The Earnings Game: Everyone Plays, Nobody Wins

Introduction

It is all about the shares price. The shares market is so active and everybody wants to win in this game. In reality, nobody would want to become a loser. They try to think the best way to gain the advantage and win in this game. Unfortunately, the players in the game used questionable tactics in order to win the game.

All players are connected with each other and the winner will only goes to the player who able to control the game. Finally, who will be the loser? It could be the players itself or the outsiders e. g. the citizen who does not play the game. The dynamic share market could make the economy become gloomy and undesirable consequences will be occurs. Most of the companies involved in the earnings game where the companies have desire or have took actions to meet the analysts’ earnings per share predictions. The common players of this game include the companies themselves, analysts, investors, and accounting firms.

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There are many issues had been arise in the earnings game.

Issues and Analysis

Management

In order to meet the analysts’ expectation on the earnings per share, companies will use some tactics to distort their current earnings even those tactics may against the law or regulations. The tactics included: a) Channel Stuffing Channel Stuffing is a tactic where the companies borrow from future sales to increase current results by selling goods to customers who aren’t ready to buy yet. In order to attract buyers, the companies are willing to take the cost of storing the goods.

Sunbeam, consumer appliance maker is a company who use channel stuffing to boost its earnings in winter by selling millions of dollars’ worth of backyard grills to customers. The customers not really need the goods at that season and they are allowed to defer payment until the spring. b) Premature Revenue Recognition Premature revenue recognition means the companies recording a highly contingent transaction as a firm sale. For example, MicroStrategy, a web software developer recorded the expected revenue from software upgrades other than actual sales.

This is different from accrual revenue that allowed in accounting standard which the sales have been confirmed but the revenue has not been received yet. The software upgrades by customers are just an expectation of MicroStrategy. c) Unusual Structure For example, Boston Chicken has an unusual structure by which their hundreds of stores were owned by large regional franchisees called “financed area developers” or FAD. Boston Chicken lent money to FAD to start the business or open stores. After that, FAD recovered the funds in the form of fees, royalties and interest. Therefore, Boston Chicken earns more profits as the stores opened more.

However, the funds that they got back from FAD were not their real revenue.

Advantages

The advantages of doing these tactics are due to several factors. Firstly, they wanted to show a good result to the public especially those investors who are potential to invest in their companies. Therefore, they will either collaborate with accounting firms to show a good audit report, increase their sales by using future sales to replace current sales, communicate with analyst and so on. Regardless of ethical or unethical, what they want is to increase their earning per share (EPS) in order to attract investors.

As a result, it can be concluded that channel stuffing, premature revenue recognition and unusual structure have the similar effects to achieve their ultimate goal.

Disadvantages

For the disadvantages, each approach has different side effects if the method does not work. For channel stuffing, the future sales might be threatened if they cannot find replacement for it. They need to cover for the loan as soon as possible for everything they used this channel stuffing method. If they are failing to cover the loan, probably the person in charged might need to responsible for this matter thoroughly.

In the case, CEO of Sunbeam, “Chainsaw Dunlap”, lost his job and reputation due to channel stuffing. While, for premature revenue recognition, the action actually does not follow the accounting standard because the revenue is recognized before the transaction have been made or before it happens. For example, in the case, MicroStrategy has recorded their future revenue that they expected to collect from software upgrades. This action can cause the company to overstate their sales and it will affect the trueness and fairness of financial statement of the company.

Lastly, in order to enhance current earnings at the expenses of future earnings, the unusual structure system has been applied. For example, in the case, Boston Chicken actually acts like a financial institution that give loans for both its franchisees and area developers in order to open new stores. Boston Chicken only creates the impression that their operation is successful and profitable by opened many stores but in reality, the stores was never made any profit. The profits that they gain were not coming from selling chicken but coming from selling franchises.

Boston Chicken only wants to boost their Boston Market “concept” just to increase their earnings per share (EPS). At the end, the system collapsed and the company filed for bankruptcy protection because the company would not able to complete its restructuring plan due to company debt. 2. 0 STAKEHOLDERS There are two main stakeholders that involved in this case which are investors and analysts. All the creative activities that had been done by the management are to meet the expectation of the analysts and at the same time the investors.

Investors

There is an issue that the investors only depend on earning per share (EPS) as an indicator in making their investment decisions. All of them, no matter those who have the knowledge that EPS show almost nothing about the business’s health or those who know nothing, still follow the trend of relying on only EPS in making their investment decisions even though some of them may know it is unreasonable to do so. They will abandon those shares that could not achieve the quarterly expectation without referring other information. For them, EPS is the easy indicator to know whether the company is performing well or not.

However, EPS are not accurate and adequate indicator to show the performance of company because EPS can easily to be manipulated in the market to attract investors to look at the outstanding share of a company’s stock. The higher EPS, the more investors can be attracted. Although investors know that the investment is a very risky, they do not have intentions to look other than EPS. This situation can cause some of the investors gain more profit or vice versa.

Analysts

Analysts as the intermediaries only focus on the earnings estimates.

Furnishing correct earnings estimates is what analysts are paid to do. The accuracy of their forecasts would help analysts maximize compensation; gain reputation and ranking on various analysts and at the same time manage their workload. Therefore, they are more willing to focus on earning rather than analyze the other information of the company.

Ethical Issues

Most of the organization has been collapsed because of ethical issue practiced in the organization. Same goes to the company, if this ethical issue never had been settled, they will face the same situation like other company faced it before. .

Collaboration of company management and analyst Even though there is a regulation for fair disclosure, company management still finds a loophole to collaborate with analysts in influencing and manipulating their expectation or forecast value on share. Although it is not against the law, it is unethical for them to control and influence the stock market by collaborating under the table. It is unfair to the investors who seem to be the puppets controlled and influenced by others.

Auditors

Auditors stretch the regulation to keep the good relationships with the client.

Although the auditors know every creative actions and creative accounting of the companies, they still pretend do not know anything in order to retain their clients which contribute to their revenue. It is unethical for them to do so, although it may be legal for companies to do so, however, as auditors, they have the responsible to disclose any actions which may shaken the daily operation and going concern of the companies. RECOMMENDATION

Role of Analysts

Analysts should be independence and make the risk analysis without influences by the companies’ management team.

By providing accurate and sufficient information, investors are able to make their judgments based on their knowledge. An independence body should be established to govern the analysts in order to monitor the analysts and ready to take discipline action once misconduct happened.

Role of Companies

To include annual plan in quarter earnings report Since quarter earnings report is used as a reference to identify whether the company is doing well or not, companies should enclosed annual plan in the quarter earnings report.

This can provide a clearer view to the investors about the company’s plan in one year time. Investors also can understand deeply on how the company is doing besides put all their attentions on the earning per share (EPS) only.  To implement the shareholders forum Company should give a platform the shareholders to voice out their opinion. Shareholders would able to monitor the management and give opinion to the management actions.

Role of Auditors

An auditor should follow the code of conduct. As an independence body, an auditor should give true and fair view of the financial statements. .

Role of Investors

The investor should adequate them self with investment knowledge, where do not too depends on the EPS as an indicators. As an intelligent investor, they should prepare them self before they enter the game. For example, attend some investment course or self-learning through internet. The investor has to know how to analyze the financial statement which also indicates the prospective to the company. For example, the training, introducing a new product or investment in R&D will increase the company future value.

Means while, there will be a high probability of company default if there are high bad debts or contingency assets.

Conclusion

In a nutshell, as we know and also mentioned in the case, the only solution to stop this game is for all the companies willing to abandon it. Therefore, the recommendations we suggested involving all parties in this game to change their mindset and have a brand new start in the corporate world. Everyone plays their own parts ethically to make this world have a brighter future. With the cooperation of all parties, the “Earnings Game” will be game over as soon as possible.

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