Business Pundit

According to a 2005 research study, executives with equity incentives (stock options and restricted stock grants) were more likely to “smooth” earnings so that they met or barely beat analysts’ projections. And the longer the continuation of the equity incentive plan, the greater the “management” of earnings.

The researchers summarized the reasoning behind the behavior this way: as executives’ wealth became concentrated in one holding (various forms of their own stock), the incentive to reduce the risk/volatility of that investment increased dramatically, both psychologically and in economic terms. The natural human reaction to a perceived risk is to take action to reduce that risk. In the case of equity-based incentives, executives have two options:

1. Liquidate the concentrated investment to allow diversification
2. Manipulate earnings to maximize ongoing stock performance

Note carefully my wording. The goal is not a one-time earnings windfall. Selling after one of those would attract too much of the wrong kind of attention. The goal is to imitate Jack Welsh and GE and hit the earnings projections quarter after quarter so that analysts can make ‘prescient’ projections quarter after quarter and everyone is happy.Or are they?

Which begs the BIG QUESTION:

Is this:

1. Virtuous behavior by corporate executives
2. A victimless crime
3. An outrage that must be redressed

Before you pass judgment, let me summarize the arguments for each position.

1. Equity incentives are designed to focus executives like a laser beam on increasing shareholder value. The data clearly shows that this theory works in practice!
2. So what if executives fudge the books a little? Who cares? Not their families, who have already calculated the value of those options/shares and applied them to future vacations. Not the company board members, who are also heavily leveraged in company stock. They have the very same risk profile and are likely to See No Evil. Not the analysts who make those earnings projections. All market data aside, who wouldn’t want to be told on a regular basis “you’re absolutely right, you genius!”? And finally, not the employees in the employee stock purchase program. I must admit that after examining the issue theseprograms are the most ingenious and effective hush money ever spent! Corporate employees have access to all the incriminating data, but if the ESPP shows a significant profit they’ll all cheerfully whistle past the graveyard on the way to the bank. After all, they worked for it!
3. This is an outrage that must be redressed! Unfortunately for all the beneficiaries of these “benign misdemeanors”, there’s this thing called the “slippery slope”. Maybe one quarter you delay booking a couple of deals. Or shuffle expenses from one unit to another. Then suddenly there’s a suitor at your door so you “miss” your revenue and profit targets by “oh so little” and you don’t have to pay out that big bonus pool to your employees. And that pile of cash you reserved is now looki ng pretty on your financials. Everyone is happy at the acquisition closing, but the truth soon reveals itself and mass layoffs and stock price swoons ensue. Speaking hypothetically, of course.

So what do you think?

UPDATE: Wow! Great responses! Check this one out:

“Who gets hurt? Interesting question. As a former Enron executive, I can assure everyone that the stakes are very high indeed. In the Enron, MCI and other famous cases, billions of dollars and thousands of jobs were sacrificed on the altar of quarterly earnings. Most cases of earnings management end less dramatically than those famous cases but the principle (or lack thereof)are the same - it is like smoking - highly addictive and always fatal but over an always uncertain time frame.”

Bravo, Mike! That is my experience, and I think it’s epitomized in Sir Walter Scott’s famous quip “Oh, what a tangled web we weave, when first we practise to deceive”. So for at least 400 years people have instinctively recognized the shady side of earnings managment!