When earnings are managed on a regular basis (i.e., quarter-to-quarter), owners can lose site of whether the company is truly performing to its expectations. When you force the bottom line to equal a pre-determined – often budgeted – amount, the company’s real value and any changes that occurred during the reporting period are either over or understated. This, in turn, can impact major decisions being made by the owners.
Managing earnings is more than just “cooking the books.” In a 2005 survey by Duke University of 401 financial executives, 80 percent said they would decrease value-creating activities such as research and development and marketing or would defer maintenance or hiring in order to meet earnings expectations.
One of the major differences between a privately-held and a public company (and, I would argue, a significant advantage) is that owners of closely-held companies are usually much more focused on the long-term than public company executives who have to report earnings each quarter. Closely-held companies are generally much more willing to make long-term investments that may temporarily reduce short-term earnings.
Public companies often suffer in making these decisions because they tend to be nervous about the potential hit to their share price. Take Amazon, for example. Its most recent quarterly earnings missed estimates by $1.02 per share, causing its share price to drop close to $100 per share (about 9.2 percent). While it had sales growth in excess of 20 percent compared to the prior year quarter, its profits took a major hit due to substantially increased investments in marketing, technology, and content costs. Most owners of Amazon’s shares took this news negatively and saw it as a reason to dispose of their shares. Yet if this was a privately-held company, the news would typically be seen as reflective of an owner who is very optimistic about the company’s future.
Managing earnings through accounting gimmicks inevitably catches up with you. In one quarter, you may need to increase sales $50,000 to meet budget; the next quarter it may be $100,000. Without real growth, the numbers just become too big to manipulate. We’ve seen how that can turn out; all you have to do is remember Enron.
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