To boost short-term earnings, managers can may make operating decisions to increase sales as a quarter draws to a close. Another company may cut back on staffing or R&D to minimize expenses. Additionally, accounting changes or tactics may be used to manipulate short-term earnings.
Businesses may attempt to change their earnings-target by diminishing analysts’ expectations to a more attainable number. Managers may also carefully construct the reports themselves, often burying any information that paints a better picture of the company’s health.
If a company cuts back on R&D while a competitor invests heavily in that area, the short-term reward could be greatly overshadowed by a future lack of innovative new products. Worse yet, when investors begin to feel they can’t trust earnings numbers, the result can be a drop in the stock price.
Managers know investors will react negatively if there is excessive manipulation of earnings numbers. Real cuts, versus manipulating numbers, are less likely to attract the attention of auditors — but they are also more likely to impact the business.
As a result, most companies typically either barely meet analysts’ earnings targets or fall far short. It is of prime importance for managers to meet their earnings projections, and many have ways of cutting investments or changing accounting policies to enable it. If you miss the target (with all these tools available) it may signal the company must have problems.
Earnings can affect stock price, and provide a window into a company’s health. Additionally, they may affect executives’ compensation and job security. Managers are pressured to keep the stock price high — because it is linked to their compensation. Management incentives can have a definite impact on the quality of the reports.
CFO’s believe earnings are the key metric outsiders use to judge a company’s health – and 3/4 of managers said they would make sacrifices for smooth earnings. The majority would delay a positive long-term project if it meant falling short on a quarterly earnings target. This generates a mindset of thinking mostly about the next two or three quarters.”
The now defunct ENRON is a prime example of far too much emphasis on short-term earnings. Enron culture was very competitive and short-sided — rewarding individuals for being very productive in the short run. There was no concern at Enron of the key managerial challenge of ensuring measuring and rewarding ALL business objectives. As Enron clearly demonstrated, Managers need to be constantly mindful of putting too much emphasis on one objective at the costs of others.
Source: http://en.wikipedia.org/wiki/Enron_scandal
The Enron scandal, revealed in October 2001, eventually led to the bankruptcy of the Enron Corporation and the resultant dissolution of Arthur Andersen, one of the five largest audit and accountancy partnerships in the world at that time. In addition to being the largest bankruptcy reorganization in American history at that time, Enron was attributed as the biggest audit failure.
Enron was formed in 1985 by Kenneth Lay after merging Houston Natural Gas and InterNorth. Several years later, when Jeffrey Skilling was hired, he developed a staff of executives who used accounting loopholes, special purpose entities, and poor financial reporting — and were able to hide billions in debt from failed deals and projects. Chief Financial Officer Andrew Fastow and other executives misled Enron’s board of directors and audit committee on high-risk accounting practices, and also pressured Arthur Andersen to ignore the issues.
Shareholders lost nearly $11 billion when Enron’s stock price fell from a high of $90 per share in mid-2000, to less than $1 November 2001. The U.S. Securities and Exchange Commission (SEC) began an investigation, and rival Houston competitor Dynery offered to purchase the company at a fire-sale price. The deal fell through, and on December 2, 2001 Enron filed for bankruptcy under Chapter 11. Enron’s $63.4 billion in assets made it the largest corporate bankruptcy in U.S. history at that time.
Many executives at Enron were criminally indicted for a variety of charges and were later sentenced to prison. Enron’s auditor, Arthur Andersen, was found guilty in a United States District Court. By the time the ruling was overturned, the firm had lost the majority of its customers and had shut down.
Employees and shareholders received limited returns in lawsuits, despite losing billions in pensions and stock prices. As a consequence of the scandal, new regulations and legislation were enacted to expand the accuracy of financial reporting for public companies. One piece of legislation, the Sarbanes-Oxley Act, expanded repercussions for destroying, altering, or fabricating records in federal investigations or for attempting to defraud shareholders. The act also increased the accountability of auditing firms to remain unbiased and independent of their clients.
