An Investigation of Earnings Management through Marketing Actions
Executive Summary — 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 managers use retail-level marketing actions (price discounts, feature advertisements, and aisle displays) to influence the timing of consumers' purchases in relation to their firms' fiscal calendars and financial performance. The results will be 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 promotion. Key concepts include:
- Marketing actions that produce short-term results occur more frequently when firms have incentive to manage reported earnings upwards.
- 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.
- These 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.
Combining new, hand-collected data with a widely studied dataset, we examine how firms use marketing actions to manage reported earnings.
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.
Furthermore, our results confirm managers' stated willingness to sacrifice long-term value in order to smooth earnings (Graham, Harvey and Rajgopal, 2005). 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.
Finally, a unique aspect of our research setting allows us to test who is responsible for the earnings management. While firms appear unable to increase the frequency of display promotions in the short run, they can reallocate these promotions within their portfolio of brands. We find that firms shift display promotions away from smaller revenue brands and toward larger ones following periods of poor financial performance, indicating the behavior is being driven by parties higher in the firm than the brand managers.
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