9
Earnings Management
Companies will go to great lengths to achieve a certain earnings per share (EPS) number or smooth out their earnings, but this is mostly wasted energy. The evidence shows that these efforts aren't worth it, and they may actually hurt the company. Instead, senior executive time is better spent on decisions that fundamentally grow the company's revenues or increase its returns on capital.
For decades, companies have been struggling with how to manage earnings and whether to try and smooth them out. In 1974, the Wall Street Journal published an editorial lamenting the narrow focus many executives have on EPS:
A lot of executives apparently believe that if they can figure out a way to boost reported earnings, their stock prices will go up even if the higher earnings do not represent any underlying economic change. In other words, the executives think they are smart and the market is dumb … The market is smart. Apparently, the dumb one is the corporate executive caught up in the earnings-per-share mystique.
In a recent survey, Graham, Harvey, and Rajgopal interviewed 400 chief financial officers and asked about the actions their companies would take to meet their quarterly earnings target.1 The results, summarized in Exhibit 9.1, show that fully 80 percent of the CFOs were willing to reduce such discretionary expenditures as marketing and product development to meet their short-term earnings target—even though they knew it would hurt the company's longer-term ...
