Ebook Manager Incentives for Channel Stuffing with Market-based Compensation
Operations management research usually assumes that the interests of firms’ decision makers are perfectly aligned with the interests of the firm. This however may not be the case in practice. For example, public firms are owned by shareholders but are run by their managers (CEOs and senior executives). The managers’ decisions are also motivated by the compensation they receive. The latter is typically tied to the firm’s performance measures, such as stock market prices. According to Morgenson (1998), in 1997, the 200 largest U.S. firms reserved more than 13% of their common stock for compensation awards to managers. If the stock price perfectly reflects the firm’s value, a compensation based on the stock price would perfectly align the manager’s decisions with the firm’s value. Unfortunately, that is not always the case. Managers have better information about the firm’s internal operating environment. In practice, the most common way for investors to retrieve information about a firm’s performance is through financial reports. As these reports indirectly impact the managers’ compensation, it is not surprising that managers may have incentives to intentionally manage the operation to influence the reports. For example, managers may be tempted to sell excess units of inventory and report higher sales in order to obtain a favorable short-term capital market reaction, even if it is costly for the firm in the long run. This is known as “channel stuffing.” In the notorious case of Coca-Cola’s channel stuffing between 1997 and 1999, Coca-Cola offered downstream bottlers extended credit terms to induce them to purchase more than demanded, which turned into inventory at the bottlers’ places. These “padded” sales enhanced the firm’s capital market performance in those years, but, damaged the firm’s value in the long run.
Managers in private firms may have channel stuffing incentives too. Channel stuffing is observed for private firms contemplating IPOs, since firms are tempted to influence the market price upward by boosting their sales revenues. In general, when the compensation of a manager is contingent on the assessment of the firm’s value by external parties, such as potential investors, non-managing shareholders, debt holders, etc., the manager may be tempted to pad the sales to influence the external assessment. For convenience, in the remaining of the paper, we refer to all of those external parties that may potentially value the firm as “investors.” Similarly, we refer to the valuation of the firm by the external parties as the “market price” of the firm, and the manager’s compensation contingent on the external valuation as the “market-based compensation.”
Channel stuffing is a form of “real earnings management,” in which managers distort “real” operations to influence the reported performance. In contrast, “accrual-based earnings management” involves management of discretionary accruals or creative accounting to influence the financial reports and may leave operational decisions untouched. The most famous examples of accrual-based earnings management include the cases of Enron and WorldCom, which directly led to the passage of the Sarbanes-Oxley Act (SOX) in 2002. As real earnings management is more difficult to detect by auditors or regulators, it significantly increased after the passage of SOX, while accrual-based earnings management decreased (Cohen et al. 2008). Hence, there is a pressing need to understand the determinants of real earnings management such as channel stuffing.
To evaluate a firm, rational investors must correctly interpret the performance report provided by the manager, taking the manager’s channel stuffing incentives into account. As the manager’s compensation depends on the market price of the firm, the rational manager will also anticipate how the market price will be influenced by channel stuffing activities. Hence, the manager’s channel stuffing activities and the firm’s market valuation need to be determined simultaneously. To the best of our knowledge, no theoretical study has jointly examined channel stuffing, performance report and firm market valuation.
In this paper, we develop a model that helps us to understand the key determinants of channel stuffing. To that end, we analyze a firm’s two-period inventory management problem with positively correlated demands. The demands are stochastic and must be satisfied from inventory. The firm is run by a self interested manager. The manager’s payoff partially depends upon the market price of the firm and partially depends on the long-term value of the firm. The relative weights of both components of the manager’s payoff are exogenously given. We consider a typical source of information asymmetry: The investors only know the demand distribution but do not observe the realized real demand, while the manager privately observes the real demand. If there is excess inventory beyond the real demand, the manager may pad additional sales through downstream parties, which is costly in the long run, and recognize the revenue immediately in the firm’s accounting books. The manager then reports the (possibly padded) sales revenue to the investors. However, the investors will infer the potential padding and value the firm based on their expectation of the current and future demands for the firm’s products.
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