A wise old class action plaintiffs’ lawyer once observed the following to me:

“Accrual accounting is a particularly valuable annuity for the legal profession.”

A new study validates my friend’s observation. This Wall Street Journal ($) article reports on a Criterion Research Group LLC study that suggests that the companies that are most aggressive in using accrual accounting — i.e, booking noncash earnings — are much more likely to be the subject of a shareholders’ lawsuit than companies that use the cash accounting method.
Under the accrual accounting method, companies book revenue when they earn it and expenses when they incur them rather than when they actually receive the cash or pay the expenses. Accrual accounting is common and accepted, but problems arise when companies fail to estimate properly the revenue that they have earned in a given period or the expenses that it cost to generate that revenue. Although intentionally cooking the books is a violation of generally accepted accounting principles, merely miscalculating the numbers is not.
Criterion’s study concludes that companies that are most aggressive when using accrual accounting are four times more likely to be sued by shareholders as less-aggressive peers. The new study builds on earlier research that showed companies that use more accruals generally underperform companies with fewer accruals. In that earlier report, Criterion screened 3,500 nonfinancial companies over 40 years and found that those using the most accruals had poorer forward earnings and stock returns. and also had more earnings restatements and SEC enforcement actions.
Several well-known companies are in the two highest accrual categories in the report. Among those, Rite Aid Corp., Waste Management Inc., MicroStrategy Inc. and Gateway Inc. recently settled shareholder litigation involving accounting issues. Other companies in Criterion’s highest-accrual category that are not the subject of pending litigation include Chiron Corp., eBay Inc., General Motors Corp., Yahoo Inc and the ubiquitous Halliburton, Inc.