Should investors react strongly and positively to Citi's earnings news?

Since one of my friends liked this entry, I will expand it a bit more here.


From WSJ today:

"The bank's third-quarter profit was $2.2 billion, up from $101 million a year earlier, with per-share profit of seven cents coming in just above analysts' estimates. The amount the bank set aside for credit losses fell. Revenue rose 2% from a year earlier, to $21 billion, but fell 6% from the second quarter."

The markets react strongly and positively to the positive earnings news from Citi.  It actually brought up the whole financial sector, and the whole markets.  However, if investors know something about earnings management, the earnings pattern of Citi smells like classical  accrual earnings management.

Generally, firms that announce earnings slightly beating zero threshold (e.g., 1 cent per share) or analyst estimates (e.g., if analyst consensus is 6 cents and the announced earnings is 7 cents) are found to be most likely to have managed/fudged earnings.  See Burgstahler, D., Dichev, I., 1997. Earnings management to avoid earnings decreases and losses. Journal of Accounting and Economics 24, 99-126 for further evidence.  The academic literature even find that firms may manage earnings just enough so that it is e.g., 0.5 cents about zero or analyst consensus.  When the number is rounded up, it becomes 1 cent more than zero or analyst consensus.  I am not sure if Citi is using this later roundup tools.

How could firms management earnings?  Generally, they could use either accrual or real earnings management (AEM and REM). In AEM, firms exploit the flexibility under GAAP to classify items differently.  For example, the following paper show the the main forms of accrual earnings management are as follows:

    * Unsuitable revenue recognition
    * Inappropriate accruals and estimates of liabilities
    * Excessive provisions and generous reserve accounting
    * Intentional minor breaches of financial reporting requirements that aggregate to a material breach.

See Healy, P. M. and J. M. Wahlen. 'A review of the earnings management literature and its implications for standard setting', Accounting Horizons, December 1999, pp. 365-383.

So the way that Citi has met and slightly beat earnings expectation is through the third forms above. Although I am not able to check extensively, this pattern makes me suspicious that as one of the masters of the Universe, Citi must know how to do it right so that the trace of earnings management may be less obvious.

Companies also do real earnings management, which include abnormal production to affect costs of goods sold expenses, along with timing sales recognition, R&D and advertising spending, and asset sales.  For example, company could cut the current period R&D expenses to meet earnings expectations.  They could also slash price and bring forward sales into the current period to management earnings.  They could try to realize gains on asset sales to boost up earnings.  Different from AEM, REM 1) involves changes in the timing or structuring of operations, investments, and/or financing transactions; 2) have cash flow consequences; 3) do not necessarily reverse automatically; and 4) are more difficult to detect because it is easily disguised as normal operating decisions.  In a survey of CFOs, the following paper finds that managers prefer to use REM.

See Graham, J., C. Harvey, and S. Rajgopal, 2005, The economic implications of corporate financial reporting, Journal of Accounting and Economics 40, 3-73.

A well known paper by Sloan shows that accrual earnings management can predict future returns.  Firms with more AEM to boost up earnings would subsequently outperform in stock prices.  The main explanation is that investors do not fully understand the impact of accruals and blindly react to the announced earnings numbers (which is partly fudged).  So if that is the case, Citi shareholders are likely to experience some relatively lower returns in comparison to stocks with similar risk/characteristics.  This accrual characteristic has been used by buy-side money managers extensively in the last ten years.

See Sloan, R., 1996, Do stock prices fully reflect information in accruals and cash flows about future earnings? The Accounting Review 71, 289-315.

Similarly to Sloan 1996, I have a recent working paper in which I find that firms practicing more REM to increase earnings would suffer lower future stock returns.  See my paper "Real earnings management and subsequent stock returns: at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1679832.  The paper has been presented at the annual meeting of Chicago Quantitative Alliance, a national organization of mostly buy-side researchers and portfolio managers this September.  It has made every top ten downloaded list that fits its category.  Part of the paper is likely to be in most every buy-side managers' toolkit in the future.