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Tuesday, September 27, 2005

Everyone Plays, Nobody Wins - HBR: 65-74

"The Earnings Game" refers to the desire companies have and the actions they take to meet their quarterly earnings predictions. The author uses the terms "earnings management" and "creative accounting" in describing how companies play the game. The players in the game include companies, their accountants, analysts, and Wall Street.
The idea of the game is for the companies to meet the analysts’ earnings per share predictions. Even a penny more or a penny less can lead to disaster. The reason this goal is referred to as a "game" is because it is not always attained in a manner as straightforward as one might think.
There is no actual beginning or end to the game. It is more of a continuous circle. One part in the circle is the analysts predictions of earnings for the next quarter. These predictions can be easily influenced. Companies can influence analysts by keeping them supplied with company data, to ensure that the analysts’ main source of information comes from the company itself. A second way to influence the analysts is for an executive to speak with them in an indirect manner. The regulations prevent analysts from specifically speaking of a forecast, but nothing stops them from giving hints. An executive could ask what kind of forecasts the analyst’s rivals are making. The analyst’s reply might be that he’s seen forecasts as high as 27 cents a share. Then the executive could say that 27 cents seems high and the analyst might ask if 24 cents seems like a better number. These numbers can go back and forth until it’s clear that 25 cents is the number the company expects.
The next part of the game is related to what number the company actually earns as apposed to the number the company reports. Most companies want to earn exactly what the analysts predicted. In order to attain the exact prediction, regulations are sometimes stretched and actual numbers are distorted. Large public accounting firms will sometimes stretch the regulations to keep a good relationship with a client.
One way to distort current earnings is referred to as "channel stuffing" - to borrow from future sales to increase current results. Sunbeam, referred to in the article as the champion of channel stuffing, sold millions of grills (to customers like Sears and Wal-Mart), stored the grills in warehouses, and deferred payments until spring. This was done to boost sales in the winter months. One problem with this, from the earnings management perspective, is that sales must improve in later months to cover loans. Sunbeam’s sales never grew enough to cover their loans and they eventually had to restate several quarter’s of revenue and earnings. The CEO, "Chainsaw Dunlap", lost his job and reputation in the process.
A second way to pad current earnings is premature revenue recognition. This, as it states in the article, "involves recording a highly contingent transaction as a firm sale". An example given was when MicroStrategy recorded not only the actual sale of software, but also future revenue that it "expected" to collect from software upgrades. MicroStrategy was eventually forced to admit it had overstated sales.
A third way to enhance current earnings at the expense of future earnings involves creating innovative organization structures. Boston Chicken's exotic structure is used as an example. Boston Chicken's hundreds of restaurants were owned by independent (in name only) regional franchisees who borrowed the funds needed to start the businesses from Boston Chicken. The company recovered most of these funds in fees, royalties an interest that created a very favorable profit trend for Boston Chicken as more stores were opened. Eventually the system collapsed, the company filed for bankruptcy protection and McDonald's purchased it "on the cheap" according to the author.
Another part of the "game" is the reaction on Wall Street. If a company reports a penny less or a penny more than predicted, there could be a large market reaction. The reason for this is because Wall Street understands what goes on in the "earnings game." As one stockbroker quoted in the article stated, "Things must be pretty bad if Cisco can’t manage to come up with one lousy penny". The attitude by companies is that, "if they’re going to miss by an inch, they might as well miss by a mile". If a company realizes that it is going to miss the prediction, it may use it as an opportunity to write off bad debts or to sell unwanted assets for a loss. This gives the company a reason for missing the prediction. It also makes it easier for the company to look good in following quarters.
Investors are a very important part of the game and an industry has developed to provide the so-called consensus earnings per share estimate. One website provides a whisper number developed from searching electronic chat rooms and message boards.
Overall, the earnings game does more harm than good (e.g., distorts decisions, causes a guessing contest, compromises the integrity of corporate audits and undermines the capital market). The problem is that the quarterly earnings report is of no actual use in predicting the future cash flow and performance of a company and these two items determine the basis for the value the company's stock. With the penny pinching and regulation stretching that goes on, the actual numbers become even more useless. If nothing changes, investors may eventually lose faith in all the numbers affected by the quarterly earnings reports, including stock prices. If this occurs, the capital markets will not be able to survive.
Unfortunately, the only way to completely end the game is for companies themselves to abandon it. Until then, the "Earnings Game" will continue to be a part of our live

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