Read and synthesize the information and
1. Define earnings management.
2. Define accruals earnings management and accrual management.
3. Define real earnings management.
4. What is the difference between accruals management and real earnings management? Is either ethical or unethical? What is the difference between earnings management and earnings manipulation? How might real earnings management affect the future profitability of the firm? Why?
5. What are the facts, issues, alternatives and stakeholders related to the ethical dilemma in this scenario? Is real earnings management unethical if it is potentially detrimental to the firm’s longer-term profitability?
6. Given the relationship between meeting analysts’ forecasts and stock price, identify potential misalignment of incentives between management and shareholders.
7. Does your answer to question 5 change if upper management is not expected to retire for another twenty years versus a scenario where upper management is expected to retire within the next twelve months?
8. In a publicly traded company, management works for the firm’s shareholders. However, shareholders have both long and short-term investment horizons. Should management actively manage operations and/or earnings to the detriment of one group (e.g. short term) but to the benefit of the other group (e.g. long term)?
9. Your investment portfolio contains only Devon, Inc., stock. Under what scenarios might you prefer Devon’s management to reduce advertising and research and development expenses versus maintaining or increasing the investments in advertising and research and development?
10. A debate exists about how much of management’s bonuses should be tied to accounting earnings versus the equity value of the firm. Based on your insights from this case, identify the pros and cons of accounting and equity based bonus plans.
The Case Scenario
“Joe, I need to talk to you right now about our earnings projections for this quarter,” said Rich Dailey, President and CEO of Devon, Inc., a publicly-held pharmaceutical company whose shares are traded on the New York Stock Exchange at $50.30 per share at the current time. Analysts’ forecasts of earnings per share are $3.00, $3.35, $3.75, and $4.20 for each of the next four years. Analysts note that a significant portion of the growth is attributable to Devon, Inc.’s reinvestment of its earnings into the firm’s advertising, and research and development departments. Devon, Inc. has a proud history of turning research and development projects into marketable and profitable products.
Rich was speaking to Joe Jones, the CFO of the firm. “What do you have in mind, Rich?” asked Joe.
“I have just reviewed our internal projections for next year’s earnings per share. Based on our analysis, it appears that we will fall a penny short in next year’s earnings per share. Our current projections are that next year’s earnings per share will be $2.99. I am very concerned that this year’s earnings will fall short of the analysts’ forecast, and you know what happens to our stock price when we miss the forecast even by just a penny – it takes a nose dive. As a result, I am proposing an approach to assuring we meet the forecast without our independent auditors calling us to task.”
“Rich, you know that you are asking me to engage in earnings manipulation, and you know that it goes against my moral fiber to be associated with such inappropriate behavior!”
“Joe, listen, I am not asking you to engage in earnings manipulation. All those firms that got in trouble with the SEC were manipulating their accruals, and I agree that such behavior is wrong.
However, there is a substantive difference between earnings manipulation and earnings management. What I am proposing is that we cut back on discretionary expenditures like R&D and advertising for the rest of the year since those items are a direct reduction of the bottom line. I am not taking this action lightly. In order to determine whether or not this would be considered fraud, I spent the weekend reviewing the International Standards for the Professional Practice of Internal auditing (ISPPIA). The ISPPIA specifically defines fraud as, and I quote, as “Any illegal act characterized by deceit, concealment, or violation of trust.” Here is the website for you to check for yourself:
Based on the ISPPIA, I think fraud relates to theft of assets, performing illegal acts such as paying bribes or engaging in insider trading, or intentionally misrepresenting the financial data. I do not believe that this falls into any of those categories. In fact, we are being very honest and transparent with what we are doing. We will factually report the reduction of R&D and advertising expense on the income statement.”
“But Rich,” exclaimed Joe, “cutting back on R&D and advertising will hurt the bottom line in future years – don’t you realize that?”
“Joe, my concern is this quarter, not future years. I don’t want a precipitous decline in our stock price and remember that my annual bonus is tied directly to the annual earnings number, and I have hungry mouths at home to feed! Determine how much R&D and advertising must be reduced in order for us to meet analysts’ forecasts of $3.00 a share.”
“But Rich, what you are proposing will reduce the firm’s future cash flows. Our investors are trusting us to do what is in the long term best interests of the company. I cannot in good conscience do something that will affect the long term prospects of this company.”
“Joe, I beg to differ. I think our investors only care about the immediate effect on the stock price.
We both know that the stock will get hammered if we do not at least meet the earnings forecasts. I believe our shareholders would prefer that we avoid the immediate negative stock price reaction from missing analysts’ forecasts even though we may be reducing future investment opportunities and growth prospects. Joe, in other words, we are exchanging a short term negative market reaction with a reduction in long term market performance.”
“But Rich, what are the ethical ramifications for maximizing the short term market price by reducing the future growth prospects of the company?!”