As the quarterly earnings season for the second quarter of 2010 gets underway, investors, analysts and the media will be watching to see how well public companies are emerging from the economic downturn, and what that might mean for the stock market. With unemployment rates still high and federal measures of economic growth shaky, observers are hoping for earnings numbers that reaffirm signs of a recovery.

“Last year, every earnings announcement was a record loss. People understood that because it was a really bad time. Companies wouldn’t necessarily want to come out with a record loss this year because people are expecting to see some improvement and expectations will be ratcheting up somewhat,” says Wharton accounting professor Brian Bushee. “But earnings are always about the target; it’s not as much what did you do in the same quarter last year, as what are analysts and investors expecting this quarter and did you meet that number.”

While most experts agree that a single-minded focus on the short term can cause negative consequences for companies, they also suggest that blaming the earnings reports themselves is like shooting the messenger. Although the system of quarterly earnings might be broken, fixing it is no easy matter and might create even more pressure to produce immediate results.

“Providing less information to the investors makes managers unaccountable. By the time investors realize that something [problematic] is happening in a firm, it’s probably too late,” notes Wharton accounting professor Karthik Balakrishnan. “In that sense, more information is always better…. This is assuming, however, that the information can be perfectly given to investors. In the world of imprecise information where we live, [however,] it’s a little different. You then have to think about the trade-off between providing frequent imprecise information and [producing] infrequent precise information.”

‘An Outcome, Not A Strategy’

Former General Electric CEO Jack Welch generated plenty of talk and Internet traffic in March when he was quoted in the Financial Times describing the business world’s emphasis on shareholder value as “misplaced.”

In a follow-up interview published in Businessweek, Welch called shareholder value “an outcome — not a strategy,” and noted that a focus only on the short term doesn’t energize or motivate employees to deliver tangible results. “Any fool can deliver in the short term by squeezing, squeezing, squeezing. Similarly, just about anyone can lie back and dream, saying ‘Come see me in several years; I’m working on our long-term strategy.’ Neither one of these approaches will deliver sustained shareholder value. You have to do both.”

One contributor to the pressure to deliver in the short term is quarterly earnings reports — and real and perceived consequences that come from failure to meet targets and surpass estimates. In recent years, companies like Coca-Cola, McDonald’s and AT&T ended their practice of providing earnings guidance, stating that they detract from creating a sustainable company for the long term.

The recession, and worries about the continued weakness of the economy, have caused company earnings to be scrutinized more closely, and made it harder for firms to hide their inadequacies, notes Wharton finance professor Alex Edmans. “If there’s a boom, and every firm in your industry is going up by 10% and you’re going up by 8%, you’re underperforming, but the investors are still quite happy because you’re still delivering a return. In a recession, if everyone is going down by 3% and you’re going down by 5% it’s different. It’s still a difference, but it means more in a down time because investors are actually losing money and the company has more to cover up.”

Investors also tend to seek more information from companies during down times because they want reassurance that the firm isn’t going to go under, states Wharton management professor Michael Useem. Last year, Useem conducted interviews with a group of sitting or recently retired CEOs to see how they altered their managerial style as a result of the recession. Most of the managers said they spent more time talking with investors, analysts and their boards of directors, and provided a greater amount of information about the company’s health in an effort to show they were “taking the right steps to get through the crisis.”

During times of “relatively steady growth or relatively steady decline, quarterly results are more predictable and less informative,” he adds. “When change is afoot — and at the moment, many people are hopeful that positive change is indeed coming — then quarter-by-quarter comparisons do become more significant. The job of equity analysts and investors is to track, and then predict, where a company is going to be a year out. A two- or three-quarter trend line can be very significant in making that forecast.”

Accounting Tricks vs. Real Cuts

Earnings reports provide a level of transparency to the public, but observers note that, as a true picture of how a company is doing, they should be taken with a grain of salt. Managers can make operating decisions, such as offering a discount on their products or services, to increase sales as a quarter draws to a close. A company can cut back on staffing or delay a R&D development project to minimize expenses. Accounting changes or tricks can be used to manipulate the numbers. Or businesses can attempt to change their earnings target, walking analysts’ expectations down to a number they can meet or beat. Managers also carefully construct the reports themselves, often burying any information that paints a less than rosy picture of the company’s health.

If a company cuts back on R&D while a competitor invests heavily in that area, the short-term reward could be swallowed by a lack of innovative new products in the long term. Furthermore, when investors begin to feel that they can’t trust earnings numbers, “you see a discount in the stock price,” says Shivaram Rajgopal, an accounting professor at Emory University who has authored several studies on financial reporting. Managers know investors will react negatively if there is too much manipulation of earnings numbers, so they have incentives not to let the tinkering get out of hand. “That’s why we observe that managers don’t manage earnings as much through [accounting] as through real actions, meaning cutting R&D or cutting maintenance,” Rajgopal adds. Real cuts, rather than manipulations of the numbers, are less likely to attract the attention of auditors, but they are also more likely to significantly impact the business.

Most companies either just meet analysts’ earnings targets or fall far short, Edmans points out. “It’s of prime importance for managers to meet their earnings, and they have all these ways of cutting investments or changing accounting policies to enable them to meet the target. If you miss the target, even though you had all these tools available to meet it, it means [the company] must have huge problems. That’s why you get a huge whammy if you miss it. Missing it doesn’t just mean things are bad; it means things must be really bad.”

The pressure to meet earnings expectations comes from internal and external forces. CFOs and other managers have to meet the often contradictory demands of different types of investors, satisfy analysts and ensure a positive portrayal from the media. “Hedge funds have become actively involved in the management of firms, and hedge funds are concerned about short terms…. They want a company to meet its earning target because if it doesn’t, the stock price is going to go down. If you’re a long-term investor, like a university endowment, you don’t mind if the stock price misses its target because it’s going to go up later,” Edmans notes. “The emphasis on disclosure has also become greater, in light of corporate scandals. Maybe previously, if someone delivered low earnings, you might think twice about investing. Now you think the [manager is] a crook, [that he or she is] stealing.”

Earnings can have an effect on stock price, and both numbers not only provide a window into a company’s health but also affect executives’ compensation and job security. “When you think about it, it’s not the fact that you have to give the information, it’s more the fact that [managers] are under pressure to keep the stock price high because that’s linked with their compensation,” Balakrishnan says. “Incentives have a definite impact on the quality of the reports. There is a ton of research that has shown that CEO incentives play a key role in firms’ reporting quality, the mode of information and the way that they disclose.”

A 2005 study co-authored by Emory’s Rajgopal, which included a survey of 401 financial executives and in-depth interviews with an additional 20, found that most CFOs believe earnings are the key metric that outsiders use to judge a company’s health. Three-fourths of the managers said that they would make sacrifices in economic value in exchange for smooth earnings. The majority would delay a positive long-term project if it meant falling short on a quarterly earnings target. “These classic labor models assume that managers have a long horizon, that if they indulge in value-destroying actions, the market finds out eventually and their future wages get cut,” Rajgopal states. “That’s just sort of baloney. These guys don’t have a long horizon; they’re just thinking about maybe the next two or three quarters.”

He compared managers’ focus on earnings to students who are primarily motivated by grades. “If I were to publish your grades so that everybody knew how well you did on this exam or quiz, you would be even more grade obsessed than you already are. [Managers] perceive [earnings] to be a scorecard of their performance. [The report is] published every quarter, it’s very visible, the press spends a lot of time worrying about did they meet or beat this expectation, and there’s lots of chatter on the Internet about the stock. If they consistently fail to deliver expectations, they are just seen as incompetent managers. That has real consequences for their pocketbooks.”

Even without compensation or stock price as motivation, human beings naturally tend to work harder when they are very close to meeting a goal, notes Wharton operations and information management professor Maurice Schweitzer. “They work harder in both constructive and unethical ways. They begin to feel as if, because I’m almost there, the benefit of squeezing out higher productivity one way or another is higher.” What managers think is important filters down into a company’s culture as a whole; Schweitzer warns that leaders must make sure they are motivated by the right objectives, “which very often are the long-term objectives.

“You hear stories about the Enron culture and how it was very competitive, very cutthroat and very short-sided, and rewarded individuals for being very productive in the short run. I think that’s a recipe for disaster,” he adds. “One of the key managerial challenges is making sure you’re rewarding and measuring the complete set of objectives that you have. Managers need to be constantly mindful of putting too much emphasis on one dimension of a multi-faceted outcome.”

Schweitzer suggests that Coca-Cola and other companies that stopped or scaled back earnings guidance “sent a message throughout the organization that they’re not focused on the short term profit…. There are many companies that have gone private to avoid that short-term pressure and focus on long-term objectives, although that’s a more extreme and expensive approach.”

But Rajgopal argues that firms that have stopped issuing guidance might be motivated by other concerns. According to a 2010 study he co-authored, firms were more likely to commit to a policy of non-disclosure if managers were more certain that they would have bad news to report in the future. Those firms also tended to have a larger percentage of long-term investors. “[Managers] say earnings guidance is bad and it makes us myopic, but if you look closely at those companies, the big message there is just performance; they’re not doing well so it’s hard for them to forecast anything,” Rajgopal says. “The rationale for them is not to forecast anything…. If you’re not able to meet the target, you’re seen as a bad manager or a bad forecaster.”

If Not Earnings Reports, What?

In the end, the short-term demand to produce is not necessarily a bad thing, Bushee adds. “All managers would tell you it would be great if we had long-term, stable investors who just left us alone to run the company, which sounds nice if you trust that management is going to maximize shareholder value in the long run,” he says. “Having short-term pressure is a good thing because it forces managers to focus on the company. They’re facing constant pressure to perform. If you didn’t have constant pressure, you could invest for the long-term, but you could also slack off without as much short-term penalty.”

If earnings reports were jettisoned, the question becomes what system would take their place. One option is to change the frequency by which companies provide information — either by asking executives to provide more frequent, or less frequent, updates. Both options are potentially problematic, Bushee suggests.

Technology makes it possible for CFOs to aggregate earnings and other performance numbers on a daily or weekly basis, but “that would be too much information for investors and analysts to process and too much for managers to try to explain if there’s an odd day,” Bushee notes, adding that less information might also create more unpredictability in the market. “Think about if General Motors only announced financial results once a year. That would mean the rest of the year, there is the potential for more volatility in the stock price because it’s all based on rumors, speculation and inside gossip. Nobody would have any facts to use in valuation models until we got to the end of the year. So the quarter is a nice balance between giving us timely information about how the company is doing, and not giving us too much information to process.”

Although some have suggested that a switch to the European model of corporate governance, which focuses on a broader set of stakeholders, would end such practices as cuts to staff or R&D for the sake of earnings and stock price, Rajgopal emphasizes that this approach is not necessarily better. “The stakeholder business has its own problems because, who are you really trying to work for?” he says. “At least here you have one goal and that is to maximize stock price. If you’re trying to maximize the welfare of employees, communities and other stakeholders, many of those things are contradictory.”

In the end, every firm has to decide on its own what the optimal level of communication is and whether that includes giving earnings guidance, Balakrishnan states. “We have to take a step back and see mandatory reporting, which requires managers to file information about the past quarter, as separate from earnings guidance numbers, which is a manager’s view about what they will make in the next quarter. In one case — the earnings report — the information is precise, and so there should be no reason why we should try to put any blame on that report. With earnings guidance, it’s a voluntary disclosure by a manager, and managers have to make that call based on the information they have, what they want to convey, how much they want to convey and when they want to convey it.”

Any policy intervention related to earnings would have to “look at all of the interlocking jigsaw pieces,” including managers, investors and analysts, Edmans says. “The earnings targets in and of themselves are not bad things, but if people rely on them too much and think, ‘Oh, we can just observe the earnings announcement and we don’t need to actually monitor the company,’ then that’s when it becomes bad.” What observers should do instead, Edmans adds, is take a page out of the playbook of a sports team manager. “If you want to assess a baseball player or a soccer player, you could only look at a player’s stats … but that’s not what you would do in reality. In reality, you send scouts to watch the person actually playing and to capture some of the elements of play [that] are not captured in stats.”