Group seeks end to short-sighted focus on meeting quarterly targets
NEW YORK » The gaming of company earnings is so widespread and pervasive, it has created a condition known as "the cockroach effect." When a company that usually meets earnings estimates misses a quarterly target by a penny, the stock gets creamed. The reason: Investors assume it used every trick in the accounting rule book to get that close, yet still failed.
"If you're managing earnings, and you miss by a penny, there must be a lot there," said Jeffrey J. Diermeier, president and chief executive officer of the CFA Institute. Just as seeing one cockroach is a sign many more are lurking, since accounting tweaks seldom travel alone.
The CFA Centre for Financial Market Integrity and the Business Roundtable Institute for Corporate Ethics on Monday issued a set of recommendations crafted to end what they call "short-termism," one symptom of which is the boosting and busting of a stock based on its quarterly earnings.
The day traders of the last decade may be gone, but the minute-by-minute mentality has lasted: TVs at corporate headquarters show second-by-second ticks of the company's stock price, institutional money piles in or pulls out of a stock based on the news of the day. And management gets so caught up in quarterly numbers, it neglects the long term.
Consider: In a 2005 survey of more than 400 financial executives, 80 percent of the respondents said they would decrease discretionary spending on such areas as research and development, advertising, maintenance, and hiring to meet short-term earnings targets, and more than 50 percent said they would delay new projects, even if it meant sacrifices in value creation, according to the Journal of Accounting and Economics.
The organizations' boldest suggestion is an end to quarterly earnings estimates. Instead, they'd like to see companies provide more meaningful, and potentially more frequent, communications about strategy and long-term vision, including more transparent financial reporting that reflects a company's operations.
Some companies have already jumped off the quarterly treadmill. Progressive Casualty Insurance Co. provides ratios that effectively give investors the company's current operating margin, a disclosure that has lessened stock market reaction to any one announcement.
Emerson Electric Co.'s monthly filings give the rolling three-month average of orders for its five operating segments and the entire company. The company puts out an earnings forecast at the beginning of the year and updates it as events warrant.
"We don't do quarters," Washington Post Co. Chairman and CEO Donald E. Graham said in a 2004 speech. "Quarterly earnings are not in the top 100 things you should care about if you want to value the company. ... If you care about that sort of thing, you shouldn't own our stock."
There are other ways to break the short term cycle:
» The organizations are working on a recommendation for a model earnings release, which would standardize earnings reporting. It would contain the company's actual earnings under Generally Accepted Accounting Principles (GAAP), a summary balance sheet and a summary cash flow statement.
This is a needed change because, especially after the technology bubble burst, many of the companies involved padded their press releases with a thick layer of spin. Readers wanting to know if the company made any money for the quarter were left to read until page 17 to find out.
» Because earnings numbers include so many estimates, giving a company so much wriggle room, former Securities and Exchange Chairman William Donaldson suggested companies release a range representing quarterly earnings and report what assumptions they used to reach those numbers.
"The flexibility, the assumptions you can make within GAAP make it (quarterly earnings) meaningless," Donaldson said.
"It's almost ridiculous to think of measuring something down to a penny."
» News organizations can do their bit. Business desks devote hundreds of work hours each quarter to coverage of earnings releases by companies, but very few editors ask reporters to read the more detailed quarterly filings companies make afterward with the SEC. Those filings include the assumptions the companies made, which may have made all the difference in meeting its earnings targets. Did it change the assumed return on its pension? Did it switch how it accounts for depreciation?
As John C. Bogle, founder and former CEO of the Vanguard Group, said "the role of management should not be beating abstract numeric estimates but improving the operations and long-term prospects of organizations."