READ THE ARTICLE BELOW AND ANSWER THE FOLLOWING

A) According to the authors of the article, what distinguishes bad from good earnings management? Do you agree with their distinction?

B) In their survey, the authors find that managers consider earnings management to be relatively immoral. Still, managers face pressures that may incentivize them to engage in earnings management. Figure 2 shows that stakeholders whose earnings expectations managers are most concerned about the meeting are shareholders. Explain why.

C) Figure 3 reveals how auditors come only third as stakeholders of primary concern if a company is perceived as engaging in fraudulent activity, despite the professions claim that auditors play a significant regulatory role in the financial reporting process. Explain this moderate concern expressed by the managers.

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 managementusing the subjectivity within accounting standards or structuring transactions to achieve a particular level of reported earningsdiffer 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 managementwhich is undertaken to hide true operating performance and mislead financial statement usersfrom good earnings managementwhich is undertaken to manage the business effectively and create value for shareholdersis the intent of management when making financial reporting decisions. Because managerial intent is often unknown to financial statement users, theres 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 companys 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 managements 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 thats 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 youre 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 companys 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, isnt it the CFOs 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 companys 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.

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 havent 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 companys accounting practices. With new online investment tools, interested stakeholders can acquire information about the nature of a companys 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. Theres 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 companys 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.

The most frequently cited consequence of inclusion on a publicly available watch list is the damage to the companys 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 continueconcerns 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 businesss 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 companys 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 studys results suggest that managers face conflicting pressures when it comes to managing earnings. While theyre 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.