Management or Manipulation?

A new survey finds that CFOs wield surprising power over reported earnings.
Don DurfeeDecember 1, 2006

The next time a competitor reports surprisingly strong earnings, consider this: more than half of CFOs say they can (legally) influence reported earnings by 3 percent or more.

According to a survey of CFO readers, finance executives say they can use “allowable discretion” to boost or lower earnings by a few percentage points. And the methods involved don’t require a Ph.D. in finance. Operational levers include such time-honored tactics as delaying operational spending, accelerating order processing, and driving the sales team harder. Accounting steps — which are less common — include changing the timing of an accounting charge and adjusting estimates, both of which can be permissible under GAAP. “If your percentage of sales uncollectible could fall anywhere between 2.1 and 2.5 percent with equal likelihood, you might choose 2.1 percent if you wanted to increase earnings,” says Michael Peters of Villanova University School of Business.

Granted, in the post-Sarbox era, CFOs are operating under a high level of scrutiny. Yet the practice of earnings management is relatively common. When presented with various scenarios in which their companies would either beat or miss analyst expectations, one-third of respondents said they would try to influence the results: 24 percent would increase earnings and 8 percent would try to cut them, depending on the circumstances. The study, conducted by researchers from Villanova, the University of Alabama, and Indiana University, found that such steps generally stem from desperation — they are more likely when a company is set to completely miss its target, not, as conventional wisdom holds, when they are set to just miss expectations.

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Few CFOs think their auditors would catch any such adjustments. And if auditors did notice, say respondents, they probably wouldn’t bring it up with management. Still, you may want to pause before grabbing one of those levers. “Being associated with anything resembling earnings management will do much more severe damage to your reputation today than it would have 10 years ago,” says Peters. In other words, good judgment might mean not exercising your allowable discretion.