READ THE ARTICLE BELOW AND ANSWER THE FOLLOWING: According to the authors of the article, what distinguishes bad from good earnings management? Do you agree with their distinction

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.

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.