Incentives to Increase or Decrease Accounting Earnings

Firms show the greatest tendency to artificially inflate accounting earnings when

managers have the most to gain from increasing share prices. For example, Teoh,

Welch, and Wong (1998a, 1998b) found that firms make discretionary accounting

choices that temporarily increase reported earnings before both initial and seasoned

public offerings of equity. In these cases, managers are especially interested in

improving the firm’s current stock price because they want to maximize the proceeds

from the equity issues.

Occasionally, managers also manipulate their earnings downward when they want

their firms to appear weaker than they really are. For example, Liberty and Zimmer-

man (1986) found that some firms manipulated their earnings downward before union

negotiations, and Jones (1991) found strong evidence of managers manipulating their

company’s earnings downward prior to appealing to the government for help against

foreign competitors.

²This example is based on the discussion in Louis Lowenstein, Sense and Non-Sense in Corporate

Finance(Reading, MA: Addison Wesley, 1991).

Grinblatt1336Titman: Financial	V. Incentives, Information,	19. The Information	© The McGraw1336Hill
Markets and Corporate	and Corporate Control	Conveyed by Financial	Companies, 2002
Strategy, Second Edition		Decisions

662	Part VIncentives, Information, and Corporate Control

19.3	Shortsighted Investment Choices

Savvy investors and analysts, understanding the incentives of firms to manipulate their

earnings numbers, are generally reluctant to take the reported earnings numbers at face

value. Some analysts have a preference for evaluating firms based on cash flow rather

than earnings numbers, which are less subject to accounting manipulation. However, firms

also make real investment and operating decisions that affect the cash flow numbers, as

well as earnings, and managers may be motivated to bias these decisions in ways that

make the firm look better in the short run, but which hurt the firm in the long run.

Management’s Reluctance to Undertake Long-Term Investments

Anumber of financial economists have argued that the incentive of managers to gen-

erate short-term stock price performance makes managers reluctant to take on long-

term investment projects that generate low initial cash flows.³

The reluctance to take

on long-term projects arises because investors understand that managers have an incen-

tive to falsely claim that their investment projects have substantial payoffs several years

down the road. However, investors have no way of knowing whether the managers are

telling the truth about future payoffs or whether they are simply making long-term

promises to cover up their current poor performance. As a result, the market price of

a firm’s stock tends to react negatively to poor performance in the current period, gen-

erally ignoring management claims of big payoffs in the future. While this is not a

problem for managers who are interested only in the intrinsic value of their shares, it

creates problems for other managers who have incentives to keep their current share

prices high. This problem is illustrated in Example 19.2.

Example 19.2:The Incentive to Choose Projects That Pay Off More Quickly

Micro Industries has two long-term investment strategies and a short-term strategy available

to it.The cash flows, which are retained in the firm, and their present values (assuming a dis-

count rate of zero) are described below.

Cash Flows (in $ millions)

	Years 2–11	Present
Year 1	(annual cash flow)	Value

1.	Good long-term strategy	$40	$80	$840
2.	Short-term strategy	60	50	560
3.	Bad long-term strategy	40	40	440

Micro Industries is not considering the third strategy, because its present value of $440

million is obviously an inferior choice.This third strategy creates a problem for Micro, how-

ever, because investors are aware of this strategy, and absent further proof, do not believe

that Micro can generate the kind of returns reflected in strategies 1 and 2 described above.

As a result, if the good long-term strategy is selected, Micro’s market price at the end of

year 1 will be only $440 million, reflecting the market’s belief that the cash flows of the

³Management’s incentive to be shortsighted in making investment choices is analyzed in Stein (1989),

Narayanan (1985), and Brennan (1990).

Grinblatt1338Titman: Financial	V. Incentives, Information,	19. The Information	© The McGraw1338Hill
Markets and Corporate	and Corporate Control	Conveyed by Financial	Companies, 2002
Strategy, Second Edition		Decisions

Chapter 19

The Information Conveyed by Financial Decisions

663

third strategy will be realized.However, the market price will rise to $840 million the fol-

lowing year when the year 2 cash flow of $80 million is observed.If the short-term strat-

egy is selected, investors will realize its potential when the year 1 cash flow of $60 million

is observed and they will value the firm at $560 million.Which project should management

select?

Answer:If management is concerned only with maximizing the firm’s intrinsic value, it

should select the good long-term strategy.However, if managers place sufficient weight on

having a high stock price in year 1, they should take the short-term strategy because the

market price after one year will then be $560 million rather than $440 million.

In Example 19.2, management may be reluctant to select the superior long-term

strategy because the first year cash flows lead investors to believe that the company’s

future profits will be much lower than they will be in reality. However, by choosing

the lower-valued short-term strategy, investors quickly recognize the firm’s ability to

generate better than expected cash flows and reward it by boosting its stock price. The

insights of this example are summarized in the following result.

Result 19.3

Managers will select projects that pay off quickly over possibly higher NPVprojects thatpay out over longer periods if they place significant weight on increasing their firm’s short-term stock price.

What Determines a Manager’s Incentive to Be Shortsighted?

The tendency of managers to implement strategies with better long-term payoffs

increases as the weight that managers place on maximizing the current or near-term

stock price declines. To understand this, consider again Example 19.2 and assume that

management places a 75 percent weight on the year 1 value of the firm and a 25 per-

cent weight on its intrinsic value, implying that the weighted average payoff from the

long-term strategy (.75 $440 million .25 $840 million) is $540 million, which

is less than the $560 million payoff from picking the short-term strategy. However, if

management weights intrinsic value and next year’s share prices equally, then the long-

term strategy will be selected because the weighted average value from the strategy is

$640 million (.5 $440 million .5 $840 million), which exceeds the value of the

short-term strategy.

Anumber of policymakers and journalists have argued that the incentive to be

shortsighted, as Example 19.2 illustrates, applies more to U.S. managers than to Japa-

nese managers because the former place greater weight on the current share prices of

their firms. The basic argument for this tendency is that U.S. managers are monitored

more closely by institutional investors, are more subject to takeover threats, and have

a larger part of their compensation tied to the short-term performance of their firms.

The problem is compounded by the tendency of Americans to change jobs more often

than the Japanese. Some writers have claimed that these factors have tended to make

U.S. firms less willing to make long-term investments that ensure their long-term

competitiveness.⁴

⁴Kaplan (1994) provides evidence at odds with this basic belief. He suggests that Japanese managers

also may be strongly motivated to improve the short-term performance of the firms they manage.

Grinblatt1340Titman: Financial	V. Incentives, Information,	19. The Information	© The McGraw1340Hill
Markets and Corporate	and Corporate Control	Conveyed by Financial	Companies, 2002
Strategy, Second Edition		Decisions

664Part VIncentives, Information, and Corporate Control