Short-Termism and Financial Manipulation of Results: Causes, Effects and Remedies

It is the last week of the financial year. A divisional manager is ₦2 million short of the profit that triggers her annual bonus. She has three options: cut the training budget, delay the replacement of a worn machine until next year, or ask a customer to take an order early at a discount.

Each of these will lift this year’s profit and each will damage the business next year or the year after. Her bonus does not care. Performance systems that reward managers on the results of one year invite exactly this behaviour, which is called short-termism. A related, worse temptation is to move revenue and costs between years, or to classify costs so that the results look better than they are.

This topic explains what short-termism is, how it shows up, why it happens, the harm it does, the forms of financial manipulation of results, and what senior management can do about it through the design of targets, rewards and controls. It builds on the earlier topic on non-financial performance indicators, which are one of the remedies. The next topic covers sustainability and ESG performance measures.

Short-termism

What it is

Performance management systems are often used to reward managers: an annual bonus for keeping department costs below budget, or for the sales and marketing department exceeding the sales target. Bonus systems can encourage short-termism, which means taking measures that improve performance in the short term even though they are misleading or harmful to the business in the longer term.

It also arises from the thinking of managers and other stakeholders who emphasise strategies that give short-term returns, to the detriment of long-term value.

Forms and examples

• Deferring investment. A manager paid a bonus for keeping departmental costs within budget defers buying new equipment, so as to avoid the higher depreciation, even though the equipment would eventually improve output.
• Cutting discretionary spending on training, research and development, maintenance, advertising and staff development, which have a cost now and a benefit later.
• Selling at a loss to reach a target. Near the year end, with sales below budget and a bonus based on sales revenue, management offer a large quantity to a customer at a heavy discount, even though the sale loses money, in order to meet the target.
• Manipulating financial results, for example treating expenditure that should be an expense as a long-term asset (so that the cost is spread over years), moving revenue from one accounting period to another, delaying the recognition of expenses or losses, or pushing stock into distributors at the year end (channel stuffing). Window dressing means improving the appearance of year-end figures, such as cash or gearing, with temporary actions.
• Cutting quality or safety to lower cost.

Causes

• Reward systems linked to annual or quarterly results.
• Market pressure: the stress on quarterly earnings, a focus on the short-term share price, and the part played by institutional investors who want results to meet their own short-term objectives.
• Volatility in markets, which makes it tempting to concentrate on what can be controlled now.
• New technologies and the desire to reduce transaction costs and trading, which encourage short holding periods and quick returns.
• Weak governance and tolerant cultures, where results matter more than how they are obtained.

Harm and remedies

Problems caused by short-termism

• It rewards executives for short-term results, which leads them to take excessive short-term risks.
• It can damage corporate governance in listed companies, as pressure for results encourages manipulation.
• It slows growth: companies focused on the long term enjoy higher revenue growth, earnings and economic profit than those focused on the short term.
• It reduces investment, innovation and recruitment; companies emphasise bonuses and overtime instead of building the workforce.
• It weakens the ability to survive financial crises and downturns.
• It creates pressure over quarterly earnings and may lead to share buy-backs to lift short-term results.
• It neglects sustainability objectives.
• It misleads: results that are good because of cutting the future are not a guide to real performance.

What management can do

• Set targets linked to long-term success: growth in profits over several years, revenue from new and innovative products, return on capital over a project’s life.
• Reward the achievement of these targets, rather than (or as well as) short-term ones, for example by deferred bonuses, share-based pay that vests over several years, and clawback if results are later reversed.
• Use a balanced set of measures (the balanced scorecard and non-financial indicators) so that the effects of cutting training, quality or customer service show up early.
• Use appraisal of investments on a full-life basis (net present value), so that deferral of a worthwhile project is seen as a cost.
• Controls and ethics: independent review of unusual year-end transactions, consistent accounting policies, audit and a culture that rewards honesty; accountants should resist pressure to misstate results.
• Reduce the importance of single-year numbers in pay, and separate controllable from uncontrollable factors.

Telling short-termism from sound cost control

Not every cut or deferral is short-termist. Removing waste, stopping a project whose forecast cash flows no longer justify it, or postponing spending because the need has really gone are good management. The test is whether the action reduces long-term value while improving the measured result. Three questions help: does the spending have a future benefit that will be lost?

Is the main reason for the action the effect on this year’s measure or bonus? Would the decision be the same if the manager were rewarded on three years’ results? The management accountant has a duty to report figures honestly.

Where a superior asks for a year-end treatment that is not justified by the facts, such as capitalising a cost that is an expense, the accountant should refuse, explain the effect on the true result, and use the organisation’s procedures for raising concerns if pressure continues.

Layouts for testing short-term decisions

1. Short-term effect on this year’s profit and on the bonus.
2. Long-term cost: extra cost later, lost contribution, or lost net present value.
3. Net effect on the company.
4. Remedy: change of target, reward or control.

Money is in naira and each answer is rounded once, at the end.

Worked examples

1. Short-term effect. Depreciation of ₦2.4m is avoided this year, so costs look ₦2.4m better.
2. Net present value.
   4.2 × 3.7908 = ₦15.92m
   less 12 = ₦3.92m.
   The machine adds value.
3. Net effect. The company gives up inflows of ₦4.2m a year to save ₦2.4m of an accounting charge that is not cash. The deferral costs value, even though the accounts look better.

1. Loss on the sale.
   500 × (700 − 800) = ₦50,000 loss.
2. Bonus triggered. ₦400,000 paid.
3. Net effect. The company loses ₦50,000 on the sale and pays ₦400,000, a total cost of ₦450,000, and may also set a precedent for lower prices. The target rewards revenue, not profit.

1. Profit overstated this year.
   by 3.0 − 0.6 = ₦2.4m.
2. Later years carry a charge of ₦0.6m a year for work that was done and paid for in year one. The manipulation moves profit from the future into the present, and the asset is not real.

Expect variants: a case in which a bonus is just out of reach and the manager considers actions, a requirement to discuss ethical responsibilities of the accountant, and proposals for a better reward system.

Common mistakes

• Describing short-termism without examples from the case.
• Ignoring the manager’s incentive, which is the cause.
• Calling every cost cut short-termist. A cut that removes real waste is not.
• Omitting remedies, or naming only one.
• Missing the ethical point that manipulation of results is dishonest.
• Judging by accounting profit alone. Look at cash and net present value.

Quick revision

• Short-termism: short-term gains that harm the long term; caused by annual-result rewards and investor pressure.
• Forms: deferring investment, cutting discretionary spend, loss-making year-end sales, manipulating results.
• Remedies: long-term targets and rewards, balanced measures, full-life appraisal, controls and ethics.

How the marks are earned

• Identify the behaviour and its cause.
• Quantify the short- and long-term effects.
• Recommend remedies.

Practice questions

These are original questions, written in the style of the Skills examination. Work each one before you open the answer.

Recall check: multiple choice

Section B style: written questions

Model answers

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