The choice of accounting treatment gives leeway to companies on how profits are reported. Under pressure to meet profit expectations of the market, companies may succumb to temptation to froth up their earnings. These are short-term measures and reality unfolds later causing damage to the stock price.
When stretched to extremes, we have high profile profit manipulation and bankruptcy cases like Enron and Worldcom. These stocks were still trading at high valuations before the collapse and many investors were caught off-guard.
Fortunately, there are tools we can employ to detect such earnings manipulation. Two well known ones are the Beneish M-Score and the Sloan Accrual ratio. ProThinker employs both in order to be able to catch more instances of possible earnings manipulation.
Research has proven that these tools are useful in detecting fraud cases like Enron and Worldcom before they happen.