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Curbing earnings manipulation

Incentive-based contracts can lead to earnings manipulation, but a new study co-authored by Professor Jan Bouwens of Cambridge Judge finds those risks can be reduced through “organisation identity” by managers.

Closeup view of accountant working at sunny office on laptop while sitting at wooden table.

Just weeks after appointing a new CEO in 2014, British retailer Tesco stunned financial markets by revealing it had overstated first-half results by £250 million, mostly “due to the accelerated recognition of commercial income and delayed accrual of costs.” The company’s shares plunged 11.5 per cent on the day, wiping out £2 billion in value.

Tesco said it had been alerted to the “serious issue” by an internal whistleblower. But many companies are not so fortunate to uncover creative accounting that can risk corporate reputation or worse.

Professor Jan Bouwens

Professor Jan Bouwens

Jan Bouwens, Professor of Management Accounting at Cambridge Judge Business School, has for many years studied this kind of earnings manipulation by company managers – sometimes to keep shareholders happy, but often because contractual bonus provisions can entice executives to enhance their own remuneration by disguising the firm’s economic performance.

“Incentive contracts are implemented ex-ante to motivate productive effort, but ex-post these contracts can elicit opportunistic accounting choices,” says Jan. “This includes shifting profits into a current period by postponing necessary expenditures, accelerating sales, or shifting funds between accounts.”

In fact, a 2005 study found that 80 per cent of chief financial officers surveyed indicated that they would delay research and development, advertising, and maintenance spending to achieve earnings benchmarks.

So what’s a company to do? Firms need to satisfy shareholders by meeting earnings forecasts and they are bound to honour contractual obligations to executives, yet they also need to do the right thing for the company and its long-term future.

A new study co-authored by Jan, published in the journal Accounting, Organizations and Society, concludes that “organisation identity” (OI) – identifying strongly with the firm – reduces the level of opportunistic earnings manipulation by managers.

“Given that most firms use incentive contracts, our results support the idea that it is possible to use incentives provided the firm implements strategies to ensure that individuals are committed to the firm,” the study says. “To the extent that incentive contracts prompt managers to take actions that benefit themselves but may be harmful for the firm, it would appear that OI curbs this incentive-induced behaviour.”

The study is based on the responses of 183 senior financial controllers in the Netherlands, with average firm size of 1,350 employees and a level of incentives representing 23 per cent of respondents’ average base salary.

For managers and people who design executive compensation schemes, the findings suggest that firms can create conditions that minimise manipulation by boosting organisation identity.

Such steps include investing in recruitment and socialisation processes that enhance the likelihood that managers identity with their firm. For example, online apparel retailer Zappos initiated a programme to observe the behaviour of candidates outside of the official interview programme – and candidates who treat rank-and-file workers disrespectfully are not hired. Accountancy firm PricewaterhouseCoopers sends its recruits for a week to Portugal for a programme designed to assure that there is a good fit between the appointee and the firm.

“When appointing executives, the firm can make sure that the objectives of the appointees match those of the firm,” says Jan. “This can translate into managers feeling bad when the firm is hit by bad news, and feeling personally complimented when someone makes positive remarks about the firm.”
Incentive-based contracts are not going away any time soon, and in fact they represent a calculated trade-off: firms use such bonus systems to seek higher achievement, while weighing the risk that their managers resort to manipulation.

“With these latest findings, we at least know that the firm can reduce this risk significantly by appointing managers who can demonstrate they truly care about the wellbeing of their firm,” says Jan.
The study – entitled “Organization identity and earnings manipulation” – is co-authored by Professor Margaret A. Abernethy of the University of Melbourne in Australia, Professor Jan Bouwens of Cambridge Judge Business School, and Dr Peter Kroos of the University of Amsterdam in the Netherlands.