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The use of advertising activities to meet earnings benchmarks: evidence from monthly data

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Abstract

Using a unique database of monthly media advertising spending, we examine whether managers engage in real earnings management to meet quarterly financial reporting benchmarks. We extend prior literature by (1) separately analyzing advertising activities, allowing us to explore the possibility that managers could reduce or boost advertising to meet benchmarks; (2) analyzing actual activities as opposed to inferring them from reported expenses, which are also subject to accrual choices; (3) investigating the timing, within a quarter, of altered advertising spending; and (4) examining quarterly earnings benchmarks. We find that managers, on average, reduce advertising spending to avoid losses and earnings decreases. However, we also report that firms in the late stages of their life cycle increase advertising to meet earnings benchmarks. Finally, we find some evidence that firms increase advertising in the third month of a fiscal quarter and in the fourth quarter to beat prior year’s earnings.

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Notes

  1. Chapman (2008) examines the pricing behavior of soup manufacturers utilizing a unique data set of supermarket price data. He finds some evidence of meeting earnings benchmarks through the provision of price promotions during the final month of the quarter.

  2. In the event that the altering of advertising activities does not get reflected in the financial statements in the current period, then one does not expect to find a relation between these advertising activities and financial reporting objectives. This correlation is expected to arise when managers alter their activities and anticipate that their actions would have a direct impact on reported expenses and financial results.

  3. The feasibility of altering advertising expenditures is also related to the organizational structure of the firm, the incentives provided to the marketing staff and the degree of control over the staff by the CEO.

  4. This is consistent with the definitions and interpretations of real earnings management in the accounting literature, as advanced recently by Graham et al. (2005) and Roychowdhury (2006).

  5. See the full transcript at http://internet.seekingalpha.com/article/3995.

  6. “Blockbuster began offering free in-store rentals to subscribers of online rival Netflix Inc. on Tuesday as it tries to take market share from Netflix and reach its year-end subscriber goal. Netflix subscribers can get one free rental at Blockbuster stores for each address label they bring in from their Netflix mailing envelopes. The offer to Netflix subscribers, which runs until December 21, comes after Blockbuster began allowing subscribers to its own online rental service to swap DVDs they received in the mail at Blockbuster stores. The program, called Total Access, highlights the main difference between the two competitive services: Blockbuster has stores where consumers can immediately satisfy a desire for a particular movie. Blockbuster forecasted that it will add about 500,000 subscribers in the current quarter, to reach its year-end goal of 2 million total subscribers.” (Financial Wire, December 6, 2006).

  7. See Assmus et al. (1984) and Bagwell (2007) for a review of this literature.

  8. Ideally we would like to empirically capture the life cycle of the product. However, we are limited by the fact that sample firms have multiple products, possibly in different life cycles. We assume that there is a positive correlation between a firm’s life cycle and its products’ average life cycle.

  9. Zang (2006) argues that there is a pecking order in the tradeoff between earnings management through real activities versus through accrual decisions. Specifically, managers exhaust the options for real earnings management before resorting to earnings management through accruals. In contrast, in our analysis we study the timing of real activities, which may occur before any accrual decisions are made.

  10. Since we use quarterly data we divide the top of the range defined in Roychowdhury (2006) of 0.005 by a scale of 4.

  11. See Appendix 2 for a detailed description of each media channel.

  12. We begin the sample construction with an initial screen in Compustat because the search of our proprietary database requires a manual input of firms and does not allow a restricted search based on the advertising number that is included in the database. As a result, we have to prepare a list of firms from an external source (Compustat) that will form our initial sample. A check of the data indicates that, by employing this cutoff, we include in our initial sample more than 95% of firms with non missing annual advertising expenses in Compustat.

  13. While this approach tries to minimize the measurement error in our dependent variable, it is certainly not free from such error. However, since this measurement error appears in our dependent variable, its only effect would be manifested in a lower R 2. Clearly, this is not likely to bias the inferences we draw based on the reported results.

  14. Since we capture only media-related advertising, and not all advertising activities, our results are also consistent with a shift from media spending to other advertising activities. However, we believe that such an interpretation is still consistent with real earnings management, under our maintained assumption that the “mix” of advertising activities was initially optimal.

  15. The results on the MBE variable are stronger when all observations are included in the analysis. The weaker results for MBE are consistent with the notion that managing real activities towards a moving benchmark, such as analysts’ forecasts, is inherently more difficult.

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Acknowledgments

We gratefully acknowledge the financial support of the Center for Research in Economics and Strategy at the Olin Business School. We have benefited from the comments of two anonymous referees, Eli Bartov, Anne Beatty, Messod Beneish, Larry Brown, Donal Byard, Sandra Chamberlain (FARS discussant), Masako Darrough, Richard Dietrich, Nick Dopuch, Peter Easton, Richard Frankel, James Hansen, Steve Huddart, Bjorn Jorgensen, April Klein, Andy Leone, Fred Lindahl, Thomas Lys, Christina Mashruwala, Shamin Mashruwala, Brian Miller, Doron Nissim, Shail Pandit, Sugata Roychowdhury, Kristi Schneck, Ram Venkataraman, Xin Wang, Joe Weber, TJ Wong, Minlei Yei (AAA discussant), Amy Zang (CFEA discussant), Paul Zarowin, Jerry Zimmerman, participants at the 2008 FARS conference, the 2008 AAA annual meeting, the 2007 Conference of Financial Economics and Accounting, the 2007 Nick Dopuch Conference, and workshop participants at University of Arizona, Baruch College, University of Chicago, Chinese University of Hong Kong, Columbia University, Georgia State University, George Mason University, George Washington University, IDC Herzliya, INSEAD, University of Illinois at Chicago, University of Illinois at Urbana-Champaign, University of Maryland, University of Miami, The Ohio State University, Penn State University, Southern Methodist University, Stanford University, University of Technology Sydney, and Washington University in St. Louis.

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Correspondence to Tzachi Zach.

Appendices

Appendix 1

Our database records advertising activities at the time they appear in a media outlet (for example, when they are aired on television or appear in print). According to Statement of Position (SOP) 93-7: Reporting on Advertising Costs, firms are required to expense advertising activities as they are incurred. Thus, if firms follow GAAP, our database will include all media-related advertising that should have been expensed in the period in which it was aired or printed.

The following paragraphs from SOP 93-7 describe the accounting treatment in detail:

1.1 Paragraph 26

The costs of advertising should be expensed either as incurred or the first time the advertising takes place… except for

  1. 1.

    Direct-response advertising (1) whose primary purpose is to elicit sales to customers who could be shown to have responded specifically to the advertising and (2) that results in probable future economic benefits.

  2. 2.

    Expenditures for advertising costs that are made subsequent to recognizing revenues related to those costs.

1.2 Paragraph 42

Advertising activities may have several component costs. Two primary components, which are made up of other components, are the costs of (a) producing advertisements, such as the costs of idea development, writing advertising copy, artwork, printing, audio and video crews, actors, and other costs, and (b) communicating advertisements that have been produced, such as the costs of magazine space, television airtime, billboard space, and distribution (postage stamps, for example).

1.3 Paragraph 43

Costs of producing advertising are incurred during production rather than when the advertising takes place.

1.4 Paragraph 44

Costs of communicating advertising are not incurred until the item or service has been received and should not be reported as expenses before the item or service has been received… For example

  • The costs of television airtime should not be reported as advertising expense before the airtime is used. Once it is used, the costs should be expensed, unless the airtime was used for direct-response advertising activities that meet the criteria for capitalization under this SOP.

  • The costs of magazine, directory, or other print media advertising space should not be reported as advertising expense before the space is used. Once it is used, the costs should be expensed, unless the space was used for direct-response advertising activities that meet the criteria for capitalization under this SOP.

Our database contains only media-related advertising that cannot be treated as direct-response advertising and therefore has to be expensed in the period of appearance.

Suppose that an advertisement appeared on television on January 15, 2007. This advertisement will be captured in our database. If the firm follows GAAP, the advertisement will appear as an expense in the financial statements for the quarter ending on March 31, 2007. Thus, our database captures all media-related advertising activities during the period in which they are supposed to be expensed in the income statement.

Appendix 2

This appendix describes the various media outlets from which the advertising data are collected.

2.1 Television

Cable television: Commercial occurrences and advertising activities information for 52 cable television networks. Cable television is monitored via satellite 24 hours a day, 365 days a year.

Spot television: Commercial occurrence and expenditure information for more than 600 English-speaking stations and 35 Spanish-speaking stations in 100 major markets. Spot television is monitored 21 hours a day (5 a.m.–2 a.m.). The monitored stations constitute the principal stations in each market and typically include the network affiliates, major independents, and Spanish affiliates. Public broadcasting stations are not monitored.

Network television: Commercial occurrence and expenditure information for seven broadcast networks: ABC, CBS, FOX, NBC, PAX/I, MNTV, and CW.

2.2 Print

Magazines: All paid advertising space and expenditure data in over 350 consumer magazines and over 30 local magazines.

Newspapers: All advertising space in over 250 daily and Sunday newspaper editions and Sunday magazines, including national newspapers such as The New York Times, USA Today, and The Wall Street Journal. In national newspapers, all national and regional editions are measured.

2.3 Radio

Local radio: Data are based on the tracking of radio billings by stations in more than 100 radio markets.

National spot radio: Nationally placed spot radio data for approximately 4,000 stations in more than 225 markets. Reported expenditures are based on audited billings from contract information provided by the following major national station representative organizations: ABC, Allied, Christal, Clear Channel, Cumulus, D&R, Infinity, Katz, KHM, Lotus, and McGavren.

2.4 Internet

Advertising expenditure information is measured for over 2,500 sites and 90,000 brands in the United States and Canada. A proprietary spider probes the sites on an ongoing basis and captures and stores every image on a page.

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Cohen, D., Mashruwala, R. & Zach, T. The use of advertising activities to meet earnings benchmarks: evidence from monthly data. Rev Account Stud 15, 808–832 (2010). https://doi.org/10.1007/s11142-009-9105-8

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