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A nightmare scenario: the quarter-end is approaching; you huddle with the CFO over the forthcoming earnings report and realize that earnings will fall short of the consensus estimate. Overcoming the initial panic, you recognize that something must quickly be done. But what? Here are the frequently followed courses of action managers take when facing the specter of the consensus miss, along with their consequences (see figure 1-2).

SALES BLITZ–COST CUTS (SHIFTS). The knee-jerk reaction to an earnings shortfall is to boost revenues and income by an end-of-quarter sales offensive, offering unusually large discounts, particularly common among medium-size and small technology companies, which finalize most of their sales in the last days of the quarter by offering exceptionally favorable terms. The obvious downside is that customers, aware of the vendor’s predicament from missing the numbers, wait until the end of the quarter to squeeze the last penny of the seller’s profit. In general, large price incentives surrender substantial economic value to customers and condition them to expect similar discounts in the future, and, while the sales blitz may boost EPS by a few pennies, the lower prices often shrink the margins—a closely watched indicator—leading to a price drop despite the EPS “hit.”²³ Most ominously, the artificially enhanced end-of-quarter sales cannibalize the next quarter’s revenues, thereby exacerbating the forthcoming EPS shortfall.

FIGURE 1-2

Actions and their consequences

Managers encounter similar issues with another favorite action: last-minute cost cuts—distinct from carefully-thought-through efficiency measures—aimed at meeting the consensus estimate. Such cost cuts or shift of expenses—advertising, maintenance, travel—to the following quarters also exacerbate the problems down the road. Thus, both the sales blitz and last-minute cost cuts (shifts) make sense only if the EPS shortfall is small and temporary. Most shortfalls unfortunately are not.²⁴

THE BIG BATH. This course of action is tempting when you face a substantial earnings deficiency. Here is how it works. Couple the earnings shortfall with a massive asset write-off—decrease of the book value of inventory, goodwill, or long-term assets—or with sizable restructuring charges (employee layoff costs, plant-closing expenses), thereby reporting an eye-popping loss that detracts investor attention from the consensus miss. An added advantage is that the large write-offs and restructuring charges boost future earnings by lowering asset values and depreciation. Arthur Levitt, Securities and Exchange Commission (SEC) chairman in the 1990s, describes an additional “benefit” of the big bath:

These charges help companies “clean up” their balance sheet—giving them a so-called “big bath.” Why are companies tempted to overstate these charges? When earnings take a major hit, the theory goes, Wall Street will look beyond a one-time loss and focus only on future earnings. And if these charges are conservatively estimated [namely, future expenses are overstated] with a little extra cushioning, that so-called conservative estimate is miraculously reborn as income when estimates change or future earnings fall short (emphasis mine).²⁵

Thus, overstated write-offs, when reversed, boost future reported earnings. However, the “gains” from reversing previous exaggerated restructuring charges have to be fleshed out in the financial report and are thus obvious to the careful investor.²⁶ Essentially, asset write-offs and restructuring charges are strategically important events called for by Generally Accepted Accounting Principles (GAAP) when fundamental economic circumstances, like competitive position, worsen. The infrequent nature of write-offs makes them too blunt an instrument to smooth out temporary earnings shortfalls (although some companies, like Eastman Kodak—dubbed a serial restructurer—“bathe” their financials frequently).

MANAGED EARNINGS. Although often tempting, this is the worst course of action when facing a consensus miss. A distinction is frequently made between earnings management—changes in reported earnings made within the boundaries of GAAP, such as switching accounting procedures or tweaking income statement estimates—and earnings manipulation or fraud, which involve GAAP-violating schemes, such as front-loading revenues or capitalizing expenses (a WorldCom favorite). In practice, however, the boundaries between earnings management and manipulation are often blurred. Consider, for example, the ploy Sarah McVay documented in 2006, in which companies shift regular expenses from their natural abode—cost of sales, or general and administrative expenses—to the income statement category of “special items,” generally reserved for nonrecurring, unusual items (such as the consequences of a strike).²⁷ Such a shift doesn’t affect the bottom line, yet inflates the closely watched “core (recurring) earnings.” Is this earnings management or manipulation? Judging by the shared intent to deceive investors, who cares?

Chapter 3 is devoted to the follies of management or manipulation of financial information, showing that such practices are both ethically wrong and highly likely to be surfaced sooner or later by whistleblowers, auditors, or the SEC. Once disclosed, information manipulation is very detrimental to the company’s operations and reputation and often devastating to the perpetrating managers.²⁸

RECOMMENDED COURSE: WARN, REPORT TRUTHFULLY, AND FIX THE FUNDAMENTALS. As soon as you realize you are going to disappoint investors—miss the consensus, or report an earnings or sales drop—preferably well before quarter-end, issue a public warning to this effect along with a detailed and credible plan of how you intend to fix the business fundamentals. Then, report the grim results truthfully and keep investors engaged, sharing with them the progress of the corrective moves, whether successful or not. A warning will not mollify investors, though; your stock will be hit on the announcement. Vodafone, the leading wireless communications company, lost almost 6 percent (S&P 500 dropped less than 1 percent) when it warned in February 27, 2006, of slowing revenues and a gross margin drop for the year ending March 31, 2007.²⁹ Sometimes the price hit on the warning is temporary, as in Vodafone’s case. On March 3, 2006, a mere week after the warning, Vodafone’s stock price returned to its pre-warning level. Of course, if investors aren’t convinced of the efficacy of the corrective measures, the price drop will last longer. The main advantages of the warning are that it enhances managers’ credibility as straight shooters and as executives who are on top of things (they weren’t surprised by the shortfall), and that the warning often lessens the company’s exposure to shareholder litigation and the estimated damages to investors, as I show in chapter 6.

Most importantly, in financial reporting, honesty prevails. How do I know? In 2009, Sanjeev Bhojraj and colleagues examined empirically what happens to companies that miss the consensus estimate by a penny without managing earnings, compared with companies that beat the consensus by a penny with the help of earnings management.³⁰ A few research particulars of this smart exercise: The study examined 1,390 companies that missed the consensus and 2,125 firms that beat it. The researchers assessed whether a company managed its earnings or not by tracking unusual changes in the major expense items that are susceptible to manipulation—accounting accruals (subjective reserves, provisions, estimates), R&D, and advertising expenses. Thus, for example, an unusual (relative to comparable firms) decrease in R&D, advertising expense, or in the bad-debt reserve (an accrual) at a company that beat the consensus by a penny leads to the presumption of earnings management.

The outcome of this analysis is both surprising and reassuring. First, the manipulators that beat the consensus received as a group a temporary 3 percent to 4 percent bump in stock price but lost it by year-end.³¹ This corroborates my earlier argument that beating the consensus by manipulation is a temporary fix, and sooner rather than later the true adverse fundamentals can no longer be masked. In sharp contrast, the one-penny missers that resisted the temptation to manage earnings didn’t suffer price decline, and from roughly a year after the consensus miss their share prices increased significantly. Thus, refusal to manipulate earnings prevails and will even be rewarded.