Under pressure to hit immediate performance targets, many managers inflate earnings, often by cutting expenditures. In a recent survey of 401 top financial executives, 80% said they would decrease spending on “discretionary” activities like marketing and R&D to meet short-term goals.1 But how discretionary can such spending be, given that cutbacks in these areas can have substantial negative effects on future performance? It’s true that this kind of shortsightedness may temporarily fool the stock market by giving the appearance of improved prospects. However, in our study following the financial performance of 2,859 companies over five years, firms that appeared to make short-term expense adjustments to inflate earnings when they issued equity ended up losing profits in the long run, causing their market value to drop by more than 20% four years out.
A version of this article appeared in the July–August 2007 issue of Harvard Business Review.