Study Finds Link Between Aggressive Accounting, Non-Accounting Lawsuits

A bent toward aggressive accounting is a red flag for directors and officers insurers looking to spot future defendants in securities class actions–including those that have nothing to do with accounting restatements, according to a research group.

In fact, a report published by Criterion Research Group earlier this year found that the heaviest users of accounting accruals face four times more non-accounting securities class actions–those without any accounting allegations–than companies with the lowest levels of accruals on their financial statements.

Neil Baron, chairman of the New York- based research firm, explained that accruals are non-cash items on accounting statements. “They affect earnings, but there’s no cash in and no cash out,” he said. A simple way to look at it is to say that accruals are the difference between earnings and cash flow, he explained.

(Editor’s Note: Under accrual accounting, companies attempt to record revenue and other income items when they are earned or incurred, instead of when they are received or paid as under a cash accounting approach.)

Criterion and other research firms have previously demonstrated a strong correlation between accounting-related class actions and overuse of accruals. (See NU, Oct. 14, 2004, for a report on similar research by New York-based Advisen.)

Explaining the less intuitive, recently discovered link between aggressive use of accruals and non-accounting securities class actions, Mr. Baron said: “You can have a securities class action that’s based on misrepresentation that has nothing to do with accounting. If investors bought stock based on some touting of an approval of a drug,” for example, “and it turns out that was wrong, then you’re going to have a securities action” on behalf of stockholders when the stock drops in response to news that the drug wasn’t approved.

Executive teams that rush products to market before they’re fully tested–resulting in products liability lawsuits–and those that make overly optimistic pronouncements about product approvals, are often the same executives who feel pressured to meet Wall Street earnings targets and resort to aggressive revenue recognition, he said.

Non-accounting securities class actions are by no means a trivial matter for D&O liability insurance underwriters.

According to litigation statistics compiled by PricewaterhouseCoopers (available at www.10b5.com), there have been 79 non-accounting securities class actions this year. (In total, securities class actions as of Nov. 1–both accounting and non-accounting cases–numbered about 145, according to PWC. Other sources–such as Stanford Law School in cooperation with Cornerstone Research–put filings to date at 160, but do not split out non-accounting cases.)

Accounting missteps, of course, have been the big news–and the big driver of securities suits in recent years, with executives of Enron and Worldcom serving as the poster boys for bad accounting behavior. In fact, the steady stream of accounting blow-ups that resulted in a surge of securities lawsuits helped coax Mr. Baron out of the retirement some years back to start the research group.

The former general counsel of Fitch couldn’t help but be intrigued by developments in corporate America. “We went back and looked at the 10Ks and 10Qs of companies that blew up, and nine out of 10 times, it was there,” he said, referring to evidence of earnings manipulation through non-cash accruals. “You could see it, if you looked in the right place.

Providing an example of one area ripe for abuse, he said a company might have a five-year contract with the government, for which revenue is booked based on the percentage of work completed under generally accepted accounting principles.

“You might have a situation where the executives have options, but they’re about to run out and the stock price is below the strike price,” he continued. When the CFO tells the CEO that one year’s worth of work has been completed, the CEO may persuade the CFO, instead, to book two years under such a scenario, he said.

“That increases current earnings even though you haven’t received the cash,” Mr. Baron explained. “And what happens the next year? Obviously, net earnings are going to suffer,” he added. Similarly, companies can abuse the reporting of bad debt reserves by underreporting them, he said, noting that companies that do this also borrow from next year to bolster current earnings.

Mr. Baron noted that all companies use accruals, and overaccrued revenues or underaccrued debts can result from honest mistakes “Nevertheless, it creates poor earnings quality because your earnings are not going to persist,” he said.

For its studies, Criterion quantifies the portion of accruals in the earnings of 5,400 public companies. It then ranks the companies in 10 categories–or deciles–putting those having the highest accrual components in the 10th decile, and those with the lowest in the first decile.

According to Criterion’s latest research, there were nearly six times more accounting-related securities class actions against companies in Criterion’s 10th decile than in the first accrual decile as of the class start date–the date on which the lawsuit alleges misleading information was first in the market. There were also four times more non-accounting securities class actions against companies in the 10th decile than in the first as of the class start date.

“When we identified a class action, we went back and saw what accrual decile the company was in for the period it got sued,” Mr. Baron said, noting that all class action securities cases from 1996 through April 2005 were studied. If a company got sued in 2005 for actions in 2003, Criterion looked to see what decile the company was in for 2003, he said. The correlations were revealed through these hindsight tests.

Working in the reverse direction, D&O insurers can use information about deciles to underwrite and price policies for potential insureds going forward. “We found that 90 percent of the class actions are brought within three years of the bad behavior,” Mr. Baron said.

For one type of forward test, Criterion put companies into high-risk and low-risk buckets based on the time frames they stayed in high or low deciles. Companies that remained in the ninth or 10th deciles for four consecutive quarters at some time during the past three years were categorized as high risk, while those that were never above the sixth decile were put in the low-risk category.

While Criterion notes there are endless possibilities for defining such categories, these particular classifications proved to be predictive. Companies that fell in Criterion’s high-risk bucket represented about 21 percent of the universe of companies, but about 37 percent of all class actions–accounting and non-accounting–and 41 percent of accounting class actions.

Low-risk companies, on the other hand, which accounted for 19 percent of all companies, faced only 8.4 percent of accounting-related class actions and 8.8 percent of all class actions after exhibiting low-risk patterns.

Mr. Baron explained that subscribers to Criterion’s research can also go to Criterion’s Web site, type in a company’s stock ticker symbol, and not only view the decile history but also view a bar chart showing which accrual items are high contributors to earnings. Clicking on a particular bar–say, receivables or other non-current assets–will bring up an explanation of why a high percentage might raise a red flag for companies in high deciles.

This, in turn, can help the D&O underwriter dig deeper, understanding what questions need to be asked to make informed decisions about extending coverage or pricing a risk.

“We picked up Krispy Kreme before it crashed because it showed the category ‘other non-current assets,’” Mr. Baron said, explaining that the doughnut franchiser had a disproportionately high amount of goodwill (an intangible asset) on its books.

Turning to receivables, he said a company that shows high growth in receivables may be boosting revenues by booking sales to customers with weak credit profiles–or just booking fictitious sales.

Such companies are going to be irresponsible in other areas. “It’s a matter of behavior,” he suggested, adding that while companies engaged in accounting trickery remain a small percentage, D&O carriers need a means of trying to pick them out of the universe of potential insureds.

Subscribers to the research on Criterion’s Web site pay between $25,000 and $50,000 per year, depending on the number of users, Mr. Baron said. A new feature, useful to reinsurers, allows subscribers to input a portfolio of companies (for example, a primary insurer’s D&O book) to view the distribution of limits in high- and low-risk categories, he said.

Infographic: (with art of pulling cash out of a magician’s hat)

Flag: By The Numbers

Head: Accounting Trickery

According to Criterion’s latest research:

o There were nearly six times more accounting-related securities class actions against companies in Criterion’s highest accrual category (10th decile) than in the first accrual decile as of the class start date.

o There were four times more non-accounting-related securities class actions against companies in the 10th decile than in the first decile as of the class start date.

o High-risk companies–those which remained in the ninth or 10th deciles for four consecutive quarters at some time during the past three years–represented 21 percent of the universe and faced 37 percent of securities class actions.

o Low-risk companies–those that were never above the sixth decile during the past three years–represented 19 percent of all companies but faced only 8.8 percent of securities class actions.

o The three-year period was selected because Criterion also found that roughly 90 percent of class actions are brought within three years of the date on which false information entered the market (the class start date).

FYI

There’s no correlation between industry groups and accrual deciles, according to Neil Baron, chairman of the New York- based Criterion research firm. In fact, industry classes from chemical and drug producers to apparel makers–and even insurance agents and brokers–have companies ranked in every decile from 1 through 10, NU found when granted access to Criterion’s site.

Callout, if needed to fill jump:

Criterion’s research supports the theory that management teams that behave irresponsibly when booking revenues or other accounting items will also be irresponsible when pushing out products.