Update: Why CEOs Manipulate Earnings

January 2, 2016

An analysis by Forbes magazine, “Four Reasons Executives Manipulate Earnings,” explains reasons CEOs use to rationalize management of earnings. First, the report says, their bonuses depend on it. Since “performance based” bonuses were made tax deductible in 1993, a larger proportion of executive compensation is being based on exceeding predetermined adjusted earnings targets. The targets can exclude various cost items and are usually neither audited nor comparable year to year, leading to emphasis on short-term results.


Second, executives want to continually lower the performance bar to assure receipt of a bonus whether the company succeeds or not. The Forbes study showed companies would increase “cookie jar” reserves to save for reversal to beat targets in future years.


The third rationalization for earnings misrepresentation is that “everyone else is doing it.” A study by Simi Kedia, Kevin Koh, and Shivaram Rajgopal, titled “Evidence on Contagion in Earnings Management,” found that “earnings manipulation at companies was strongly related to the percentage of firms in the same industry or the same region that had announced restatements [of their financial statements] in the previous 12 months.”


Last, Forbes believes executives face very little accountability, usually getting to keep bonuses that through legal or regulatory actions are later determined to be unearned.


It’s difficult to see how current executive compensation practices really do align with the long-term, sustainable interests of shareholders. See The Trouble with Earnings Management as well as The Pay-For-Performance Misnomer for more on this topic.


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