Earnings Manipulation for Pros

| Sat Feb. 13, 2010 12:30 PM EST

The Wall Street Journal has a fascinating little story today. A pair of Stanford researchers examined half a million earnings reports and concluded that companies routinely adjust their earnings upward. How did they figure this out? It turns out that a favored way of doing this is to use accounting adjustments to boost your earnings per share ever so slightly — say, from 5.4 cents to 5.5 cents, which then gets rounded up to 6 cents. And a difference of a penny a share in the headline earnings number makes a noticeable difference in your stock price:

The authors' conclusions rest on a simple piece of statistical analysis. When they 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. They dub the effect "quadrophobia."

....In their most intriguing finding, the authors found that companies that later restate earnings or are charged with accounting violations report significantly fewer 4s. The pattern "appears to be a leading indicator of a company that's going to have an accounting issue," Mr. Grundfest said.

So here's your pro investing tip for the day: If you're thinking of buying stock, check to see if the company has too few threes or fours in the first decimal place of their earnings-per-share numbers over the past few years. If they do, buy the stock! These guys know how to please the analysts. But don't hold on too long! Eventually they'll restate and you'll be screwed. Timing is everything.