An Investigation of Earnings Management Through Marketing Actions

Prior research hypothesizes managers use „real actions,‟ including the reduction of discretionary expenditures, to manage earnings to meet or beat key benchmarks. This paper examines this hypothesis by testing how different types of marketing expenditures are used to boost earnings for a durable commodity consumer product which can be easily stockpiled by end-consumers. Combining supermarket scanner data with firm-level financial data, we find evidence that differs from prior literature. Instead of reducing expenditures to boost earnings, soup manufacturers roughly double the frequency and change the mix of marketing promotions (price discounts, feature advertisements and aisle displays) at the fiscal quarter-end when they have greater incentive to boost earnings. 1 We thank the James M. Kilts Center, GSB, University of Chicago for data used in this study and also Dennis Chambers, Paul Healy, VG Narayanan, two anonymous referees and seminar participants at the Harvard Business School, the Massachusetts Institute of Technology, the London Business School Transatlantic Conference and the AAA FARS 2007 Conference for their helpful comments on the paper. 2 Kellogg School of Management, Northwestern University, [email protected] 3 Harvard Business School 2 Our results confirm managers‟ stated willingness to sacrifice long-term value in order to smooth earnings (Graham, Harvey and Rajgopal, 2005) and their stated preference to use real actions to boost earnings to meet different types of earnings benchmarks. We estimate that marketing actions can be used to boost quarterly net income by up to 5% depending on the depth and duration of promotion. However, there is a price to pay, with the cost in the following period being approximately 7.5% of quarterly net income. Finally, a unique aspect of the research setting allows tests of who is responsible for the earnings management. While firms appear unable to increase the frequency of aisle display promotions in the short run, they can reallocate these promotions within their portfolio of brands. Results show firms shifting display promotions away from smaller revenue brands toward larger ones following periods of poor financial performance. This indicates the behavior is determined by parties above brand managers in the firm. These findings are consistent with firms engaging in real earnings management and suggest the effects on subsequent reporting periods and competitor behavior are greater than previously documented.