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An Investigation of Earnings Management through Marketing Actions

By Harvard Law School Program on Corporate Governance

(Editor’s Note: This post comes to us from Craig Chapman at Northwestern’s Kellogg School of Management)

My recently updated working paper An Investigation of Earnings Management through Marketing Actions, co-written with Thomas J. Steenburgh provides a novel view on earnings management. Earnings management behavior may be divided into two categories: 1) the opportunistic exercise of accounting discretion; and 2) the opportunistic structuring of real transactions. This paper focuses on the latter by providing evidence that firms vary their use of retail-level marketing actions (price discounts, feature advertisements, and aisle displays) to influence the timing of consumers’ purchases in relation to the firms’ fiscal calendar and financial performance. The results are of interest to practitioners negotiating with suppliers as well as those responsible for setting price and promotion strategy in response to competitor actions, and practitioners responsible for designing incentive-based compensation as well as regulators monitoring reporting of fiscal period-ending promotions.

We find that:

? In contrast to prior literature that suggests firms reduce marketing expenditures in order to boost reported earnings, we find 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 they engage in similar behavior following periods of poor financial performance. In addition to offering promotions more frequently, we find that firms offer deeper price discounts to manage earnings during these periods.

? While these actions boost unit sales, revenue, and profits in the near term, the resulting gains come at the expense of long-term profit and may not be in the strategic interest of the firm. We estimate that marketing actions can be used to boost quarterly net income by up to 20% depending on the depth of promotion. But there is a price to pay, with the cost in the following period being 23.5% of quarterly net income.

? The results imply that firms make systematic decisions across their product lines to manage earnings and indicate the behavior is being driven by parties higher in the firm than the brand managers.

The full paper is available for download here.

Full post as published by The Harvard Law School Corporate Governance Blog on August 11, 2008 (boomark / email).