Real Earnings Management in Sales

• Author: MICHAEL J. AHEARNE,CRAIG J. CHAPMAN,THOMAS J. STEENBURGH,JEFFREY P. BOICHUK
• DOI: http://doi.org/10.1111/1475-679X.12134
• Published date: 01 December 2016
• Date: 01 December 2016

DOI: 10.1111/1475-679X.12134

Journal of Accounting Research

Vol. 54 No. 5 December 2016

Printed in U.S.A.

Real Earnings Management in Sales

MICHAEL J. AHEARNE,

∗JEFFREY P. BOICHUK,

†

CRAIG J. CHAPMAN,

‡AND THOMAS J. STEENBURGH

§

Received 3 January 2013; accepted 28 June 2016

ABSTRACT

We surveyed 1,638 sales executives across 40 countries regarding their compa-

nies’ likelihood of asking sales to perform real earnings management (REM)

actions when earnings pressure exists. Using this information, which we re-

fer to as companies’ REM propensities, we study how company characteris-

tics and environmental conditions relate to the responses received. The use

of cash-flow incentives for sales personnel and the distribution of interfunc-

tional power in favor of finance rather than sales are both associated with

companies’ REM propensities. In addition, we show that sales executives pre-

emptively change their behaviors in anticipation of top management’s REM

requests. Sales executives working for public companies and companies in

the United States reported higher levels of REM propensity. The data also

support an association between REM propensity and finance–sales conflict.

These findings and others are compared and contrasted with existing empir-

ical and survey-based research on REM throughout the paper.

JEL codes: M11; M12; M16; M40; M41; M52

Keywords: financial accounting; disclosure; incentives; transparency; earn-

ings management

∗University of Houston; †McIntire School of Commerce, University of Virginia; ‡Kellogg

School of Management; §Darden School of Business, University of Virginia.

Accepted by Christian Leuz. The authors are grateful for comments from seminar partic-

ipants at University of North Carolina, Charlotte, Temple University, and the 2013 Midyear

Meeting of the AAA Financial Accounting and Reporting Section. The authors gratefully ac-

knowledge the support of the Strategic Account Management Association, the Institute for the

Study of Business Markets, the Sales Education Foundation, Northwestern University,Har vard

University, McIntire School of Commerce, Darden School of Business, and the Sales Excel-

lence Institute at the University of Houston.

1233

Copyright C, University of Chicago on behalf of the Accounting Research Center,2016

1234 M.J.AHEARNE,J.P.BOICHUK,C.J.CHAPMAN,AND T.J.STEENBURGH

1. Introduction

When executives need to boost reported earnings to meet targets, they

may choose to defer discretionary expenses or accelerate revenues, prac-

tices that are termed real earnings management (REM) in the literature

(Schipper [1989], DeGeorge, Patel, and Zeckhauser [1999], Roychowd-

hury [2006]). For example, to avoid an unfavorable earnings realization,

top management teams may ask sales to reduce business travel, cut training

expenses, raise prices, and push product. Researchers to date have pre-

dominantly used proxies derived from financial statements to estimate the

extent to which companies engage in such actions (e.g., Healy and Wahlen

[1999], Gunny [2005, 2010], Cohen and Zarowin [2010], Zang [2012], Co-

hen et al. [2015], Kothari, Mizik, and Roychowdhury [2016]).

Our results stem from a survey distributed to the Strategic Account Man-

agement Association (SAMA) membership community, a population that

oversees the programs that companies use to manage their most impor-

tant customer relationships. With the survey, we capture how likely respon-

dents’ companies are to ask their sales personnel to perform various REM

actions when earnings pressure exists. This setup allows us to study REM

at a granular level and to focus on companies’ reactions to earnings pres-

sure. We refer to a respondent’s average response to these questions as his

or her company’s REM propensity, defined as the likelihood that a company

will ask its sales personnel to perform REM actions when earnings pres-

sure exists. With this measure, we further study how REM propensity relates

to company characteristics, environmental conditions, and anticipatory ac-

tions on the part of sales leadership teams that potentially undermine the

REM requests from upper-level management. These anticipatory actions

occur when sales leaders front-load activity and pre-spend budgets so that

allocated funds cannot be taken back in the fourth quarter.

More specifically, we address the following questions in this research: (1)

How does the use of cash-flow incentives for sales personnel and the bal-

ance of power between finance and sales affect a company’s REM propen-

sity? (2) Which members of the top management team make REM requests

of sales leaders? (3) Are sales leaders more likely to adjust their behavior

when REM propensity is high, potentially undermining companies’ abilities

to implement REM? We complement these inquiries with additional analy-

ses that involve archival data from CRSP and Compustat. For example, we

compare our survey measure of REM propensity to REM proxies used in

prior research and examine the relationship between REM propensity and

stock market returns. Since our REM propensity measure is hypothetical in

nature, these two analyses require the assumption that earnings pressure is

fairly pervasive and commonplace in any year.

We find that companies have a greater propensity to engage in REM

when: (1) sales personnel receive cash-flow incentives, (2) finance func-

tions make REM-related decisions, (3) companies are publicly traded, and

(4) operations are conducted in the United States. Our results also suggest

REAL EARNINGS MANAGEMENT IN SALES 1235

that sales leadership teams in companies with higher REM propensities are

more likely to engage in anticipatory actions—such as prepays designed

to thwart pressure—and that REM propensity is associated with finance–

sales conflict in the fourth quarters of fiscal years. We also provide some

evidence of an association between companies’ REM propensities and neg-

ative returns on the stock market. In a majority of cases, these findings are

robust to the inclusion of controls for competitive intensity, meet-or-beat

earnings targets, and financial distress.

This research complements and extends prior work by identifying how

top management teams use their discretion to manipulate reported finan-

cials for the purpose of meeting earnings targets. Note that this focus is

related to a broader link between external capital market pressures and

operating decisions within companies. Having positioned our paper in this

fashion, we explicitly acknowledge that even though some of the actions

we study could be considered artificial and could result in superficial im-

provements to companies’ performance, not all of the actions we study are

negative, opportunistic, nefarious, or value destructive.

We intend to contribute to the accounting literature in three ways. First,

our work adds to a small but growing literature that uses surveys to address

questions about REM that cannot be adequately addressed with archival

data alone.1For example, our survey allows us to highlight that REM

requests are associated with increased conflict between groups within a

company—an often-overlooked consequence of REM. It also allows us to

show that sales leaders working for companies with higher REM propensi-

ties are more likely to preemptively mitigate the potential impact of REM

on their day-to-day operations and client relationships. That is, we show

that a company’s REM propensity is positively associated with sales leaders’

likelihood of engaging in a wide range of anticipatory actions, such as front-

loading customer-related travel expenses and prepaying for discretionary

expenses in anticipation of fourth-quarter REM requests.

Second, we study relationships between incentive structures and cross-

functional relationships on one hand and REM propensity on the other.

Prior research has investigated how various forms of incentives relate

to earnings management (e.g., Healy [1985], Jones [1991], Cheng and

Warfield [2005], Bergstresser and Philippon [2006]), but this paper pro-

vides the first research findings, to our knowledge, that link the use of

cash-flow incentives for sales personnel with a greater likelihood of REM

during times of earnings pressure. Our results also suggest that the finance–

sales interface partially determines the likelihood that REM actions will be

1These include Bruns and Merchant [1990], a study of 13 different earnings-management

situations; Dichev et al. [2013], a study of leading executives (primarily CFOs) on earnings

quality; Graham, Harvey, and Rajgopal [2005], a study of 400 executives to determine the

factors that drive reported earnings and disclosure decisions; and Nelson, Elliot, and Tarpley

[2002], a study of auditors and their experiences with clients who they believed were attempt-

ing to manage earnings.