.

    I think the vast majority of these suits were civil suits brought by stockholders and not criminal prosecutions tho’.

  19. constantnormal says:

    Just another reason for practitioners of fundamentals investing to eschew earnings, in favor of things like sales (which are harder to fudge, tho’ not impossible) and more complex items like free cash flow per share (which is generally not targeted by the corporate manipulators due to not a whole lot of investors using that metric).

    But earnings make the headlines, so it’s earnings that are manipulated. I hated it when Apple adopted the silly “subscription” accounting to smear the iPhone revenue across a 24-month window, and when Microsoft did effectively the same thing with Windows 95 revenue. Perhaps there is a tax rational in leveling out the quarterly spikes in sales or earnings, but it seems unlikely in those two cases.

    I doubt that there are very many companies that do not pursue a final cosmetic pass through the earnings before release, looking for ways to manipulate that last half-cent per share. Would that as much effort were put into any other aspect of their business.

  20. jjay says:

    Speaking of criminals.
    Whatever happened to the Sherman Anti TrustAct?
    Walmart, GS, Citi,JPM, etc.
    Maybe RICO?
    They might have repealed along with Glass-Stiegel, I don’t know.

  21. cognos says:

    Eh… this is pretty small time stuff (some quants tell you — without magnitude or confidence that .4s appear less often? Those were the same statisticians who said — “Its AAA”!)

    1. Of course.
    2. Companies also manage earnings down (what Fannie CEO got in trouble for back in 2006!) so they can “beat” next Q.
    3. On balance… this is a “net positive” for US corporate productivity. As in — “imagine how much more productivity or lower costs companies can achieve by not wasting 10-30% of mgmt time catering to “the street”.

    Overall, this is petty analysis of a petty issue.

  22. cognos says:

    The article says… over 27 years, .4s show up 8.5% of the time (versus ~10% expected).

    Man… what a “Bananamerican” republic we live in. To the streets!

    Next thing they are gonna find… is that expensive wine sells 1.5% more of the time to …. expense accounts! The horror!

  23. Patrick Neid says:

    I put before the house none other than Cisco. They beat by exactly one penny every quarter for years in the go-go nineties.

  24. sparrowsfall says:

    >Department of Quantitative Analysis

    Put Nate Silver in charge!

  25. [...] evidence that companies manipulate earnings results.  (WSJ, Big Picture, DJ Market [...]

  26. [...] article in the Journal (WSJ) has brought bloggers’ attention (The Big Picture, MarketTalk DJ Newswires) to a paper on earnings management by Stanford researchers Grundfest and [...]

  27. ToNYC says:

    Cognitive dissonance. The paradigm is that there is big money to be made where really there is far too little to reach the non-players. The only way the little guy gets paid is through Ponzi; for the insiders, Madoff, partners in crime, one of the oldest Gypsy ruses.
    At some point in the future, the financial services industry will look like the floor of the NYSE: a museum, the space better used as fancy parking garage.
    End stage Capitalism only because “they can’t handle the Truth” . Lying is worse than dying because you get to live to see the consequences.

  28. Marc P says:

    What a surprise. There’s nothing more entertaining than watching a public company CFO gravely give “guidance” for the coming quarter in the same tones that an ancient priest would divine the future from the entrails of a sheep. The huddled masses (the financial press) bow, listen reverently, and then solemnly report the wisdom. Then, lo and behold! Actual earnings slightly beat the solemn prediction. Kabuki theater at its best.

    Next, someone should do a statistical analysis of initial public offerings. How many new stocks have prices that go up versus prices that go down immediately after issuance. Then look at who purchased in the primary sale, and how quickly they sold. Investment bankers working in the best interests of their clients? Yeah, right!

  29. Dave Eger says:

    Office Space totally saw this coming!