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The Ethicality of Earnings Management

By Erin L. Hamilton, CPA; Rina M. Hirsch, CPA; Uday S. Murthy; and Jason T. Rasso, CFE
November 1, 2018
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Just as beauty is in the eye of the beholder, so might be the ethicality of earnings management. Opinions as to the ethicality of earnings management—using the subjectivity within accounting standards or structuring transactions to achieve a particular level of reported earnings—differ quite considerably.

 

At one end of the spectrum, the deliberate manipulation of company earnings is viewed as self-serving, misleading, and analogous to fraudulent financial reporting. At the other end, U.S. Generally Accepted Accounting Principles (GAAP) allow for managerial discretion in reporting decisions, and many people believe that using that discretion to achieve earnings objectives is an integral part of doing business and protecting the interests of shareholders.

 

The only difference separating “bad” earnings ­management—which is undertaken to hide true operating performance and mislead financial statement users—from “good” earnings management—which is undertaken to manage the business effectively and create value for shareholders—is the intent of management when making financial reporting decisions. Because managerial intent is often unknown to financial statement users, there’s somewhat of a “knowledge gap” that exists between the managers who know the purpose of their accounting decisions and the users of the statements who lack insight into the goals underlying reporting decisions. This includes shareholders, creditors, regulators, and the general public.

 

In view of these conflicting perspectives on earnings management, we attempted to gain an understanding of how this knowledge gap influences the way in which managers perceive the ethicality of earnings management. Specifically, we surveyed managers of publicly traded companies with financial reporting experience to learn whether they consider public perceptions when making discretionary accounting decisions that appear aggressive (i.e., earnings management decisions). And if they do consider public perceptions, we were curious as to whose perceptions they are concerned with most.

 

We discovered that managers give considerable thought to how the public (including investors, regulators, and auditors) might perceive their earnings management behaviors. Although managers undoubtedly feel pressure to engage in earnings management to achieve certain earnings benchmarks (like analysts’ forecasts), they appear to be predominantly concerned that their earnings management behavior might become public and result in reputational harm, a loss of stakeholder trust, stock price declines, and enhanced regulatory scrutiny.

 

HOW ETHICAL IS EARNINGS MANAGEMENT?

 

Many parties with widely varying opinions have weighed in on the debate regarding the ethicality of earnings management. Regulators take a conservative approach by cautioning against inherently “unethical” earnings management, arguing that it distorts a company’s true earnings and misleads the investing public. Others regard the discretion inherent in reported earnings as a valuable tool that can be used to incorporate management’s private information and company-specific circumstances into accounting transactions.

 

These proponents argue that financial statements are more useful when such discretion is incorporated. Finally, some take a middle-of-the-road approach by recognizing that earnings management falls along a continuum ranging from justifiable interpretations of accounting standards to outright fraud, with many accounting choices falling within a gray area that’s neither completely ethical nor unethical.

 

Managers often rationalize earnings management as being a necessary evil or the “right thing to do” given the circumstances. There could even be situations where managing earnings appears to be the “ethical” choice. For example, imagine you’re the CFO of a company who has toiled tirelessly to meet analysts’ earnings forecasts for the last few periods, but to no avail.

 

Furthermore, you have had difficulty motivating your hardworking employees because results have consistently failed to reach the level necessary for employees to receive bonuses. Your company’s current period earnings are finally on track to beat expectations and trigger employee bonuses, but an important sale falls through just before the end of the period. As the CFO, you know that yet another failure to meet earnings expectations and pay employees bonuses will further damage shareholder value as well as employee morale.

 

Such a situation provides the perfect environment to argue the ethicality of managing company earnings. After all, isn’t it the CFO’s job to protect the interests of both shareholders and employees? Perhaps a more aggressive interpretation of GAAP would allow more revenue to be recognized in the current period, or perhaps a sale of obsolete equipment planned for the current period could be delayed to avoid the loss on sale that would result.

 

To learn more about how managers perceive the ethicality of earnings management and the considerations that influence these perceptions, we surveyed 122 public company managers with financial reporting experience. These managers held mid-, upper-, or executive-level positions. Participants had an average of 15.2 years of management experience and 8.2 years of experience making financial reporting decisions. Approximately 39% of participants majored in accounting or finance; 40% possessed a graduate degree; 13% held MBA degrees; and 25% majored in business areas other than accounting or finance.

 

We first asked respondents how morally right they believed earnings management to be. Managers responded on a scale of 1 to 8, where 1 = not morally right to 8 = morally right. The average response was 2.8, indicating that managers consider earnings management to be relatively immoral. The second question asked how acceptable earnings management was within their company’s culture, with 1 = culturally unacceptable and 8 = culturally acceptable. The average response was 3.9, indicating that managers lean slightly toward perceiving earnings management as culturally unacceptable.

 

Because company culture, including the tone at the top, can influence managers’ perceptions of earnings management, we also asked participants whether they have ever worked at a company that was involved in financial reporting fraud. Fifteen of the 122 managers surveyed (12.3%) indicated that they have worked in an environment where fraud has occurred. Results comparing the perceptions of managers who have worked in a relatively unethical financial reporting environment to those who haven’t appear in Figure 1.

 

 

We found that managers who have worked in a less ethical company culture (i.e., a company where fraud has occurred) perceive earnings management to be more morally right and more culturally acceptable than managers who haven’t worked in such an environment. These findings suggest that tone at the top and corporate culture influence how individual managers perceive the appropriateness of engaging in aggressive accounting practices such as earnings management. Consistent with research and anecdotal evidence, our findings further underscore the importance of top management setting an appropriate tone regarding financial reporting quality.

 

MEETING EARNINGS EXPECTATIONS

 

Managers face pressures that may incentivize them to engage in earnings management. For instance, they may feel pressure from coworkers if employee bonuses are contingent on hitting a certain level of earnings; they may feel pressure from shareholders to meet analysts’ earnings forecasts; or they may even feel pressure from friends and family to run a successful and profitable business.

 

Given that managers strive to meet the earnings expectations of so many parties, we asked 73 of the respondents to indicate the extent to which they are concerned about failing to meet various stakeholders’ earnings expectations. (The number of respondents is fewer than the initial 122 because respondents only received follow-up questions depending on their responses to the initial questions.) Figure 2 indicates the percentage of participants that viewed each stakeholder category as being of primary concern.

 

 

Managers appear to be most concerned about the expectations of shareholders and regulators. Yet they also appear to be concerned about failing to meet the earnings expectations of various other parties, specifically coworkers, friends, family, and others outside the company, such as creditors and the general public. These results suggest that managers may be sensitive to the perceptions of a larger body of stakeholders than previously expected.

 

SENSITIVITY TO PUBLIC PERCEPTIONS

 

The corporate scandals of the early 2000s brought much greater public attention to the legitimacy of financial information reported in company financial statements. That concern has continued in the years since, and the public is likely to be especially sensitive to behaviors or earnings trends that appear to be unethical or overly aggressive.

 

Although managers may want to report increasing earnings and meet analysts’ expectations, those engaged in earnings management must also be aware of how such behavior might appear to the public. If managers believe that the public can detect earnings management, they are likely to be concerned about how that behavior is viewed. This concern has the potential to impact not only managers’ perceptions of the ethicality of earnings management but also how likely they are to engage in it.

 

Today, several resources are available to the general public for assessing the aggressiveness of a company’s accounting practices. With new online investment tools, interested stakeholders can acquire information about the nature of a company’s accounting choices and compare these choices to those of other companies within the same industry.

 

The Accounting Quality & Risk Matrix developed by Audit Analytics, for example, is an online investment tool that monitors companies for “indicators of potential earnings management and other accounting quality issues.” There’s also the Accounting and Governance Risk (AGR) Metric, offered by MSCI Inc. It assigns a score ranging from 1 (representing a “very aggressive” company) to 100 (representing a “conservative” company) that acts as a composite measure reflecting the risk associated with a company’s financial reporting and corporate governance practices.

 

In addition to these composite risk scores, stakeholders can also rely on “watch lists” that identify companies with the most aggressive accounting practices, such as the Forbes Corporate Risk List, as well as lists of the most conservative and trustworthy companies, such as the Forbes “100 Most Trustworthy Companies in America” list.

 

Regulators have also started using analytical tools to identify companies employing aggressive accounting in their financial reporting. For example, the U.S. Securities & Exchange Commission (SEC) uses the Accounting Quality Model (nicknamed “Robocop”) to identify companies most likely to be engaged in earnings management by screening for large discretionary accruals and accounting practices that differ from industry standards. The SEC intends to use Robocop to identify high-risk firms for further investigation.

 

Given these various methods for detecting earnings management, managers must carefully consider the possibility that their earnings management behavior will be detected by the public and how the public might perceive and respond to such behavior. Thus, we asked the 122 financial reporting managers to describe the negative outcomes that might result if their company were included on a watch list identifying companies engaged in aggressive (or potentially fraudulent) accounting practices. The results appear in Table 1.

 

Click to enlarge.

 

The most frequently cited consequence of inclusion on a publicly available watch list is the damage to the company’s reputation. Other commonly mentioned consequences include damaged shareholder perceptions, loss of trust, negative stock market reactions, and damaged customer/supplier relationships.

 

These results conform to the negative outcomes often attributed to the “downward spiral” that occurs when a company receives a going concern opinion from its external auditor. The downward spiral refers to the series of negative events that can potentially follow a going concern opinion as stakeholders become less confident that the business will continue—concerns that may not have existed if not for the issuance of the opinion. Likewise, managers may be concerned that simply being placed on a watch list will cause a similar series of negative events that could ultimately lead to the business’s demise.

 

We also asked 51 of our participants (the subset of respondents who had indicated a relatively high level of concern that stakeholders may think their company is involved in unethical accounting practices) to indicate the extent to which they are concerned that specific stakeholder groups may suspect they are involved in unethical accounting practices, such as fraudulent financial reporting.

 

As Figure 3 shows, the SEC and shareholders appear to be the stakeholders of greatest concern to managers when it comes to perceptions of fraudulent financial reporting. Managers likely are most concerned with the perceptions of these two groups because they have the potential to harm the company’s future success, such as through increased regulatory scrutiny or decreased stock prices.

 

 

Quite a few participants, however, also indicated a high level of concern regarding the perceptions of coworkers, external auditors, and other parties outside the company, such as creditors. Interestingly, all these stakeholder groups (investors, regulators, auditors, and creditors) have been identified as parties that subscribe to services that can be used to identify companies with aggressive accounting practices. These results seem to indicate that the more these earnings management detection tools are used by stakeholders, the less likely it is that managers will engage in earnings management out of fear of appearing overly aggressive.

 

Our study’s results suggest that managers face conflicting pressures when it comes to managing earnings. While they’re concerned about negative shareholder reactions if earnings expectations are missed, they also fear appearing risky or aggressive to the public (particularly regulators and shareholders) if they were to take actions to inflate earnings.

 

These conflicting pressures raise the question: Which concern has a stronger effect on managers’ accounting decisions? To determine how managers perceive these conflicting pressures, we asked all 122 participants to identify which is most harmful to a company’s reputation: (1) missing analysts’ earnings expectations or (2) being included on a watch list of aggressive companies. Eighty-four percent of managers surveyed believe that inclusion on a watch list of aggressive companies is more damaging to a company’s reputation than missing analysts’ earnings expectations.

 

Finally, we asked the participants the extent to which they agree, on a scale from 1 (strongly disagree) to 7 (strongly agree), with the following statements:

 

  • I believe that missing analysts’ expectations is harmful to a company’s reputation in the long term.
  • I believe that an SEC fraud investigation is harmful to a company’s reputation in the long term.

 

As shown in Figure 4, the managers indicated a stronger belief that long-term reputational consequences will result from being subject to an SEC fraud investigation (mean of 5.6) compared to missing analysts’ earnings forecasts (mean of 4.6). These results suggest that managers face a difficult balancing act between satisfying the earnings expectations of various stakeholder groups and avoiding the appearance of accounting malfeasance.

 

At the end of the day, however, managers seem to believe that their company’s reputation is better protected by avoiding public scrutiny for risky behavior, such as inclusion on a watch list of aggressive companies, even if it means that earnings expectations aren’t achieved.

 

 

IMPLICATIONS FOR CFOS

 

While managers generally view earnings management as unethical, managers who have worked at companies with cultures characterized by fraudulent financial reporting believe earnings management is more morally right and culturally acceptable than managers who haven’t worked in such an environment. This suggests that the ethical tone that characterizes a manager’s work environment, such as the unethical actions of coworkers and superiors, has the potential to influence how managers perceive the ethicality of earnings management.

 

Managers also appear to be concerned with the public’s perceptions of earnings performance and the possibility that accounting choices will be perceived as overly aggressive (or potentially fraudulent). While they contemplate the perceptions of various stakeholders to some degree (for example, creditors, customers, vendors, and coworkers), they appear to be most concerned with shareholders’ and regulators’ perceptions. Managers fear that the public in particular will lose trust in the company, causing negative long-term consequences to the company’s reputation.

 

The choice to employ earnings management tactics consists of a trade-off between the incentive to meet earnings expectations and the incentive to avoid appearing exceedingly aggressive. When both incentives are present, managers are most concerned with avoiding the appearance of being engaged in aggressive or fraudulent accounting practices. This suggests that earnings management behavior depends on the degree to which the public is able to identify such behavior using investment tools, company watch lists, and other means.

 

We performed a review of existing risk assessment tools (MSCI Inc.’s Accounting and Governance Risk Metric, Audit Analytics’ Accounting Quality & Risk Matrix, and the SEC’s Audit Quality Model) and have some suggestions for CFOs and corporate managers who would like to avoid being flagged as aggressive and to increase their likelihood of making it onto the Forbes list of the “100 Most Trustworthy Companies in America”:

 

  • Be aware of the accounting practices and ratios considered typical or average for your industry. Risk metrics flag companies that stand out as being different from their peers.
  • Avoid unusual fluctuations in account balances and financial ratios when compared to prior periods.
  • Avoid abnormal levels or changes in discretionary accruals (for example, sales return allowance, allowance for doubtful accounts, and reserve for inventory obsolescence) when compared to prior periods and industry peers.
  • Avoid onetime adjustments (such as changes in accounting estimates and out-of-period adjustments).
  • Avoid late filings, restatements, material weaknesses, and unusual changes in audit fees.
  • Avoid abnormal levels of share repurchases and issuances of debt or equity.
  • Avoid CEO and CFO turnover and excessive levels of executive incentive compensation as a percentage of overall compensation.
  • Avoid accounting policies that result in relatively high reported book earnings while at the same time selecting alternative tax treatments that minimize taxable income.
  • Avoid off-balance-sheet transactions.

 

Being aware of the types of activities that may cause a company to be flagged as aggressive may give managers pause when considering one of these high-risk activities. Keep in mind, however, that some of the events that may appear aggressive on the surface (for example, issuance of debt or equity, officer changes, and large fluctuations in account balances) simply occur in the normal course of a business.

 

As such, it isn’t always possible to avoid the appearance of aggressiveness. When seemingly aggressive accounting choices must be made, it’s especially important to communicate the business rationale underlying the accounting decisions. Such increased communication may help manage the expectations and perceptions of the most important stakeholder groups.

 

For instance, detailed disclosures within financial statements can help explain to shareholders and creditors why an accounting estimate differs from prior years or industry peers, and open dialogue between corporate managers and external auditors can help to ward off implicit beliefs that management may be acting aggressively. Such increased communications and disclosures will likely be beneficial to companies wanting to avoid the appearance of aggressiveness because, in today’s environment, someone is always watching.

 


Warning Signs

 

Companies showing some of these characteristics may be engaging in earnings management or aggressive financial reporting practices:

 

  • Unusual percentage changes in account balances and financial ratios year over year
  • Accounting practices or financial ratios that are inconsistent with those of industry peers
  • Volatility in account balances over a two-year period
  • Unusual level of discretionary accruals (for example, sales return allowance) as compared to prior periods and/or industry peers
  • Significant accounting policies are changed frequently or applied inconsistently year over year
  • A onetime adjustment, such as a change in accounting estimate, or an out-of-period adjustment
  • Unusually complex financial disclosures or unusual level of disclosure compared to industry peers
  • Open regulatory cases, especially when brought by a regulatory entity, such as the SEC or Department of Justice
  • Receipt of a qualified or going concern audit opinion
  • Restatement of a financial statement
  • Late filing of financial statements
  • Deficiency (such as material weakness) in internal controls over financial reporting
  • Auditor change, especially more than once, in a
  • two-year period
  • CEO or CFO turnover
  • Executives (such as CEO or CFO) with a high proportion of incentive-based compensation compared to overall compensation
  • Large number of off-balance-sheet transactions or non-GAAP measures as compared to industry peers
  • Meeting or beating earnings targets (such as EPS forecasts) consistently every period

This article is based on a study funded by the IMA® Research Foundation. For more results from the study, see “The Naughty List or the Nice List? Earnings Management in the Days of Corporate Watchdog Lists” at http://bit.ly/2IZdIPI. Erin Hamilton also received financial support for this research from the EY Faculty Fellowship at UNLV, and Rina Hirsch was supported by a summer research grant from Hofstra University’s Frank G. Zarb School of Business.

 

Erin L. Hamilton, CPA, Ph.D., is an assistant professor of accounting and EY Faculty Fellow at the University of Nevada, Las Vegas. She can be reached at erin.hamilton@unlv.edu.
Rina M. Hirsch, CPA, Ph.D., is an assistant professor of accounting at Hofstra University and a member of IMA’s Long Island Chapter. She can be reached at rina.hirsch@hofstra.edu.
Uday S. Murthy, Ph.D., is the director of the Lynn Pippenger School of Accountancy and the Quinn Eminent Scholar at the University of South Florida. He can be reached at umurthy@usf.edu.
Jason T. Rasso, CFE, Ph.D., is an assistant professor of accounting at the University of South Carolina. He can be reached at jason.rasso@moore.sc.edu.
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