Abstract
Much recent work in strategy and popular discussion suggests that an excessive focus on “managing the numbers” – delivering quarterly earnings at the expense of longer term investments – makes it difficult for firms to make the investments necessary to build competitive advantage. “Short termism” has been blamed for everything from the decline of the US automobile industry to the low penetration of techniques such as TQM and continuous improvement. Yet a vigorous tradition in the accounting literature establishes that firms routinely sacrifice long-term investment to manage earnings and are rewarded for doing so. This paper presents a model that can reconcile these apparently contradictory perspectives. We show that if the source of long-term advantage is modeled as a stock of capability that accumulates gradually over time, a firm’s proclivity to manage short-term earnings at the expense of long-term investment can have very different consequences depending on whether the firm’s capability is close to a critical “tipping threshold”. When the firm operates above this threshold, managing earnings smooths revenue with few long-term consequences. Below it, managing earnings can tip the firm into a vicious cycle of accelerating decline. Our results have important implications for understanding managerial incentives and the internal processes that lead to sustained advantage.
Highlights
There is little doubt that the desire for smooth, reliable earnings has a significant effect on managerial behavior
Research within the finance and accounting literatures finds that managers do sacrifice long-term investments in response to pressure from the capital markets
Benner (2007; 2010) has further suggested that firms going through significant technological transitions face intense pressure from analysts, causing them to reduce capital investment and investment in R&D. Does such a focus on short-term results detract from overall firm performance? Despite the ubiquity of this practice, both popular opinion and the available data remain decidedly mixed and the strategy literature takes a distinctly different perspective from that which dominates the finance and accounting literatures
Summary
There is little doubt that the desire for smooth, reliable earnings has a significant effect on managerial behavior. Research within the finance and accounting literatures finds that managers do sacrifice (at least some) long-term investments in response to pressure from the capital markets. Benner (2007; 2010) has further suggested that firms going through significant technological transitions face intense pressure from analysts, causing them to reduce capital investment and investment in R&D. Graham et al.’s, (2005) large-scale qualitative study of CFOs and CEOs finds that 78% of the managers surveyed admit to forgoing some long-term value in favor of smoother earnings. Does such a focus on short-term results detract from overall firm performance? Does such a focus on short-term results detract from overall firm performance? Despite the ubiquity of this practice, both popular opinion and the available data remain decidedly mixed and the strategy literature takes a distinctly different perspective from that which dominates the finance and accounting literatures
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