Analyze and discuss when earnings management may be an ethical practice and when it is an unethical practice.

Question

What will be an ideal response?

Answer 1

Earnings management that is motivated by the intent to deceive users of financial statements and the stock markets and/or to enhance one's personal wealth is unethical. It is intent that matters when evaluating the ethics of earnings management.

Earnings management occurs when companies artificially inflate (or deflate) their revenues or profits, or earnings per share (EPS) figures. Well-publicized ways of managing earnings during the period of financial fraud in the early 2000s were: (1) by using aggressive accounting techniques such as capitalizing costs that should have been expensed (e.g., WorldCom accounted for its line costs as capital expenditures rather than expensing them against revenue); and (2) by establishing or altering the elements of an estimate to achieve a desired goal (e.g., Waste Management's lengthening of the useful lives on trash hauling equipment to slow down depreciation each year).

Another perspective on earnings management is to divide the techniques into two categories: operating earnings management and accounting earnings management. Operating earnings management deals with altering operating decisions to affect cash flows and net income for a period such as easing credit terms to increase sales. Ken Merchant believes while these may appear to be ethical because they involve management choice, the result may be to distort operating policies as is the case when needed repairs are delayed to a subsequent year to make the current earnings look better.

Accounting earnings management deals with using the flexibility in accounting standards to alter earnings numbers. Generally, the end result of earnings management is to distort the application of GAAP, thereby bringing into question the quality of earnings. The question to be answered is whether the distortion is the result of appropriate decision making given that choices exist in the application of GAAP, or if it is motivated by a conscious effort to manipulate earnings for one's advantage, which is fraud.

Examples of earnings management includes:

• Meeting or beating analysts' earnings expectations
• Maximizing bonuses and other performance rewards
• Enhancing the value of stock options, and
• Avoiding the consequences of violation of debt covenants.

A variety of authors believe earnings management is unethical. Healy and Wahlen define it as "when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company, or to influence contractual outcomes that depend on reported accounting numbers."

Dechow and Skinner note the difficulty of operationalizing earnings management based on the reported accounting numbers because they center on managerial intent, which is unobservable. Dechow and Skinner offer their own view that a distinction should be made between making choices in determining earnings that may comprise aggressive, but acceptable, accounting estimates and judgments, as compared to fraudulent accounting practices that are clearly intended to deceive others.

Schipper views earnings management as a purposeful act by management as might be the case when earnings are manipulated to get the stock price up in advance of cashing in stock options.

Hopwood et al. believe that earnings management is management's routine use of nonfraudulent accounting and economic discretion, while earnings manipulation can refer either to the legitimate or aggressive use, or fraudulent abuse, of discretion. By their reckoning, earnings management is legitimate, while earnings manipulation can be legitimate, marginally ethical, unethical, or illegal, depending on its extent. The problem with this distinction is ethics relates to one's intent. If one intends to manipulate earnings through smoothing or other techniques, it is unethical because it is designed to deceive another party; if not, why engage in the practice?

Thomas E. McKee defines earnings management as "reasonable and legal management decision making and reporting intended to achieve stable and predictable financial results." McKee believes earnings management reflects a conscious choice by management to smooth earnings over time and it does not include devices designed to "cook the books." McKee contends that a more positive definition is needed that portrays managers' motives in a positive light rather than the negative view adopted by others.

The acceptability of earnings management techniques can be judged using the ethics framework established earlier in the book. Virtue ethics examines the reasons for actions taken by the decision maker as well as the action itself. McKee's definition is self-serving from a management perspective and does not reflect virtues such as honesty (full disclosure) and dependability (reliable numbers). The definition also ignores the rights of shareholders and other stakeholders to receive fair and accurate financial information. McKee's explanation that earnings management is good because it creates a more stable and predictable earnings stream by smoothing net income cannot overcome the fact that a smooth net income by choice does not reflect what investors and creditors need or want to know because it masks true performance. Further, McKee's explanation for the "goodness" of earnings management is nothing more than a rationalization for an unethical act. Hopwood et al. provide cover for their view of the ethics of earnings management by stating that "the ethics issue might possibly be mitigated by clearly disclosing aggressive accounting assumptions in the financial statement disclosures." The problem here is disclosure should not be used to mask the ills of improper accounting that tests the limits of what does and does not present fairly financial position, results of operations, and cash flows. A disclosure may be nothing more than a rationalization for an unethical action with respect to earnings management, thereby closing the Fraud Triangle.