Three of Four Financial Executives Willing to Sacrifice Shareholder Value to Meet Earnings Expectations

February 9, 2004
Finance, Management

DURHAM, N.C. -- Three quarters of businesses would knowingly sacrifice shareholder value in order to report earnings that rise smoothly from year to year, according to a Duke University and University of Washington study of more than 400 senior financial executives.

“These results are not only surprising, but also are a revealing indicator of the current practice of business in the United States,” said John Graham, professor of finance at Duke’s Fuqua School of Business. “One goal of our study was to try to understand the processes that firms might use to manage earnings so that they are smooth and in an upward trajectory. To our surprise, rather than making accounting adjustments, CFOs admit that they instead take real economic actions to meet earnings expectations.”

The study, “The Economic Implications of Corporate Financial Reporting,” was conducted by Graham, Campbell R. Harvey, the J. Paul Sticht professor of international business at Fuqua, and Shiva Rajgopal, assistant professor of accounting at the University of Washington Business School in Seattle.

The research group surveyed 401 financial executives via paper survey and e-mail in late 2003 to assess attitudes regarding reporting of earnings, motivation to manage earnings and choice of techniques used to manage earnings. In-depth interviews were conducted in person or via telephone with an additional 20 executives. The surveyed executives hold senior positions with responsibility for financial reporting.

“We were troubled to find the lengths executives are willing to go to in order to meet their earnings projections,” Harvey said. “Taking economic measures to protect earnings does not help a company in the long run.”

The study found that 55 percent of the surveyed firms would delay starting a project to avoid missing an earnings target, even if it meant sacrificing value. Other economic actions that companies reported using to meet targets included deferring maintenance and delaying hiring.

According to the researchers, these findings are in part an unintended negative consequence of the Sarbanes-Oxley law passed in 2002. “In the post-Enron world, firms are very risk averse about manipulating earnings through accounting actions, even accounting actions that are perfectly legal,” Rajgopal said. “They apparently prefer to use economic levers, such as deferring needed maintenance and delaying profitable investment projects.”

The Sarbanes-Oxley law, passed in the wake of a series of highly publicized corporate accounting scandals, instituted new measures regarding financial reporting, corporate ethics, oversight of the accounting profession and conflicts of interest, and calls for civil and criminal penalties for violators.

The research study also offers an explanation for why the stock market reacts so negatively to a small miss in earnings. “As one CFO put it, ‘everyone manages earnings to hit the target,’ so missing an earnings target is seen as an indicator of more widespread problems -- like seeing one cockroach, you know there are 100 behind the wall,” Graham said.

In contrast, say the researchers, if a firm delivers stable earnings and meets or exceeds earnings targets, it builds credibility within the financial market, reduces the perceived risk of its stock and enhances the external reputation of the firm’s management.

Executives lament that many decisions are effectively forced on them by the market’s myopic focus on earnings, the survey found. “Our interviews revealed that CFOs do not like the system, but they are forced to play the game or risk losing their jobs,” Rajgopal said.

Added Harvey, “The obsessive focus on short-term results at the cost of long-term value creation is a significant challenge to the competitive strength of the United States in the global economic arena. I was shocked by the honesty of the executives’ responses. There was no cover-up -- they are telling it like it is.”

The researchers propose that executives may have been so forthcoming about their practices to call attention to the problems created by the current focus on short-term earnings. “Perhaps they see this research paper as the first step in defusing the cycle of short-termism,” Harvey said. _ _ _ _

Harvey holds the endowed J. Paul Sticht professor of international business chair at the Fuqua School of Business. He earned his doctorate in business finance from the University of Chicago and is the author of more than 100 publications. He is also a research associate of the National Bureau of Economic Research in Cambridge, Mass.

Graham earned his doctorate in finance from Duke. He joined The Fuqua School of Business faculty in 1997 and has published widely in the areas of corporate finance, investments and taxes.

Rajgopal earned his doctorate in accounting from the University of Iowa and served on the faculty at The Fuqua School of Business from 2002 until 2003, when he joined the faculty of the University of Washington School of Business. His research interests include financial reporting issues and accounting and disclosure issues related to derivatives and risk management. 

Notes to editors: The full research paper and charts are available at:

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