Suppose you are a long-term investor in a stock. Management outperforms analysts' earnings expectations quarter after quarter. Which of these tactics seriously harms your interests?

I. Accrual earnings management (e.g., decreasing bad debt reserves to boost earnings)
II. Management tries to bias down analysts’ estimates with gloomy forecasts
III. Real earnings management (e.g., cut advertising expenses to boost earnings)

Question

Suppose you are a long-term investor in a stock. Management outperforms analysts' earnings expectations quarter after quarter. Which of these tactics seriously harms your interests?

I.    Accrual earnings management (e.g., decreasing bad debt reserves to boost earnings)
II.    Management tries to bias down analysts’ estimates with gloomy forecasts
III.    Real earnings management (e.g., cut advertising expenses to boost earnings)

BlackTom AI · Accepted Answer

The question asks which tactics seriously harm a long-term investor's interests when management consistently beats earnings expectations. We'll evaluate each option in turn.
Option I: Accrual earnings management (for example, decreasing bad debt reserves to boost earnings).
This tactic relies on accounting choices rather than actual cash performance. By reducing bad debt reserves, the company reports higher earnings without necessarily improving cash flow or long-term profitability. For a long-term investor, this can mislead about true operating performance and may signal earnings quality problems. Therefore, this option plausibly harms investor interests.
Option II: Management tries to bias down analysts’ estimates with gloomy forecasts.
If management repeatedly issues pessimistic guidance to push analyst estimates downward, it can depress stock price or valuations regardless of actual fundamentals, and may create a self-fulfilling prophecy. While the intention might be to set modest expectations, it can harm investors by reducing perceived upside, complicating capital-raising, and masking true performance. Thus, this tactic also harms investor interests, though the mechanism is more about expectations management than earnings manipulation per se.
Option III: Real earnings management (for example, cutting advertising expenses to boost earnings).
This involves manipulating operating decisions that affect cash flows and long-term competitiveness. Cutting advertising can boost short-term earnings by lowering expenses, but it reduces future revenue potential and market position. For a long-term investor, this undermines sustainable profitability and can harm value, so this tactic is a genuine harm.
Now, considering the combinations:
- If we examine I only: It identifies at least one tactic that harms investors, but ignores the others that may also harm, so it does not capture the full risk set.
- If we examine II only: This captures a form of earnings/valuation manipulation via guidance, which can harm investors, but it ignores accrual and real earnings management that also undermine value.
- If we examine I and III both: Both accrual manipulation and real earnings management affect reported earnings quality and long-term cash-generating ability, directly harming investors’ interests. This pairing covers two distinct but harmful practices.
- If we examine I, II and III: This includes all three tactics, recognizing that each can harm investors, though II is more about expectations management and signaling, which can still degrade investor trust and valuation in practice.
- If we examine III only: It identifies real earnings management, but ignores accrual-based manipulation and biasing forecasts, which can also be harmful.
In summary, the options differ in which tactics they include. The strongest and most comprehensive assessment of harm to a long-term investor would recognize that both accrual earnings management and real earnings management are harmful, and depending on interpretation, guidance bias (II) can also be harmful in terms of valuation and trust. Therefore, the candidate combinations that include I and III (with or without II) are the ones that align with significant harms, while those that exclude I or III would miss key harm sources.

IFEPIA7022_001_2025_3 - Economics of Finance EOF Final - Dec 16, 2025

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