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Earnings games show a diseased system

Earnings games show a diseased system
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First Published: Mon, Nov 05 2007. 01 44 AM IST
Updated: Mon, Nov 05 2007. 01 44 AM IST
US companies use all sorts of tricks to get sales in before the end of the year. Fourth-quarter revenues were inflated by 6%, according to Gaming the Numbers, a study by the REL financial consultancy. Conversely, the following first quarter sales were 4% lower than they should have been. The practice makes all too much sense in the current system.
REL identifies five major ways of increasing sales to meet targets: offering customer incentives, intensifying collection activity, slowing payments, delaying goods receipts and running at full capacity unnecessarily. Together those activities impose a working capital swing of $100 billion (about Rs4 trillion) on the US economy. The associated strategic costs cut shareholder value in the long run.
What should be done? REL makes some sensible suggestions: setting management targets on a rolling 12-month basis; getting audit committees onside and changing working capital management processes. But it would be more sensible to attack the problem at the roots: the enormous rewards that top bosses garner for hitting arbitrary numerical targets, and the high probability of getting fired if the targets aren’t met.
There’s no question that bosses have more riding on their company’s performance than they used to. CEO compensation has moved from around 40 times average US worker pay in 1980 to 364 times in 2006. The biggest payouts usually come from meeting earnings objectives. And failure to do so leads to calls—often heeded—for a change at the top.
The REL study measures some of the costs of this system. Its benefits are elusive. While targets may sometimes inspire, they often create perverse and costly incentives. If shareholders had the courage to cut top management pay and keep incentives under control, they would be rewarded with higher profits.
This study suggests that such changes would also reduce the level of earnings manipulation.
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First Published: Mon, Nov 05 2007. 01 44 AM IST