In their study, The Ethics of Managing Earnings: An Empirical Investigation, published in Journal of Accounting Public Policy in 1994, Kenneth A. Merchant and Joanne Rockness explore empirically the controversial issue of earnings management. According to them, Earnings management practices probably raise the most important ethical issues facing the accounting profession (p.79).

a. Why would the authors consider earnings management as the most important ethical issue facing the accounting profession? (10 points, 1 page maximum).

The authors presume a continuum of earnings management practices: at one extreme, there are practices that everyone will denounce as unacceptable, such as fraud. At the other extreme, are practices that most people will view as acceptable, such as, a fully disclosed switch from accelerated to straight-line depreciation.

b. Explain why these two practices could be regarded as good illustrations of both extremes of earnings management acceptability? (10 points, 1 page maximum).

Previous research has assumed that the placement of earnings management practices on this acceptability continuum depends on the following 6 factors: (2 pts each, total: 12 points, 1 page maximum).

c1: accordance with GAAP,

c2: clarity of intent to deceive,

c3: clarity of disclosure,

c4: materiality,

c5: period of effect (e.g., year vs. month),

c6: direction (i.e., boost or decrease earnings).

The authors asked participants (all profit-center managers in the US) to evaluate various scenarios involving earning management practices by indicating their judgment as to the acceptability of each of these practices, to be ranked from Ethical Practice to Totally unethical, the manager should be fired. While findings overall confirm previous studies, authorswere surprised by two of their results.

First, conservative earnings management (i.e. downwards earnings adjustments) is generally regarded as more acceptable, especially by the auditors, given the prudence principle, respondents consider this practice to be as unethical as upwards earnings adjustments.

d. Find an explanation to this unexpected finding. (5 pts, page)

Then, the authors found significant disagreement among the respondents for most of the scenarios (p. 91).

e. Using the ethical theories studied in class, provide an explanation to this finding direction (10 pts, 1 pagemaximum)