Companies Downplayed Their Earnings. Here’s Why.

Earnings took a hit in the first half of 2022 amid persistent inflation and rate hikes, but a deeper look shows a more complicated picture beneath the slump.

According to the latest note from the research firm New Constructs, some of the nation’s largest companies purposely understated their earnings in the first half of 2022. New Constructs CEO David Trainer argues that many companies may have done so to avoid reporting significant losses in the second half of the year, where fears of recession are mounting due to deteriorating economic conditions.

New Constructs came to that conclusion after comparing reported earnings with core earnings, which account for income and expenses that are buried in footnotes and in the “management discussion and analysis” section of many financial statements. In 2019, scholars from Harvard Business School and MIT’s Sloan School of Management found that public companies were able to manipulate earnings by putting key information in footnotes and other areas that tend to be overlooked by analysts. Many investors, the note explained, are unaware that companies can decide when to record certain income statement items and miss investment opportunities.

The note went on to say that in the trailing 12 months ended June 2022, the operating earnings of S&P 500 companies were 1 percent lower than core earnings, as computed by New Constructs. GAAP earnings, which are a common set of accounting standards, were also 3 percent lower than core earnings. In the previous quarter, both S&P earnings and GAAP earnings were 4 percent higher than core earnings.

“We are [at the] beginning of a new pattern,” Trainer told II in an interview. He said that the fact that companies have started to understate their operating earnings implies that corporate executives are worried about the earnings outlook in the coming months. Companies tend to overstate earnings in a good market cycle and understate otherwise, he added. 

Companies tend to downplay their earnings more often when markets tank. In 2020, 2015, and 2008, there were also significant write-downs of corporate earnings, according to a previous analysis by New Constructs.

“This is a pattern [that I’ve seen] all the way back to the tech bubble,” Trainer said. “Whenever you get into a bad market, no good opportunity goes to waste. Bad sentiment means that good [earnings] don’t matter, so [companies] might as well take their lumps now and set up for when the market is more sanguine.”