Cooking the Books, Cooking the Planet

Earnings management is the anodyne term that describes the manipulation of financial reporting with the intent to misrepresent a firm’s underlying economic performance. Some view it as financial fraud; others a harmless act akin to driving down Highway 401 on a sunny day at 120 kilometres an hour. 

The motivation to manage earnings is clear: pressure to meet the expectations of securities analysts and shareholders and avoid a potential selloff of shares. The “victims” are less so: equity or bond investors, bankers, regulators or competitors who rely on financial statements to make decisions—groups not exactly naive to the ways of managerial discretion and financial reporting.

Long a source of debate, earnings management operates in an ethical grey zone. Defenders say accounting standards allow for managerial discretion in reporting earnings. Besides, when firms cut discretionary expenses, reduce research and development, tinker with depreciation rates or put off capital projects, all to meet earnings targets, aren’t they hurting themselves more than anyone else? 

“Most research to date has been about managing estimates of bad debt and that sort of thing,” says Michael Welker, Distinguished Professor of Accounting at Smith School of Business. “This has led people to think earnings management isn’t a big deal because there are no clear and identifiable victims. But now it’s getting darker.” 

Smoking gun 

How dark? Recently, studies have linked earnings management to higher workplace injury rates and corporate wage theft (when firms fail to pay employees for overtime or force them to under-report hours worked). Both hurt vulnerable employees. Now, a new study that Welker helped conduct found a smoking gun connecting earnings management to something else—air pollution.

For the study, Welker teamed up with Smith School of Business colleagues Ning Zhang, Commerce '83 Fellow of Accounting, and Zheng Liu, a doctoral student, as well as Hongtao Shen and Yang Zhao of Jinan University in China. 

The team had a hunch that pollution abatement costs are a prime target for struggling firms feeling pressure to come up with a positive earnings story. They had good reason: Most emission reduction expenditures are variable costs that can be cut by switching off abatement technology, such as sulphur dioxide scrubbers, and switching them to full power when inspections are imminent.

From a firm’s perspective, this is often a better alternative than cutting R&D or advertising, which could damage its long-term interests. By cutting pollution abatement expenses, it passes on the costs of a dirtier environment to the community in which it operates.

The Chinese experience 

But how to prove it? The research team focused its study on China, where there have been a variety of efforts to control sulphur dioxide emissions that cause acid rain and air pollution. They zeroed in on the market performance and environmental track record of a selection of publicly-traded Chinese manufacturers from 2003 to 2012. 

Getting the environmental emission data and financial analysts’ forecasts for these firms was straightforward. The bigger challenge was identifying those firms that felt pressure to engage in earnings management. The researchers couldn’t exactly be flies on the wall in manufacturers’ accounting offices. Fortunately, earlier research showed that firms just meeting analyst forecasts or exceeding them by a couple of cents are prime suspects for earnings manipulation. The researchers used this technique to find firms in their sample likely to engage in accounting legerdemain.

The analyzed data told a convincing story. Firms that just met or beat analyst earnings forecasts had higher-intensity sulphur dioxide emissions than firms not under earnings pressure. They released, on average, 0.26 kilograms more sulphur dioxide per 1,000 CNY (Chinese yuan renminbi) of output. The emission intensity during suspect years was 26.7 per cent higher than the average for emission-releasing establishments. The researchers estimated the cost savings from these additional emissions at between 0.4 and 1.4 cents per share.

The harmful effect of earnings management on sulphur dioxide emissions rose as environmental regulation and monitoring fell. In China, the environmental regulator is a local agency dependent on local government, which in turn depends on tax revenue from firms in its jurisdiction. The study found that firms that were key contributors to the local economy showed higher-intensity sulphur dioxide emissions. The same held true for state-owned enterprises aligned with the central government and protected from environmental monitoring and enforcement.

The opposite was also the case: Firms were much less likely to surreptitiously cut back on their abatement expenses when monitoring was tight and regulations were enforced. This was evident among firms in designated acid rain control zones and in cities that hosted the 2008 Beijing Summer Olympics, 2010 Shanghai World Expo and 2010 Guangzhou Asian Games. These were occasions when China increased environmental monitoring to burnish its image on the world stage. This was also evident among firms mandated to disclose data relating to corporate social responsibility. 

Who pays the cost?

Welker hopes to see more research done on the true cost of earnings management. He also wants capital market regulators to take note. “This is part of an increasingly disturbing pattern of what firms are doing when they find themselves in this situation,” he says. “These are savings for the firm but they’re not bearing the cost. It’s the population that lives around these factories that bears the costs.”

Investors and directors should take note as well. Research shows that companies with more long-term-oriented investors and CEOs with vested incentives that cannot be exercised in the short term are less likely to engage in this sort of financial sleight of hand.

In the larger picture, these research findings are a cautionary tale about capital markets oriented around short-term performance. Over the past decade, concern about short-termism has grown. This study is a sobering lesson about who really pays when firms obsessively primp for the next quarterly report.

The message seems to be getting through. The backlash to short-termism explains today’s calls for “stakeholder capitalism”, the popularity of ESG metrics and the openness to adopt new director roles, stewardship codes and loyalty shares. 

The new stream of earnings management research should add fuel to the fire. “Now that the genie is out of the bottle, people will look more and more at what firms are doing just to find a few pennies of earnings per share to meet earnings targets,” says Welker. “They’ll be asking if this is what we really want from our capital markets.”