The existence of earnings management techniques does not justify their use. Some would say that any form of earnings management is unethical. Others would say that some amount of earnings management within certain bounds is necessary to survival in the modern world. Required: Is earnings management ethical?

Answer 1

Universal agreement exists that creating fictitious transactions is unethical. Universal agreement also exists that short of reporting fictitious transactions, managers have a broad range of options available to them as regards the application of generally accepted accounting principles in the reporting of earnings. Managers are faced with the choice of reporting the most conservative, worst-case number, the most optimistic, highest earnings number, or something between these two extremes.

One method of achieving a particular earnings amount is a change in accounting estimate or principle. Managers may choose to make a change in accounting estimate or principle within the bounds of GAAP. Questions then arise as to whether the change really results in an earnings figure that more accurately reflects the financial position, operations, or cash flows of an entity, or whether the change is made in order to achieve a specific earnings amount and perhaps even deceive the users of financial information. Managers also face the task of determining the level of disclosure required to sufficiently inform the user of financial information regarding an accounting change and to avoid deception. Should managers make such a change?

Managers also have an ethical and fiduciary responsibility to carefully manage resources of a publicly traded company in order to maximize the value to the shareholder. Investors and creditors are unlikely to be willing to risk providing funds to a company that does not appear to be capable of succeeding. Accounting income is viewed as a key measure (though not the only measure) of an enterprise's success. This line of reasoning suggests that managers have a responsibility to manage reported earnings within the constraints of generally accepted accounting principles.

The cost of capital is another consideration in the debate of managing earnings. The cost of capital is the cost a company bears to obtain external financing. The more reliable the information provided by a company, the more confidence potential investors and creditors can place in that information. Better decisions can made if high-quality information is available. The ability to make better decisions reduces the risk to potential investors and creditors and thus reduces a company's cost of capital.

Many managers would suggest that some level of earnings management is necessary for an entity to survive in the current business environment. This earnings management must always remain within the bounds of GAAP. Managers face a trade-off between say strategically matching gains and losses versus not being able to obtain financing for their companies in order to ensure the survival of these companies. These managers hold that strategically matching gains and losses, for example, is far less costly and damaging to investors and creditors than to endanger the enterprise's continued existence as a result of not being able to obtain financing.

Earnings management is a function of a manager's personal ethics. Each individual must be constantly aware of the earnings management continuum and where his/her behavior falls on that continuum. Each individual also must be aware of how close he/she is to the boundaries of what is acceptable under GAAP. Proper corporate governance policies can be helpful in creating a process for boards of directors to review the earnings management activities of a company's management. The overly optimistic attitude of corporate managers and the temptations to always hit the earnings target can be controlled by the constant supervision of an active and qualified board of directors.