Inever understood why stock markets respond so dramatically to earnings reports. Why should a company’s stock experience sharp moves in pricewhenever it beats or misses analysts expectations by a penny or two per share?
After all, anyone with a passing knowledge of accounting rules knows how much scope they allow for reporting financial results — especially so in the case of quarterly reports (which are not audited). Areas where judgment calls are often exercised include the value of inventories and reserves set aside for bad debts.
A recent research studyreminds how earnings can be managed by company executives. It examined nearly half-a-million quarterly reports from 1980 to 2006 and found that there was a tendency to report enough earnings to be able to round up to the next penny per share. Such an adjustment could be important if it meant meeting or beating analysts expectations.
So if the initial calculations generated 35.4 cents per share, many companies would do a little tweak somewhere to find another $20,000 to $40,000 to bring earnings up to 35.5 or 35.6 cents a share. Then they could round up to 36 cents in their quarterly report.
Companies that tended to engage in suchtweaking were also found to be more likely to restate financials and to be sued in SEC proceedings alleging accounting violations.