RESEARCH CORNER

The importance of reported earnings

Although accountants might beg to differ, finance theory suggests that managerial decisions should focus on maximizing value (discounted cash flows), not on accounting profits. In practice, which view dominates?

The results of an extensive and carefully conducted survey of over 400 financial executives-most of them CFOs-help shed light on this question. In "The economic implications of corporate financial reporting," published by the Journal of Accounting and Economics (2005, Vol. 40, pp. 3-73), John Graham, Campbell Harvey, and Shiva Rajgopal offer the following highlights:

* 51% of financial executives identified earnings as the most important measure of performance, compared to 22% for cash flow from operations and free cash flow combined.

* 89% believe a smooth earnings path causes investors to perceive lower risk; 57% believe it reduces a company's risk premium.

* 86% believe that meeting earnings benchmarks (last year's earnings; analyst forecasts) helps to build credibility with capital markets; 77% believe it helps management's external reputation. By contrast, 81 % believe that failing to meet benchmarks creates uncertainty about future prospects.

* In order to meet benchmarks, 80% said they would decrease discretionary spending (such as maintenance, R&D, and advertising); 55% said they would delay investments, even if doing so would reduce net present value; 28% would use accounting reserves previously set aside; 20% would sell assets to realize gains; and 8% would change accounting estimates.

* 59% of respondents said they would forego a project that offered a return 4% above the hurdle rate if doing so would allow the firm to meet the next quarter's earnings target.

The fact that financial executives would attach considerable importance to earnings isn't surprising, but it is sobering that a majority would admit to engaging in myopic behaviour in an effort to boost earnings and meet investors' expectations. That said, it's comforting that only a small minority say they would resort to using accounting discretion to meet benchmarks.

These findings raise interesting questions: Are executives' beliefs about the capital market implications of meeting earnings targets justified? And if the theory of finance is correct, does that mean management is focusing on the wrong performance measure? More on this topic next month...

© 2006 Institute of Chartered Accountants of British Columbia Provided by ProQuest LLC. All Rights Reserved.