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newsobserver.com, Raleigh, NC Site Updated:  8:29 AM | TUESDAY, FEBRUARY 10, 2004 
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Tuesday, February 10, 2004 6:51AM EST

Executives cynical about earnings


By EMERY P. DALESIO, The Associated Press

DURHAM -- Three-quarters of business executives say they massage earnings reports to meet or beat Wall Street expectations and would sacrifice shareholder value to keep earnings sloping up smoothly, according to a survey released Monday.

The study of 401 senior financial executives by researchers at Duke University and the University of Washington found that 55 percent would delay starting a project to avoid missing an earnings target. Four out of five executives said they would defer maintenance and research spending to meet earnings targets.
The preference for smooth earnings growth instead of even slight variations is so strong that 78 percent of the surveyed executives would give up economic value in exchange, the study said.

"I was shocked by the honesty of the executives' responses. There was no cover-up -- they are telling it like it is," said Campbell R. Harvey, an international business professor at Duke.

Edward Ketz, an accounting professor at Penn State and author of the book "Hidden Financial Risk: Understanding Off-Balance Sheet Accounting," said the study was less a surprise than an indication of how cynically executives treat earnings reports.

"You wonder whether they're looking at the long-term effects of these things by making short-term decisions," Ketz said.

Karl J. Schulze, a former corporate chief financial officer and now head of the Los Angeles forensic accounting firm of Schulze Haynes, said that attitudes expressed in the survey are prevalent in the business world.

"Long-term shareholder value has traditionally been sacrificed for short-term earnings, especially since most executive compensation packages have been, and continue to be, weighted toward near-term performance rather than creation of long-term value," he said.

The executives responding to the study resort to managing earnings because they fear running afoul of the Sarbanes-Oxley Act, passed in 2002 after revelations that Enron manipulated earnings with accounting tricks, said Shiva Rajgopal of the University of Washington Business School in Seattle.

"They apparently prefer to use economic levers, such as deferring needed maintenance and delaying profitable investment projects," he said.

The researchers said the executives managed earnings targets because the stock market punishes even a small miss in earnings.

"As one CFO put it, everyone manages earnings to hit the target, so missing an earnings target is seen as an indicator of more widespread problems -- like seeing one cockroach, you know there are 100 behind the wall," said Duke finance professor John Graham, one of the study's co-authors.

In contrast, say the researchers, if a firm delivers stable earnings and meets or exceeds earnings targets, it builds credibility within the financial market, reduces the perceived risk of its stock and enhances the external reputation of the firm's management.

Executives say that many decisions are effectively forced on them by the market's myopic focus on earnings, researchers said. "Our interviews revealed that CFOs do not like the system, but they are forced to play the game or risk losing their jobs," Rajgopal said.






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