What did Enron, WorldCom, and Tyco all have in common? Accounting abuses on a grand scale and massive financial deception from the very highest levels of management. As investors lost billions of dollars, the earnings management game with its fuzzy math and earnings magic came under fire, and stronger, sweeping legislation was enacted to reform American business practices.
While much has been made of the opportunistic exercise of accounting discretion, a second type of earnings management strategy has gone largely ignored: the opportunistic structuring of real transactions. New research by Craig Chapman of the Kellogg School’s accounting and information management department examines the ways in which managers use retail-level marketing actions to influence the timing of consumer purchases in relation to their firms’ fiscal calendars and financial performance.
In a new paper entitled An Investigation of Earnings Management through Marketing Actions, Chapman and his colleague, Thomas Steenburgh (Harvard Business School), report evidence that soup makers use tactics such as price discounts to improve earnings at the end of a reporting period. The authors underscore that the companies do so despite the fact that “the resulting gains come at the expense of long-term profits and may not be in the strategic interest of the firm.”
Patterns of Price Discounting
Chapman came across the phenomenon while buying supplies for his infant son. “I began to notice a regular pattern of price discounting on diapers and baby formula,” he recalls. “I found myself stockpiling product and making purchases only when items were offered at special prices. At the same time, Chrysler, Ford, and General Motors were all reporting significant sales growth associated with offers of employee discounts for all. In each case, it appeared that price reductions close to the end of the fiscal period were boosting sales in the current period that might adversely affect sales levels in the future.”
Chapman did more than take personal advantage of the discounts. He decided to explore how companies might use such marketing as an earnings management strategy. He and Steenburgh chose to focus on soup because, they report, it “is easily stockpiled and is purchased in greater quantities when it is offered at a discount.” In addition, Chapman notes, “there are multiple manufacturers with cross-sectional variation in their fiscal calendars, allowing us to control for seasonality effects.”
While steep discounts often cost the company, the practices offer savings opportunities for consumers and red flags for investors.Alternative products had built-in disadvantages. “I believe the same thing happens with cars, but you get rid of your car. And if you filled your fridge with beer, you’d probably drink more; I’m not sure that’s the case with soup,” he continues. “You need something that shows changes in demand. I chose an item with as few variables as possible.”
For their data, the researchers relied on information on the buying patterns of households in Sioux Falls, South Dakota, and Springfield, Missouri, between 1985 and 1988 gathered by the ERIM marketing testing service. Based on that data, they then collected information on soup makers’ promotions and financial performances, in some cases from the companies themselves.
Tactical Timing of Market Promotions
In contrast to prior literature suggesting that firms reduce marketing expenditures in order to boost reported earnings, Chapman and Steenburgh found that soup manufacturers roughly double the frequency of all marketing promotions (price discounts, feature advertisements, and aisle displays) at the fiscal year-end, and that the firms engage in similar behavior following periods of poor financial performance. The authors observed that firms generally offer deeper and more frequent discounts to manage earnings upwards during these periods.
Chapman and Steenburgh point out that the use of such marketing practices effectively enables firms to artificially inflate their reported revenues, but since the extra products have been sent to end consumers, the firms escape scrutiny from the United States Securities and Exchange Commission.
“We estimate that soup manufacturers use price reduction to legally boost sales revenue and quarterly earnings by almost 20 percent,” they report. “Nevertheless, there is a price to pay, as we estimate that quarterly EPS [earnings per share] falls by 23.5 percent in the subsequent reporting period, resulting in a net loss of 3.5 percent of the quarterly EPS to the manufacturer.”
Chapman sums up the situation when he observes, “They’re promoting a product and selling it at a lower price today that they might have sold at a higher price tomorrow. The process involves extra costs.”
When the study was completed, Chapman found plenty of anecdotal evidence to support its results. “You mean the ‘can can’ effect,” the executive of a New England trucking company told him, explaining that supermarket chains complained that his trucks were not strong enough because they were overloaded at the end of every quarter.
Chapman suggests that the effect applies to a host of durable products that are easily stored and have a high contribution margin along with sufficiently high price elasticity.
“The more I’ve presented the paper, the more it’s clear that everybody—from software companies to cars to contractors—is doing this to make their financial targets,” Chapman says. “It’s a basic tool of business.”
Brand Managers Overruled
The study also revealed that decisions to use marketing as a tool of earnings management are made at high levels in the executive suite. “We observe that firms switch their promotional slots from smaller revenue brands to larger brands in periods when we predict them to have incentives to manage earnings upwards,” Chapman and Steenburgh report. “Since it is highly unlikely that a brand manager would voluntarily give up promotional support, this change is consistent with the actions being directed by parties higher in the organization than brand managers.” Chapman’s conversations with brand managers have confirmed that fact. “They complain about how their head offices keep interfering with their planning process with short-term plans,” he says.
The results of this study have far-reaching implications. They will not only benefit practitioners negotiating with suppliers and those responsible for setting price and promotion strategy in response to competitor actions, but also those who design incentive-based compensation and regulators who are monitoring reporting of fiscal period-ending promotion.
While earnings management strategies involving steep discounts often cost their users, the practices offer savings opportunities for consumers and red flags for investors. “[Consumers] can save significant amounts of money by timing their purchases,” Chapman advises. “Investors, meanwhile, should be aware that, when they see firms reporting increases in their top line revenues and decreased margins, they should watch carefully for subsequent deterioration in performance.”