04 Nov 2014Working Paper Summaries

Making the Numbers? ‘Short Termism’ & the Puzzle of Only Occasional Disaster

by Hazhir Rahmandad, Nelson P. Repenning and Rebecca Henderson

Steady and reliable earnings bring many advantages to the firms that deliver them. Share prices rise, capital costs decline, and bonuses become both bigger and more likely. Such firms grow faster and attract more talented people to manage that growth. Despite these benefits, however, scholars and practitioners have long been critical of the short-term focus that often characterizes western managers. In this paper the authors develop and describe a model suggesting that the solution to this seeming paradox lies in the fact that earnings management, above a given threshold, is relatively harmless, but below this threshold it can be disastrous. The results have important implications for understanding managerial incentives and the internal processes that create sustained advantage. Key concepts include:

The model in this paper reconciles the tension in management scholarship between those who have shown that a focus on "managing earnings" is associated with better performance in the capital markets and those who have suggested it may be dangerously short sighted.
Balancing attention to both short and long term investments may be a critical source of competitive advantage.
A key source of above average performance might be the differential ability of firms to create relational contracts that incorporate subjective evaluations of capability.

Author Abstract

Much recent work in strategy and popular discussion suggests that an excessive focus on "managing the numbers" ―delivering quarterly earnings at the expense of longer-term investments―makes it difficult for firms to make the investments necessary to build competitive advantage. "Short termism" has been blamed for everything from the decline of the U.S. automobile industry to the low penetration of techniques such as TQM and continuous improvement. Yet a vigorous tradition in the accounting literature establishes that firms routinely sacrifice long-term investment to manage earnings and are rewarded for doing so. This paper presents a model that reconciles these apparently contradictory perspectives. We show that if the source of long-term advantage is modeled as a stock of capability that accumulates over time, a firm's proclivity to manage short-term earnings at the expense of long-term investment can have very different consequences depending on whether the firm's capability is close to a critical "tipping threshold." When the firm operates above this threshold, managing earnings smoothes revenue and cash flow with few long-term consequences. Below it, managing earnings can tip the firm into a vicious cycle of accelerating decline. Our results have important implications for understanding managerial incentives and the internal processes that create sustained advantage.