Gaming the System

Gaming the system

The easiest way to define “Gaming the System” is to cheat the system by finding ways to take advantage of a system of rules and regulations for personal benefits. In order to take advantage is to exploiting a loophole which is not illegal, but the system gaming can be illegal. One of the example of a loophole is “tax inversion” among corporations. Corporate inversion occurs when a company in United States buys or combines with a foreign company in a country with a lower corporate tax rate. This is a legal way for a corporation to reduce its tax burden by moving the headquarters out of the United States into country with a lower tax rate. Even though it is legal but it has created a political and media storm of outrage in 2014. However, it is complicated to discover how to do it because a person need to manipulate the code that policymakers had not intended.

According from the article “Agency Costs of Overvalued equity”, in order to rise the stock price, the firm must produce a positive earning that outperform what they had projected. However if the earning turn out to be negative, the manager might take their risk to manipulate the numbers by pulling some revenues from next period into the present period so the firm won’t lose any credit from their shareholders. Therefore, the firm value will be affect if all the lie goes to the public.

According from the article, the author implied that excessively high stock valuations induce managers to engage in earnings management with the purpose of sustaining upward trends in earnings and stock price. Moreover, when a firm’s stock price become overvalued, the chance for conflicts of interest between managers and owners increases.

“Corporate managers and the financial markets have been playing a game similar to the budgeting game. Just as managers’ compensation suffer if they miss their internal targets, CEOs and CFOs know that the capital markets will punish the entire firm if they miss analysts’ forecasts by as much as a penny. … Generally, the only way for managers to meet those expectations year in and year out is to cook their numbers to mask the inherent uncertainty in their business. And that cannot be done without sacrificing value”

The managers of overvalued firms not only resist market correction of overvalued stock prices, but also attempt to prolong overvaluation by engaging in earnings management that increase reported income. It implied that managers do not seek overvaluation for its own sake but just want to increase the manager welfare which connected to the firm’s performance. In addition, the more overvalued the equity, the greater the incentive to sustain such overvaluation because the managers’ wealth is tied to the firm’s stock price. This renders little incentive for the manager to correct the overvaluation. In addition, lack of incentive does not imply that managers will engage in earnings management because as outlined more specifically below, the costs of earnings management can be extremely high for both the manager and the firm.

On the other hands, the role of CEO is to act as a self-interested agent. Assuming that the decision to issue misstated financial statements is influenced by the CEO’s personal assessment of expected benefits less costs. CEO’s incentive is to maintain or increase the stock price when stock options are cheaper than the market price (in-the-money). By doing accounting irregularities also might indirectly increase the stock price by letting the firm to acquire hard assets by selling shares while the stock price is inflated, issuing new debt on advantageous terms, or paying fewer shares in an acquisition.