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The ethics of managing earnings: An empirical investigation
The Ethics of Managing Earnings: An Empirical Investigation Kenneth A. Merchant
and Joanne Rockness
This paper describes the findings of a study designed to explore empirically the controversial issue of earnings management. Earnings management practices probably raise the most important ethical issues facing the accounting profession, yet little research has explored the topic. To assess the prevailing morality regarding earnings management practices, we used a questionnaire comprised of 13 potentially questionable earnings management activities. General managers, staff managers, operating-unit controllers, and internal auditors were sampled. The responses show some areas of general agreement. For example, acceptability was judged to vary with the type, size, timing, and purpose of the actions. But we also found significant areas of disagreement. The paper concludes with a discussion of the implications of this general disagreement and suggestions for future research.
1. Introduction One thing lawmakers and designers of organizational control systems and professional codes of conduct have in common is their need to distinguish between acceptable and unacceptable forms of behavior. Sometimes these groups’ tasks are easy as, for example, conclusions that theft of assets is unacceptable are not controversial. But for many other types of behaviors, deriving these prescriptions is difficult. One controversial, and important, area is that of earnings management. Earnings management can be defined as any action on the part of management which affects reported income and which provides no true economic advantage to the organization and may in fact, in the long-term, be detrimental (Merchant 1989, pp. 168-169). There is evidence to show that many managers do manage earnings (e.g., Healy 1985, pp. 106-107; DeAngelo 1988, pp. 34-35). But earnings management actions can be
Address reprint requests to: Professor Joanne Rockness, Department Business Law, Cameron School of Business Administration, The University Wilmington, Wilmington, NC 28403.3297. Journal 01 Accounting
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K. A. Merchant and J. Rockness
quite harmful. For example, the National Commission on Fraudulent Financial Reporting (1987, pp. 5-6) concluded that earnings management activities can mislead financial-statement users and, sometimes, are precursors of more serious, illegal (fraudulent reporting) activities. Our paper reports the findings of an empirical investigation aimed at assessing the prevailing morality with respect to earnings management. The study responds to the call made by many (e.g., Burton and Sack 1989, pp. 114-116) for additional research on topics related to ethics and fraud to improve our understanding of the problems and the means for improvement. We focused our study on the ethics of managing earnings because earnings is “widely believed to be the premier information item provided in financial statements” (Lev 1989, p. 15.5). We used a questionnaire originally developed by Merchant (1989, pp. 241-244) and then modified and published in Harvard Business Review (1989) which was comprised of 13 potentially questionable earnings management activities. Samples of general managers, staff managers, operating-unit controllers, and internal auditors were asked to judge the acceptability of each of the actions. We hoped that the responses would yield some agreement on the morality of engaging in various types of earnings management. We foun~d some areas of general agreement; for example, acceptability was judged to vary with the type, size, timing, and purpose of the actions. But we also found significant areas of disagreement. Our findings generally confirm those of Bruns and Merchant (1990, pp. 22-24). Although Bruns and Merchant used this same earnings management questionnaire, their data were derived from voluntary responses received after the questionnaire was published in Hamard Business Review, so their findings were susceptible to possible response bias. Our paper is organized as follows. The next section summarizes the literature dealing with the incidence and causes of earnings management. Then the research method and findings are discussed. The paper concludes with a discussion of the findings and some suggestions for further research. 2. Literature
Review
As noted below virtually all prior research on earnings management has taken an economics perspective. That is, the research has focused on questions about the incentives managers have to manage earnings and the consequences of their manipulative actions (i.e., the costs and benefits of allowing discretion in the choice and application of accounting methods). As noted below prior published research has provided evidence that managers do manage earnings through their choices of accounting policies, their accounting judgments, or their timing or selection of operating decisions. It has also shown that managers’ actions are related to a number of their incentives. For example, Healy (1985, pp. 95-107) found an association between accounting accruals and the incentives managers were
The Ethics of Managing Earnings
81
provided by earnings-related bonus plans. Merchant (1990, pp. 305-306) found that a large proportion (> 90%) of the profit center managers in one arguably well-run corporation boosted earnings in a recent recessionary year, with their primary motivation being the achievement of their budget targets. McNichols and Wilson (1988, p. 30) found that managers have a tendency to decrease earnings when earnings are extreme in either direction. DeAngelo (1988, pp. 34-35) found that incumbent managers in proxy contests take actions to boost earnings. Hand (1989, pp. 621-622) found that managers timed their debt-equity swaps to smooth income. DeFond and Jiambalvo (1991, p. 653) found that managers who overstate earnings are more likely to be in firms which need earnings because they have not been performing well and/or they are highly leveraged, and in firms which have weaker control systems, evidenced by diffuse ownership and no audit committees. Research has provided little evidence about the consequences of earnings management actions. In an essay on the topic, Schipper (1989, pp. 101-102) drew on the findings of some analytical research (Dye 1988, pp. 225-226; Trueman and Titman 1988, pp. 138-139) on the effects of accounting accruals and concluded that harm is minimized if the communication is transparent and no contractual frictions exist. In other words, the key questions are: Are the details of the actions disclosed so that financial analysts can undo the earnings effects? And, are the incentives such that it is worthwhile for them to do so? The economics perspective, however, focuses only on a limited set of the causes and consequences of earnings management actions. Noreen (1988, pp. 359-360) argued for a broader perspective. He (1988, pp. 359-360) suggested that managers’ behaviors may be affected by forces not normally considered within the self-interest focused economic framework, such as conscience, religion, or genetics. Some applied-ethics textbooks (e.g., Bowie and Duska 19901, in fact, describe examples in both business and personal areas of decision-making where individuals’ beliefs about their obligations and duties, or fairness and justice, overrode their short-term, and even long-term, self-interests. Noreen argued that not only do these noneconomic motivators exist, some forms of them “are a necessary lubricant for the functioning of markets” (Noreen 1988, p. 368). The ethical perspective raises some interesting and important issues. Most of the earnings management actions which have been studied are legal, not inconsistent with generally accepted accounting principles (GAAF’), and within the managers’ prerogatives. The ethical perspective, however, raises the question as to whether these things are the right things to do. Should we, for example, judge it acceptable for a manager to boost earnings by squeezing reserves? If not, the individuals engaging in these actions are acting in a socially unacceptable way. If the individuals’ moral codes do not prevent the actions, it might be beneficial to enact laws or codes of conduct to deter such activities, and to create audit programs and
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K. A. Merchant and J. Rockness
other forms of controls to detect and correct the manipulations before the financial statements are published. A related question is: Is the intent behind the action relevant? Should our moral judgments depend on the purpose for which the earnings are being boosted? For example, are managers’ actions undertaken to boost earnings to augment their bonuses more heinous than their doing so to prevent their firm from defaulting on the terms of its bank loans? If intent is relevant, the prevention/detection process becomes more complicated. These earnings management issues are important. The National Commission on Fraudulent Financial Reporting (1987, pp. 23-24) concluded that virtually every case of fraudulent financial reporting starts with small ethical transgressions. And a Touche Ross (1988) survey of directors and top executives of major corporations, deans of business schools, and U.S. senators and representatives, with 1,017 respondents, found that the “increased concentration on short-term earnings” (p. 69) was rated as the second most important condition threatening to undermine American business ethics (just behind “decay in cultural and social institutions” (p. 69)). The U.S. Congress is actively looking at these issues. Attempts have been made to write legislation defining the line between right and wrong in financial reporting as well as to require accountants to blow the whistle on corporate fraud (Berton 1992). But thus far these efforts have not been passed into law. How does a society, the accounting profession, or an individual firm draw the line between acceptable and unacceptable earnings management practices? Merchant (1987, p. 42) studied a number of recent cases of fraud in financial reporting and concluded that two factors-accuracy and informativeness-define a nearly seamless continuum of earnings management practices. This continuum is shown in Figure 1. At one extreme, near 0,
are practices
which virtually
everyone
would
denounce
as unaccept-
able, such as fraud. At the other extreme, near 0, are practices which most people would view as acceptable such as, perhaps, a fully-disclosed switch from accelerated to straight-line depreciation if the business is in need of more earnings (Merchant 1987, p. 41). Based on interviews and panel discussions with financial-statement preparers, users, auditors, and regulators, Merchant (1987, p. 25) hypothesized that six factors affect people’s placements of earnings management practices on this acceptability continuum: l
“accordance
l
“clarity
with GAAP,”
l
clarity of “disclosure,”
of intent
l
“materiality,”
l
“period
l
“direction”
of effect”
to deceive,”
(e.g., year vs. month),
(i.e., boost or decrease
earnings).
The Ethics
Proportion of people judging practice as acceptable (S)
of Managing
83
Earnings
50%
0%
Inaccurate, deceptive
Accurate, informative Character Reporting
of FinancialPractices
Figure 1. An acceptability continuum of financial Merchant (1987, p. 42). Reprinted with permission.
reporting
practices
from
In later interview and questionnaire studies, Merchant (1989, pp. 178-180) and Bruns and Merchant (1990, pp. 22-24) found a great disparity between judgments about the acceptability of operating methods, as opposed to accounting methods, of managing earnings. @chipper (1989, p. 92) referred to these two earnings management methods as real and accruals-based, respectively.) Operating methods of managing earnings involve altering operating decisions, such as the decision to work overtime at year end to push out more shipments in the current year (Merchant 1989, p. 170). These decisions may affect both cash flow and income (Merchant 1989, p. 170). Accounting earnings management consists of using the options available in both accounting rules and the application of those rules (Merchant 1989, p. 169). The preceding discussion suggests the following multi-part research question:
Research Question 1: How should the acceptability of earnings management In particular, should the judgments depend on:
actions
be judged?
84
K. A. Merchant and J. Rockness
1. 2. 3. 4. 5. 6.
type of action (e.g., accounting vs. operating consistency with GAAP; the direction of the effect on earnings; materiality; the period of effect; and the purpose in mind.
manipulation);
Evidence is sparse, but it is likely that ethical judgments about earnings management practices are not constant across all groups of individuals. They may vary with people’s individual characteristics (e.g., religion, education) and characteristics of their environment (e.g., national or corporate culture, professional norms).’ Our paper focuses on two of these potentially important factors: corporate ethical climate and professional norms. A corporation’s ethical climate is a normative value system which is shaped and communicated by, among other things, organizational policies and procedures, reward systems, and top executives’ behaviors (Goodpaster and Matthews 1982, pp. 135-138; Victor and Cullen 1988, pp. 101-104). NO significant body of empirical evidence has been gathered to show links between a corporation’s ethical climate and its employees’ tendencies to engage in one or more forms of earnings management. But one of the conclusions of the National Commission on Fraudulent Financial Reporting (1987, pp. 32-36) was that managers in corporations with a poor ethical “tone at the top” are more likely to engage in fraudulent financial reporting activities than are those in corporations whose top management sets a better tone. Judgments about earnings management actions are probably also related to individuals’ professional norms which, in turn, are related to the roles the individuals play in the financial-reporting process. Auditors and accountants have professional standards of conduct dealing with financial-reporting issues,2 but managers, many of whom claim to be professionals, are not regulated formally by a professional body. The professional standards which exist are somewhat vague but they may affect ethical judgments about earnings management practices. These issues lead to the following research question: Research
Question 2 :
Are moral judgments 1. managers 2. personnel auditors)?
consistent
across different
in different firms, or in different roles (e.g.,
general
populations, managers,
such as: accountants,
‘For discussions of individual ethical reasoning see, for example, Kohlberg (1984). ZInterpretations of professional conduct are not absolute. They vary, for example, across cultures. Karnes et al. (1989, pp. 34-38) found significant differences between U.S. public accountants’ perceptions of unethical business practices and those of public accountants in Taiwan. However, Karnes et al. did not compare public accountants' judgments with those of other respondent groups.
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The Ethics of Managing Earnings
3. Research Method Data were collected through the use of a questionnaire, developed by Merchant (1989) and subsequently modified and used by Bruns and Merchant (19901, which consisted of 13 short scenarios, each describing a potentially questionable earnings management activity taken by a hypothetical profit center manager. The questionnaire method of measuring ethical views is consistent with that used in prior research (e.g., Becker and Fritzsche 1987; Karnes et al. 1989; Flory et al. 1992). The activities described in the scenarios were developed based on knowledge of real events gained from prior research (Merchant 1985; 1989) involving interviews with large samples of operating and staff managers. One scenario, for example and its alternatives is as follows: 2. [The general manager] ordered his employees to defer all discretionary expenditures (e.g., travel, advertising, hiring, maintenance) into the next accounting period, so that his division could make its budgeted profit targets. Expected amount of deferral: $150,000. b. The expenses were postponed from November January in order to make the annual target.
and December
until
The complete questionnaire, containing each question and alternative, used in our study can be seen in Harvard Business Review, March-April 1989, pp. 220-221. Participants in the study were asked to evaluate each scenario by indicating their judgment as to the acceptability of each of the practices using the following scale (Harvard Business Review, March-April 1989, pp. 220-221): 1 = Ethical practice. 2 = Questionable practice. I would not say anything to the manager, but it makes me uncomfortable. 3 = Minor infraction. The manager should be warned not to engage in the practice again. 4 = Serious infraction. The manager should be severely reprimanded. 5 = Totally unethical. The manager should be fired. The scenarios were designed to address the research questions as follows (as noted above the questions can be found in Harvard Business Review, March-April 1989, pp. 220-221): 1. Type of earnings management action. a. Questions 1, 2a, 2b, 4a, 4b, 4c described operating methods of managing earnings. The others described accounting methods. b. Question 4 added a different cut on method. The earnings management activities listed included: 1) use of techniques to accelerate sales; 2) an end-of-year push to accelerate product shipments, and 3) sale of certain assets to realize income.
86
K. A. Merchant and J. Rockness
2. Consistency with GASP. Of the seven accounting manipulations, three were consistent with GAAP (questions 5b, 6a and 6b). 3. Direction of effect. Three of the 13 scenarios referred to actions designed to decrease (as opposed to increase) earnings (questions 1, 5a, 5b). 4. Materiality was introduced as a concern between questions 7a and 7b. 5. The period of effect was introduced as a concern between questions 2a and 2b. 6. The purpose in mind was introduced as a concern between questions 6a and 6b. The questionnaire did not include all the possible combinations of factors (as in a full factorial experimental design). But the questions were designed so that there would be minimal confounding of results. For example, the questions describing accounting and operating manipulations included approximately equal mixes of large and small effects and incomeincreasing and income-decreasing effects. Permission was received to use the questionnaire in two corporations and one chapter of the Institute of Internal Auditors (ICA). Corporation A permitted the sending of the questionnaire to all the attendees of a meeting of their worldwide general and financial management staffs in October 1987. This group included all the profit center managers in the firm and all the corporate and line controller staffs down to the level of division controller. A total of 119 questionnaires were sent by company personnel in interoffice mail, attached to a cover letter from the corporate controller, to be returned directly to one of the authors. A single request netted a total of 100 responses, an approximate 84% response rate. Corporation B permitted the sending of the questionnaire to all the attendees of a worldwide controllers’ meeting in May 1989. Those attending included all finance and accounting staff down to the level of division controller and a sampling of other high-level personnel. The data collection method was identical to that used in Corporation A with two exceptions: the cover letter was signed by the chief financial officer, and the corporation did not disclose how many questionnaires were sent out. Coincidentally, exactly 100 were returned. There were approximately the same number of attendees as Corporation A. However, due to last minute additions and cancellations a precise response rate for Corporation B could not be determined. The two corporations are similar in many ways. They are both large, divisionalized, multinational, manufacturing companies. Most of their businesses have a high high-technology content, although the two firms do not compete in any market segment. Corporation A produces electronic equipment. Corporation B is in the communications industry, and parts of its operations are regulated. Both firms had annual incentive plans providing
87
The Ethics of Managing Earnings
managers cash awards, normally between 20% and 66% of base salary, based partially on accounting measures of performance. Both corporations also had a long-term incentive plan providing awards based on multi-year corporate (not operating unit) performance. And both corporations had a formal, written code of ethics written in broad, general terms. There are only a few significant differences between the two corporations. One is that Corporation B is significantly larger than Corporation A. A second is that the key financial performance measure for Corporation A was based on operating profit, while for Corporation B it was profit before tax. And third, Corporation A had recently had a major incident of fraud in a foreign subsidiary, and internal control issues were on many of its managers’ minds. Questionnaires were also sent to the entire membership of one chapter of the Institute of Internal Auditors in January 1988. The responses were used as the focus of a chapter dinner meeting, so the cover letter was signed by the program chairman. A single request netted 108 responses from the 165 members (approximately 65%). Ninety of the respondents were practicing internal auditors. Table 1 summarizes the responses by organization and by role. A significant number of responses were received from general managers, corporate staff, operating-unit controllers, and internal auditors. In addition to our analysis of the questionnaire responses, we were able to learn more about the issues through discussions with a number of respondents. These discussions were possible because we presented the questionnaire results to each of the three groups of respondents at formal meetings. 4. Results Table 2 shows the mean scores and standard deviations for the responses of the entire set of 308 respondents for each of the 13 scenarios. Two Table 1. Classification of Respondents Corporation General managers Corporate staff Operating-unit controllers Internal auditors Other Total respondents
A
Corporation
B
HA Chapter
26
11
31
6.5
96
39
22
61
4 100
2 100
-
Total 37
90
90
18 108
22 308
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K. A. Merchant and J. Rockness
Table 2. Mean Scores and Standard Deviations, All Respondents Question 1 2a 2b 3 4a 4b 4c 5a 5b 6a 6b 7a 7b
Mean 1.26 1.81 2.09 3.42 1.96 1.31 1.25 3.27 3.51 3.59 3.69 3.76 4.05
*See page 85 of this paper for a description
Standard Deviation
Range* 1-4 l-5 1-5 t-5 l-5 l-5 1-5 l-5 1-5 l-5 1-5 l-5 l-5
0.58 1.01 1.27 0.80 1.09 0.69 0.68 1.07 1.19 1.18 1.11 0.98 0.94 of the judgment-scale
(n = 308)
range.
conclusions can be drawn from these data. First, lack of agreement exists among the item ratings. This suggests that the scenarios tapped a number of points along the acceptability continuum shown in Figure 1. And second, the large ranges of responses and the high standard deviations for some scenarios show that the respondents did not agree in their judgments; we found no near-unanimous prevailing morality regarding earnings management activities. The first research question was designed to facilitate the exploration of questions as to whether judgments of acceptability of various earnings management practices depend on various attributes of the practice. The results can be summarized as follows: 1. Ethical judgments were affected by the fYpe of earnings management practice. The first two lines of Table 3 compare the mean ratings for the questions describing accounting methods of managing earnings with those describing operating methods. It shows a highly significant difference; the accounting methods were judged much more harshly (t = 44.5; p < .OOl>. The responses for question 4, which varied the method of manipulation, also revealed a significant difference. From the data shown in Table 2, the respondents judged the liberal-payment-term method as significantly less acceptable than either working overtime to accelerate shipments (the t statistic was t = 11.66; p < .OOl> or selling excess assets to realize the profit (the t statistic was t = 10.99; p < .OOl). 2. Whether or not the accounting manipulations were consistent with GAAP seemed not to matter. The third and fourth lines of Table 3 show that
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The Ethics of Managing Earnings
Table 3. Mean Acceptability Ratings for Earnings Management Three Contrasting Attributes (n = 308) Attribute
Questions
Mean Rating**
Accounting method
3, 5a, 5b, 6a, 6b, 7a, 7b
3.61
Operating method
1, 2a, 2b, 4a, 4b, 4c
1.61
Consistent with GAAP
5b, 6a, 6b
3.60
Inconsistent with GAAP
3, 5a, 7a, 7b
3.63
Increases earnings
2a, 2b, 3,4a, 4b, 4c, 6a, 6b, 7a, 7b
2.69
Decreases earnings
1, 5a, 5b
2.68
Practices with t Statistic
44.5*
- 0.53
0.50
* =p < .Ol “*See page 85 of this paper
for a description
of the judgment-scale
range.
consistency with GAAP made no significant difference (t = - .53; n.s.> in the respondents’ acceptability judgments. The direction of effect on earnings was not important. The last two lines of Table 3 show that the actions which boosted earnings were not rated significantly different from those which decreased earnings in the short-run (for use in a later period) (t = SO; n.s.>. Materiality mattered. The average ratings for questions 7a and 7b, shown in Table 2, show that the larger earnings management action (7b) was rated significantly less acceptable than the smaller (immaterial) action (7a) (the t statistic was t = -5.51; p < .001X The period of ejj‘kt mattered. Question 2 referred to a quarter-end manipulation, while 2b referred to a year-end manipulation. Table 2 shows that the year-end action was judged significantly less acceptable (the t statistic was t = -8.86; p < .OOl>. The manager’s purpose was a concern. Question 6a referred to a purpose which could be interpreted as being in the corporation’s best long-term interest (continuation of some important product development projects), while 6b asked about a more selfish purpose (make budgeted profit targets). As the data in Table 2 show, the respondents judged the selfish action more harshly (the t statistic was t = -3.67; p < .OOl>. The second research question asked whether the judgments varied across respondent populations. Table 4 shows that the ratings from the
90
K. A. Merchant
Table 4. Mean Judgment
Ratings by Respondent
and J. Rockness
Organization
f Statistic
Sample
Mean Rating**
Corporation A
2.90
A VS.B = 4.58*
2.57
A vs. IIA = 4.04*
2.61
B vs. IlA = -0.69
(n = 100) Corporation B (n = 300) IIA chapter (n = 108)
* = p < .Ol **See page 85 of this paper
for a description
of the judgment-scale
range
Corporation A respondents (the corporation which had had the recent major fraud incident) were significantly more harsh than were those from Corporation B (the t statistic was r = 4.58; p < .OOl) or from the IIA chapter (the t statistic was t = 4.04; p < .OOl>. The data in Table 5 show, surprisingly, that the general managers were the most conservative in their judgments, meaning that their judgments about the acceptability of the earnings management actions were the most harsh. The internal auditors were the most liberal. These differences were not consistent for all the questions as, for example, the general managers and internal auditors agreed in condemning the actions which were not consistent with GAAP (means of 3.50 and 3.48, respectively). Across all questions, however, the internal auditors were significantly more liberal in their judgments than the general managers (the t statistic was t = 2.59; p < .OS> or the operating-unit controllers (the t statistic was t = 2.20; p < .os>.
5. Discussion
and Conclusions
A primary purpose of our study was to assess the prevailing morality with respect to earnings management practices. We found areas of general
Table 5. Mean Judgment Ratings by Role Role General managers (n = 37) Corporate staff (n = 96) Operating-unit controllers (n = 61) Internal auditors (rl = 90) **Set page
85 of this paper
Mean Rating** 2.83 2.70 2.79
t Statistics GM vs. staff = 1.42 GM vs. controllers = 0.31 GM vs. auditors = 2.59* Staff vs. controllers = 1.06 Staff vs. auditors = 1.39 Controllers vs. auditors = 2.20*
2.60
for a description
of the judgment-scale
range.
The Ethics
of Managing
Earnings
91
agreement about some characteristics of the practices; the judgments were affected by the type (e.g., operating vs. accounting), size (materiality), timing (accounting period-end), and purpose (e.g., increase bonus) of the action. We suggest, tentatively, that organizations or professions which define to their employees or members which actions are not allowable can, and probably should, use at least some of these specific earnings management characteristics in their definitions. We also found a few surprises in the data. One is that the respondents did not, on average, consider either consistency with GAAP or the direction of the effect on earnings in making their judgments. Regarding the consistency-with-GAAP finding, either the respondents believed that manipulators should not use GAAP as a defense for their actions, or enough of them were ignorant of the details of GAAP to render the findings statistically insignificant. The respondents did not condone excessive conservatism because they apparently viewed the understatement of earnings in the current period as providing a potentially misleading signal, and they realized that managers who decreased earnings in a current accounting period were doing so to increase their abilities to increase them in a future period. This view appears to conflict with auditors’ generally high tolerance for conservatism in financial reporting. The judgments from the different respondent groups varied in some systematic ways. The ethical climate within Corporation A seems to have been significantly different from that within Corporation B; A’s respondents’ judgments were significantly more conservative (see Table 4). On paper the two corporations’ control systems appeared quite similar, but the differences might have been caused by one or more difficult-to-observe control factors, such as the tone at the top. Alternatively, the cause may have been the then recent fraud which had occurred in a subsidiary of Corporation A. If so, these data may be illustrating the value of periodic reminders of the costs of internal control violations. It is also important to note that we found significant disagreement among the respondents for most of the scenarios. For example, the distribution of responses for question 2b, regarding the ethics of deferring discretionary expenditures at year-end to achieve the annual budget target, was on our 1 through 5 scale 150, 52, 50, 42, and 14, respectively. In other words, these data show that approximately 48% (l-50/308) of the respondents thought this action was acceptable; approximately 34% (106/308) thought it not acceptable (with various degrees of condemnation), and approximately 17% (52/308) were not sure. These data indicate far less than unanimous agreement about where the line between right and wrong should be drawn, and these differences existed even among personnel filling identical roles in the same firm. Similarly, we learned in subsequent discussions that many individuals were not confident in their judgments. For example, one indicated that he was not happy with his responses and knew he needed ethics education.
K. A. Merchant and J. Rockness
92
This suggests that the use of questionnaires such as the one we used can provide a useful vehicle to communicate corporate managers’ positions on the acceptability of various forms of managing earnings. If these findings are borne out in subsequent studies, they can be used by those who wish to take a normative stance and argue that the prevailing morality needs improvement. One obvious potential problem is the lack of agreement among the respondents, even among those within a single corporation. None of the actions described in the questionnaire would be transparent to external financial-statement users, and users can assess the ethical stands of a firm’s dominant coalition only over a long period of time. Thus their abilities to judge the quality of a firm’s short-term earnings reports are severely hindered. These findings are also troubling because, as the National Commission on Fraudulent Financial Reporting (1987, pp. 24-25) concluded, a danger exists that over time the financial reporting practices within a firm will sink to their lowest, most manipulative level. The managers who engage in earnings management practices the most will appear to be more effective because they will have smoother earnings patterns and will have achieved their budget targets more often. Thus these are the managers who will be promoted, and the manipulative culture will grow exponentially. We believe that other tentative but critical, normative statements can be made based on these findings, but we regard them as being outside the scope of our study.
6. Limitations
and Suggestions
for Future Research
Our study was intended to explore empirically the controversial issue of earnings management, probably the most important ethical issue facing the accounting profession. We have provided some preliminary evidence which helps to place some common earnings management practices on the “acceptability continuum (Merchant 1987, p. 42).” And we presented some data suggesting that the ethical climate varied between Corporation A and Corporation B. Our findings must be treated as tentative, however, because the study had a number of limitations. First, the questionnaire format permitted the provision of only short scenario descriptions, and some of the variation in responses might have been caused by differences in assumptions the respondents made about some of the unmentioned contextual variables (e.g., whether the action was within the manager’s area of authority). It is likely that the large variances in responses would have been smaller if more scenario context had been provided. Second, the sampling was opportunistic. The cooperation of two corporations and the IIA chapter provided us an opportunity to get useful samples from those populations, but the responses from personnel from other populations might have been different. Among the groups which
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The Ethics of Managing Earnings
might provide different answers are external auditors, regulators, and representatives from other corporations and other types of organizations. Respondents from non-U.S. populations would also likely be different (e.g., Becker and Fritzsche 1987, pp. 92-95; Karnes et al. 1989, pp. 34-38). And third, although all the responses were anonymous, some response biases, such as social-desirability bias or question-order biases, may have been present in the responses. And the timing of the use of the questionnaire may have affected the responses, as for all three respondent groups the questionnaire was distributed in conjunction with an invitation to a meeting to discuss the findings. These data are only an incomplete first step toward understanding a complex set of issues-the bases of people’s ethical judgments about earnings management practices. In some ways the findings raise more questions than they answer. The questions assessed only a limited set of the many forms of earnings management actions which managers can and have used; for example, none of the questions referred to changes in accounting policies because the questionnaire setting was at the division level of organization, and division managers rarely have the discretion to make such changes. And we were able to say little about why the respondents’ judgments varied so much. Such issues should provide good motivations for further research. Clearly much more remains to be done, as studies could usefully employ different examples of manipulative accounting practices, on different samples of respondents, and with better controls on the data collection. We appreciate the comments by seminar participants at Arizona State University, North Carolina State University, University of California (Los Angeles) and University of Glasgow (Scotland) and, particularly, Kirsten Ely, Larry Grasso, and Paul Williams.
References Becker, H. and Fritzsche, D. J. Winter 1987. A comparison of the ethical behavior of American, French and German managers. Columbia Journal of World Business 22(4):87-95.
Berton, L. Sept. 22, 1992. Holding accountants accountable. The Wall Street Journal 220(59):AlS.
Bowie, N. and Duska, R. 1990. Business Ethics. 2nd edition. Englewood
Cliffs, NJ:
Prentice-Hall. Bruns, W. J., Jr. and Merchant, K. A. August 1990. The dangerous managing earnings. Management Accounting 72(2):22-25. Burton, J. C. and Sack, R. J. Dec. 1989. Editorial: Ethics accounting education. Accounting Horizons 3(4):114-116.
morality
and professionalism
of in
DeAngelo, L. Jan. 1988. Managerial competition, information costs, and corporate governance: The use of accounting performance measures in proxy contests. Journal of Accounting and Economics 10(1):3-36.
94
K. A. Merchant
DeFond, M. and Jiambalvo, J. July 1991. Incidence ing errors. The Accoclnting Reciew 66(3):643-655.
and J. Rockness
and circumstances
Dye, R. Autumn 1988. Earnings management in an overlapping Journal of Accounting Research 26(2):195-23.5.
of account-
generations
model.
Flory, S. M., Phillips, T. J., Reidenbach, R. E. and Robin, D. P. April 1992. A multidimensional analysis of selected ethical issues in accounting. The Accounting Review 67(2):284-302. Goodpaster, K. E. and Matthews, J. B., Jr. Jan.-Feb. 1982. Can a corporation a conscience? Hunlard Business Review 60(1):132-141.
have
Hand, J. Oct. 1989. Did firms undertake debt-equity swaps for an accounting profit or a true financial gain? The Accounting Review 64(4):587-623. Harnard Business Ret:iew. March-April 1989. Ethics Harvard Business Reriew 89(2):220-221.
test for everyday
paper
managers.
on accounting
Karnes, A., Sterner, J., Welker, R. and Wu, independent auditors’ perceptions of unethical Journal of Accounting 24(1):29-41.
F. 1989. A bicultural study of business practices. Zntemationai
L. 1984. The Philosophy of Moral Decelopment.
Kohlberg, Row.
decisions.
Journal
Healy, P. M. April 1985. Effect of bonus schemes of Accounting and Economics 7(1-3):85-107.
New York:
Harper
&
Lev, B. 1989. On the usefulness of earnings and earnings research: Lessons and directions from two decades of empirical research. Journal ofAccounting Research 27(Supplement):153-201. McNichois, provision Merchant, making:
M. and Wilson, G. P. 1988. Evidence of earnings management from the for bad debts. Journal of Accounting Research 26(Supplement):l-31. K. A. 1985. Organizational controls and discretionary program decision A field study. Accounting, Organizations and Society 10(1):67-85.
Merchant, K. A. 1987. Fraudulent and Questionable Financial Reporting: A Corporate Perspective. Morristown, NJ: Financial Executives Research Foundation. Merchant, K. A. 1989. Rewarding Results: Motivating Profit Center Managers. Boston: Harvard Business School Press. Merchant, K. A. 1990. The effects of financial controls on data manipulation management myopia. Accounting, Organizations and Society 15(4):297-313.
and
National Commission on Fraudulent Financial Reporting. Oct. 1987. Report of the National Commission on Fraudulent Financial Reporting. New York: American Institute of Certified Public Accountants. Noreen, E. 1988. The economics of ethics: A new perspective Accounting, Organizations and Society 13(4):359-369. Schipper, K. Dec. 1989. Commentary 3(4):91-102. Touche
on earnings
management.
on agency theory. Accounting Horizons
Ross. 1988. Ethics in American Business. New York: Touche
Trueman, B. and Titman, S. 1988. An explanation for accounting ing. Journal of Accounting Research 26(Supplement): 127- 139. Victor, B. and Cullen, J. B. March 1988. The organizational climates. Administratke Science Quarterly. 33(1):101-125.
Ross.
income
smooth-
bases of ethical
work
and Joanne Rockness
This paper describes the findings of a study designed to explore empirically the controversial issue of earnings management. Earnings management practices probably raise the most important ethical issues facing the accounting profession, yet little research has explored the topic. To assess the prevailing morality regarding earnings management practices, we used a questionnaire comprised of 13 potentially questionable earnings management activities. General managers, staff managers, operating-unit controllers, and internal auditors were sampled. The responses show some areas of general agreement. For example, acceptability was judged to vary with the type, size, timing, and purpose of the actions. But we also found significant areas of disagreement. The paper concludes with a discussion of the implications of this general disagreement and suggestions for future research.
1. Introduction One thing lawmakers and designers of organizational control systems and professional codes of conduct have in common is their need to distinguish between acceptable and unacceptable forms of behavior. Sometimes these groups’ tasks are easy as, for example, conclusions that theft of assets is unacceptable are not controversial. But for many other types of behaviors, deriving these prescriptions is difficult. One controversial, and important, area is that of earnings management. Earnings management can be defined as any action on the part of management which affects reported income and which provides no true economic advantage to the organization and may in fact, in the long-term, be detrimental (Merchant 1989, pp. 168-169). There is evidence to show that many managers do manage earnings (e.g., Healy 1985, pp. 106-107; DeAngelo 1988, pp. 34-35). But earnings management actions can be
Address reprint requests to: Professor Joanne Rockness, Department Business Law, Cameron School of Business Administration, The University Wilmington, Wilmington, NC 28403.3297. Journal 01 Accounting
0
1994 Elsewer
Science
and Public Inc.
Policy,
13.79-94
of Accountancy and of North Carolina at
79
(19Y4) 027X-4254/94/$7.00
80
K. A. Merchant and J. Rockness
quite harmful. For example, the National Commission on Fraudulent Financial Reporting (1987, pp. 5-6) concluded that earnings management activities can mislead financial-statement users and, sometimes, are precursors of more serious, illegal (fraudulent reporting) activities. Our paper reports the findings of an empirical investigation aimed at assessing the prevailing morality with respect to earnings management. The study responds to the call made by many (e.g., Burton and Sack 1989, pp. 114-116) for additional research on topics related to ethics and fraud to improve our understanding of the problems and the means for improvement. We focused our study on the ethics of managing earnings because earnings is “widely believed to be the premier information item provided in financial statements” (Lev 1989, p. 15.5). We used a questionnaire originally developed by Merchant (1989, pp. 241-244) and then modified and published in Harvard Business Review (1989) which was comprised of 13 potentially questionable earnings management activities. Samples of general managers, staff managers, operating-unit controllers, and internal auditors were asked to judge the acceptability of each of the actions. We hoped that the responses would yield some agreement on the morality of engaging in various types of earnings management. We foun~d some areas of general agreement; for example, acceptability was judged to vary with the type, size, timing, and purpose of the actions. But we also found significant areas of disagreement. Our findings generally confirm those of Bruns and Merchant (1990, pp. 22-24). Although Bruns and Merchant used this same earnings management questionnaire, their data were derived from voluntary responses received after the questionnaire was published in Hamard Business Review, so their findings were susceptible to possible response bias. Our paper is organized as follows. The next section summarizes the literature dealing with the incidence and causes of earnings management. Then the research method and findings are discussed. The paper concludes with a discussion of the findings and some suggestions for further research. 2. Literature
Review
As noted below virtually all prior research on earnings management has taken an economics perspective. That is, the research has focused on questions about the incentives managers have to manage earnings and the consequences of their manipulative actions (i.e., the costs and benefits of allowing discretion in the choice and application of accounting methods). As noted below prior published research has provided evidence that managers do manage earnings through their choices of accounting policies, their accounting judgments, or their timing or selection of operating decisions. It has also shown that managers’ actions are related to a number of their incentives. For example, Healy (1985, pp. 95-107) found an association between accounting accruals and the incentives managers were
The Ethics of Managing Earnings
81
provided by earnings-related bonus plans. Merchant (1990, pp. 305-306) found that a large proportion (> 90%) of the profit center managers in one arguably well-run corporation boosted earnings in a recent recessionary year, with their primary motivation being the achievement of their budget targets. McNichols and Wilson (1988, p. 30) found that managers have a tendency to decrease earnings when earnings are extreme in either direction. DeAngelo (1988, pp. 34-35) found that incumbent managers in proxy contests take actions to boost earnings. Hand (1989, pp. 621-622) found that managers timed their debt-equity swaps to smooth income. DeFond and Jiambalvo (1991, p. 653) found that managers who overstate earnings are more likely to be in firms which need earnings because they have not been performing well and/or they are highly leveraged, and in firms which have weaker control systems, evidenced by diffuse ownership and no audit committees. Research has provided little evidence about the consequences of earnings management actions. In an essay on the topic, Schipper (1989, pp. 101-102) drew on the findings of some analytical research (Dye 1988, pp. 225-226; Trueman and Titman 1988, pp. 138-139) on the effects of accounting accruals and concluded that harm is minimized if the communication is transparent and no contractual frictions exist. In other words, the key questions are: Are the details of the actions disclosed so that financial analysts can undo the earnings effects? And, are the incentives such that it is worthwhile for them to do so? The economics perspective, however, focuses only on a limited set of the causes and consequences of earnings management actions. Noreen (1988, pp. 359-360) argued for a broader perspective. He (1988, pp. 359-360) suggested that managers’ behaviors may be affected by forces not normally considered within the self-interest focused economic framework, such as conscience, religion, or genetics. Some applied-ethics textbooks (e.g., Bowie and Duska 19901, in fact, describe examples in both business and personal areas of decision-making where individuals’ beliefs about their obligations and duties, or fairness and justice, overrode their short-term, and even long-term, self-interests. Noreen argued that not only do these noneconomic motivators exist, some forms of them “are a necessary lubricant for the functioning of markets” (Noreen 1988, p. 368). The ethical perspective raises some interesting and important issues. Most of the earnings management actions which have been studied are legal, not inconsistent with generally accepted accounting principles (GAAF’), and within the managers’ prerogatives. The ethical perspective, however, raises the question as to whether these things are the right things to do. Should we, for example, judge it acceptable for a manager to boost earnings by squeezing reserves? If not, the individuals engaging in these actions are acting in a socially unacceptable way. If the individuals’ moral codes do not prevent the actions, it might be beneficial to enact laws or codes of conduct to deter such activities, and to create audit programs and
82
K. A. Merchant and J. Rockness
other forms of controls to detect and correct the manipulations before the financial statements are published. A related question is: Is the intent behind the action relevant? Should our moral judgments depend on the purpose for which the earnings are being boosted? For example, are managers’ actions undertaken to boost earnings to augment their bonuses more heinous than their doing so to prevent their firm from defaulting on the terms of its bank loans? If intent is relevant, the prevention/detection process becomes more complicated. These earnings management issues are important. The National Commission on Fraudulent Financial Reporting (1987, pp. 23-24) concluded that virtually every case of fraudulent financial reporting starts with small ethical transgressions. And a Touche Ross (1988) survey of directors and top executives of major corporations, deans of business schools, and U.S. senators and representatives, with 1,017 respondents, found that the “increased concentration on short-term earnings” (p. 69) was rated as the second most important condition threatening to undermine American business ethics (just behind “decay in cultural and social institutions” (p. 69)). The U.S. Congress is actively looking at these issues. Attempts have been made to write legislation defining the line between right and wrong in financial reporting as well as to require accountants to blow the whistle on corporate fraud (Berton 1992). But thus far these efforts have not been passed into law. How does a society, the accounting profession, or an individual firm draw the line between acceptable and unacceptable earnings management practices? Merchant (1987, p. 42) studied a number of recent cases of fraud in financial reporting and concluded that two factors-accuracy and informativeness-define a nearly seamless continuum of earnings management practices. This continuum is shown in Figure 1. At one extreme, near 0,
are practices
which virtually
everyone
would
denounce
as unaccept-
able, such as fraud. At the other extreme, near 0, are practices which most people would view as acceptable such as, perhaps, a fully-disclosed switch from accelerated to straight-line depreciation if the business is in need of more earnings (Merchant 1987, p. 41). Based on interviews and panel discussions with financial-statement preparers, users, auditors, and regulators, Merchant (1987, p. 25) hypothesized that six factors affect people’s placements of earnings management practices on this acceptability continuum: l
“accordance
l
“clarity
with GAAP,”
l
clarity of “disclosure,”
of intent
l
“materiality,”
l
“period
l
“direction”
of effect”
to deceive,”
(e.g., year vs. month),
(i.e., boost or decrease
earnings).
The Ethics
Proportion of people judging practice as acceptable (S)
of Managing
83
Earnings
50%
0%
Inaccurate, deceptive
Accurate, informative Character Reporting
of FinancialPractices
Figure 1. An acceptability continuum of financial Merchant (1987, p. 42). Reprinted with permission.
reporting
practices
from
In later interview and questionnaire studies, Merchant (1989, pp. 178-180) and Bruns and Merchant (1990, pp. 22-24) found a great disparity between judgments about the acceptability of operating methods, as opposed to accounting methods, of managing earnings. @chipper (1989, p. 92) referred to these two earnings management methods as real and accruals-based, respectively.) Operating methods of managing earnings involve altering operating decisions, such as the decision to work overtime at year end to push out more shipments in the current year (Merchant 1989, p. 170). These decisions may affect both cash flow and income (Merchant 1989, p. 170). Accounting earnings management consists of using the options available in both accounting rules and the application of those rules (Merchant 1989, p. 169). The preceding discussion suggests the following multi-part research question:
Research Question 1: How should the acceptability of earnings management In particular, should the judgments depend on:
actions
be judged?
84
K. A. Merchant and J. Rockness
1. 2. 3. 4. 5. 6.
type of action (e.g., accounting vs. operating consistency with GAAP; the direction of the effect on earnings; materiality; the period of effect; and the purpose in mind.
manipulation);
Evidence is sparse, but it is likely that ethical judgments about earnings management practices are not constant across all groups of individuals. They may vary with people’s individual characteristics (e.g., religion, education) and characteristics of their environment (e.g., national or corporate culture, professional norms).’ Our paper focuses on two of these potentially important factors: corporate ethical climate and professional norms. A corporation’s ethical climate is a normative value system which is shaped and communicated by, among other things, organizational policies and procedures, reward systems, and top executives’ behaviors (Goodpaster and Matthews 1982, pp. 135-138; Victor and Cullen 1988, pp. 101-104). NO significant body of empirical evidence has been gathered to show links between a corporation’s ethical climate and its employees’ tendencies to engage in one or more forms of earnings management. But one of the conclusions of the National Commission on Fraudulent Financial Reporting (1987, pp. 32-36) was that managers in corporations with a poor ethical “tone at the top” are more likely to engage in fraudulent financial reporting activities than are those in corporations whose top management sets a better tone. Judgments about earnings management actions are probably also related to individuals’ professional norms which, in turn, are related to the roles the individuals play in the financial-reporting process. Auditors and accountants have professional standards of conduct dealing with financial-reporting issues,2 but managers, many of whom claim to be professionals, are not regulated formally by a professional body. The professional standards which exist are somewhat vague but they may affect ethical judgments about earnings management practices. These issues lead to the following research question: Research
Question 2 :
Are moral judgments 1. managers 2. personnel auditors)?
consistent
across different
in different firms, or in different roles (e.g.,
general
populations, managers,
such as: accountants,
‘For discussions of individual ethical reasoning see, for example, Kohlberg (1984). ZInterpretations of professional conduct are not absolute. They vary, for example, across cultures. Karnes et al. (1989, pp. 34-38) found significant differences between U.S. public accountants’ perceptions of unethical business practices and those of public accountants in Taiwan. However, Karnes et al. did not compare public accountants' judgments with those of other respondent groups.
85
The Ethics of Managing Earnings
3. Research Method Data were collected through the use of a questionnaire, developed by Merchant (1989) and subsequently modified and used by Bruns and Merchant (19901, which consisted of 13 short scenarios, each describing a potentially questionable earnings management activity taken by a hypothetical profit center manager. The questionnaire method of measuring ethical views is consistent with that used in prior research (e.g., Becker and Fritzsche 1987; Karnes et al. 1989; Flory et al. 1992). The activities described in the scenarios were developed based on knowledge of real events gained from prior research (Merchant 1985; 1989) involving interviews with large samples of operating and staff managers. One scenario, for example and its alternatives is as follows: 2. [The general manager] ordered his employees to defer all discretionary expenditures (e.g., travel, advertising, hiring, maintenance) into the next accounting period, so that his division could make its budgeted profit targets. Expected amount of deferral: $150,000. b. The expenses were postponed from November January in order to make the annual target.
and December
until
The complete questionnaire, containing each question and alternative, used in our study can be seen in Harvard Business Review, March-April 1989, pp. 220-221. Participants in the study were asked to evaluate each scenario by indicating their judgment as to the acceptability of each of the practices using the following scale (Harvard Business Review, March-April 1989, pp. 220-221): 1 = Ethical practice. 2 = Questionable practice. I would not say anything to the manager, but it makes me uncomfortable. 3 = Minor infraction. The manager should be warned not to engage in the practice again. 4 = Serious infraction. The manager should be severely reprimanded. 5 = Totally unethical. The manager should be fired. The scenarios were designed to address the research questions as follows (as noted above the questions can be found in Harvard Business Review, March-April 1989, pp. 220-221): 1. Type of earnings management action. a. Questions 1, 2a, 2b, 4a, 4b, 4c described operating methods of managing earnings. The others described accounting methods. b. Question 4 added a different cut on method. The earnings management activities listed included: 1) use of techniques to accelerate sales; 2) an end-of-year push to accelerate product shipments, and 3) sale of certain assets to realize income.
86
K. A. Merchant and J. Rockness
2. Consistency with GASP. Of the seven accounting manipulations, three were consistent with GAAP (questions 5b, 6a and 6b). 3. Direction of effect. Three of the 13 scenarios referred to actions designed to decrease (as opposed to increase) earnings (questions 1, 5a, 5b). 4. Materiality was introduced as a concern between questions 7a and 7b. 5. The period of effect was introduced as a concern between questions 2a and 2b. 6. The purpose in mind was introduced as a concern between questions 6a and 6b. The questionnaire did not include all the possible combinations of factors (as in a full factorial experimental design). But the questions were designed so that there would be minimal confounding of results. For example, the questions describing accounting and operating manipulations included approximately equal mixes of large and small effects and incomeincreasing and income-decreasing effects. Permission was received to use the questionnaire in two corporations and one chapter of the Institute of Internal Auditors (ICA). Corporation A permitted the sending of the questionnaire to all the attendees of a meeting of their worldwide general and financial management staffs in October 1987. This group included all the profit center managers in the firm and all the corporate and line controller staffs down to the level of division controller. A total of 119 questionnaires were sent by company personnel in interoffice mail, attached to a cover letter from the corporate controller, to be returned directly to one of the authors. A single request netted a total of 100 responses, an approximate 84% response rate. Corporation B permitted the sending of the questionnaire to all the attendees of a worldwide controllers’ meeting in May 1989. Those attending included all finance and accounting staff down to the level of division controller and a sampling of other high-level personnel. The data collection method was identical to that used in Corporation A with two exceptions: the cover letter was signed by the chief financial officer, and the corporation did not disclose how many questionnaires were sent out. Coincidentally, exactly 100 were returned. There were approximately the same number of attendees as Corporation A. However, due to last minute additions and cancellations a precise response rate for Corporation B could not be determined. The two corporations are similar in many ways. They are both large, divisionalized, multinational, manufacturing companies. Most of their businesses have a high high-technology content, although the two firms do not compete in any market segment. Corporation A produces electronic equipment. Corporation B is in the communications industry, and parts of its operations are regulated. Both firms had annual incentive plans providing
87
The Ethics of Managing Earnings
managers cash awards, normally between 20% and 66% of base salary, based partially on accounting measures of performance. Both corporations also had a long-term incentive plan providing awards based on multi-year corporate (not operating unit) performance. And both corporations had a formal, written code of ethics written in broad, general terms. There are only a few significant differences between the two corporations. One is that Corporation B is significantly larger than Corporation A. A second is that the key financial performance measure for Corporation A was based on operating profit, while for Corporation B it was profit before tax. And third, Corporation A had recently had a major incident of fraud in a foreign subsidiary, and internal control issues were on many of its managers’ minds. Questionnaires were also sent to the entire membership of one chapter of the Institute of Internal Auditors in January 1988. The responses were used as the focus of a chapter dinner meeting, so the cover letter was signed by the program chairman. A single request netted 108 responses from the 165 members (approximately 65%). Ninety of the respondents were practicing internal auditors. Table 1 summarizes the responses by organization and by role. A significant number of responses were received from general managers, corporate staff, operating-unit controllers, and internal auditors. In addition to our analysis of the questionnaire responses, we were able to learn more about the issues through discussions with a number of respondents. These discussions were possible because we presented the questionnaire results to each of the three groups of respondents at formal meetings. 4. Results Table 2 shows the mean scores and standard deviations for the responses of the entire set of 308 respondents for each of the 13 scenarios. Two Table 1. Classification of Respondents Corporation General managers Corporate staff Operating-unit controllers Internal auditors Other Total respondents
A
Corporation
B
HA Chapter
26
11
31
6.5
96
39
22
61
4 100
2 100
-
Total 37
90
90
18 108
22 308
88
K. A. Merchant and J. Rockness
Table 2. Mean Scores and Standard Deviations, All Respondents Question 1 2a 2b 3 4a 4b 4c 5a 5b 6a 6b 7a 7b
Mean 1.26 1.81 2.09 3.42 1.96 1.31 1.25 3.27 3.51 3.59 3.69 3.76 4.05
*See page 85 of this paper for a description
Standard Deviation
Range* 1-4 l-5 1-5 t-5 l-5 l-5 1-5 l-5 1-5 l-5 1-5 l-5 l-5
0.58 1.01 1.27 0.80 1.09 0.69 0.68 1.07 1.19 1.18 1.11 0.98 0.94 of the judgment-scale
(n = 308)
range.
conclusions can be drawn from these data. First, lack of agreement exists among the item ratings. This suggests that the scenarios tapped a number of points along the acceptability continuum shown in Figure 1. And second, the large ranges of responses and the high standard deviations for some scenarios show that the respondents did not agree in their judgments; we found no near-unanimous prevailing morality regarding earnings management activities. The first research question was designed to facilitate the exploration of questions as to whether judgments of acceptability of various earnings management practices depend on various attributes of the practice. The results can be summarized as follows: 1. Ethical judgments were affected by the fYpe of earnings management practice. The first two lines of Table 3 compare the mean ratings for the questions describing accounting methods of managing earnings with those describing operating methods. It shows a highly significant difference; the accounting methods were judged much more harshly (t = 44.5; p < .OOl>. The responses for question 4, which varied the method of manipulation, also revealed a significant difference. From the data shown in Table 2, the respondents judged the liberal-payment-term method as significantly less acceptable than either working overtime to accelerate shipments (the t statistic was t = 11.66; p < .OOl> or selling excess assets to realize the profit (the t statistic was t = 10.99; p < .OOl). 2. Whether or not the accounting manipulations were consistent with GAAP seemed not to matter. The third and fourth lines of Table 3 show that
89
The Ethics of Managing Earnings
Table 3. Mean Acceptability Ratings for Earnings Management Three Contrasting Attributes (n = 308) Attribute
Questions
Mean Rating**
Accounting method
3, 5a, 5b, 6a, 6b, 7a, 7b
3.61
Operating method
1, 2a, 2b, 4a, 4b, 4c
1.61
Consistent with GAAP
5b, 6a, 6b
3.60
Inconsistent with GAAP
3, 5a, 7a, 7b
3.63
Increases earnings
2a, 2b, 3,4a, 4b, 4c, 6a, 6b, 7a, 7b
2.69
Decreases earnings
1, 5a, 5b
2.68
Practices with t Statistic
44.5*
- 0.53
0.50
* =p < .Ol “*See page 85 of this paper
for a description
of the judgment-scale
range.
consistency with GAAP made no significant difference (t = - .53; n.s.> in the respondents’ acceptability judgments. The direction of effect on earnings was not important. The last two lines of Table 3 show that the actions which boosted earnings were not rated significantly different from those which decreased earnings in the short-run (for use in a later period) (t = SO; n.s.>. Materiality mattered. The average ratings for questions 7a and 7b, shown in Table 2, show that the larger earnings management action (7b) was rated significantly less acceptable than the smaller (immaterial) action (7a) (the t statistic was t = -5.51; p < .001X The period of ejj‘kt mattered. Question 2 referred to a quarter-end manipulation, while 2b referred to a year-end manipulation. Table 2 shows that the year-end action was judged significantly less acceptable (the t statistic was t = -8.86; p < .OOl>. The manager’s purpose was a concern. Question 6a referred to a purpose which could be interpreted as being in the corporation’s best long-term interest (continuation of some important product development projects), while 6b asked about a more selfish purpose (make budgeted profit targets). As the data in Table 2 show, the respondents judged the selfish action more harshly (the t statistic was t = -3.67; p < .OOl>. The second research question asked whether the judgments varied across respondent populations. Table 4 shows that the ratings from the
90
K. A. Merchant
Table 4. Mean Judgment
Ratings by Respondent
and J. Rockness
Organization
f Statistic
Sample
Mean Rating**
Corporation A
2.90
A VS.B = 4.58*
2.57
A vs. IIA = 4.04*
2.61
B vs. IlA = -0.69
(n = 100) Corporation B (n = 300) IIA chapter (n = 108)
* = p < .Ol **See page 85 of this paper
for a description
of the judgment-scale
range
Corporation A respondents (the corporation which had had the recent major fraud incident) were significantly more harsh than were those from Corporation B (the t statistic was r = 4.58; p < .OOl) or from the IIA chapter (the t statistic was t = 4.04; p < .OOl>. The data in Table 5 show, surprisingly, that the general managers were the most conservative in their judgments, meaning that their judgments about the acceptability of the earnings management actions were the most harsh. The internal auditors were the most liberal. These differences were not consistent for all the questions as, for example, the general managers and internal auditors agreed in condemning the actions which were not consistent with GAAP (means of 3.50 and 3.48, respectively). Across all questions, however, the internal auditors were significantly more liberal in their judgments than the general managers (the t statistic was t = 2.59; p < .OS> or the operating-unit controllers (the t statistic was t = 2.20; p < .os>.
5. Discussion
and Conclusions
A primary purpose of our study was to assess the prevailing morality with respect to earnings management practices. We found areas of general
Table 5. Mean Judgment Ratings by Role Role General managers (n = 37) Corporate staff (n = 96) Operating-unit controllers (n = 61) Internal auditors (rl = 90) **Set page
85 of this paper
Mean Rating** 2.83 2.70 2.79
t Statistics GM vs. staff = 1.42 GM vs. controllers = 0.31 GM vs. auditors = 2.59* Staff vs. controllers = 1.06 Staff vs. auditors = 1.39 Controllers vs. auditors = 2.20*
2.60
for a description
of the judgment-scale
range.
The Ethics
of Managing
Earnings
91
agreement about some characteristics of the practices; the judgments were affected by the type (e.g., operating vs. accounting), size (materiality), timing (accounting period-end), and purpose (e.g., increase bonus) of the action. We suggest, tentatively, that organizations or professions which define to their employees or members which actions are not allowable can, and probably should, use at least some of these specific earnings management characteristics in their definitions. We also found a few surprises in the data. One is that the respondents did not, on average, consider either consistency with GAAP or the direction of the effect on earnings in making their judgments. Regarding the consistency-with-GAAP finding, either the respondents believed that manipulators should not use GAAP as a defense for their actions, or enough of them were ignorant of the details of GAAP to render the findings statistically insignificant. The respondents did not condone excessive conservatism because they apparently viewed the understatement of earnings in the current period as providing a potentially misleading signal, and they realized that managers who decreased earnings in a current accounting period were doing so to increase their abilities to increase them in a future period. This view appears to conflict with auditors’ generally high tolerance for conservatism in financial reporting. The judgments from the different respondent groups varied in some systematic ways. The ethical climate within Corporation A seems to have been significantly different from that within Corporation B; A’s respondents’ judgments were significantly more conservative (see Table 4). On paper the two corporations’ control systems appeared quite similar, but the differences might have been caused by one or more difficult-to-observe control factors, such as the tone at the top. Alternatively, the cause may have been the then recent fraud which had occurred in a subsidiary of Corporation A. If so, these data may be illustrating the value of periodic reminders of the costs of internal control violations. It is also important to note that we found significant disagreement among the respondents for most of the scenarios. For example, the distribution of responses for question 2b, regarding the ethics of deferring discretionary expenditures at year-end to achieve the annual budget target, was on our 1 through 5 scale 150, 52, 50, 42, and 14, respectively. In other words, these data show that approximately 48% (l-50/308) of the respondents thought this action was acceptable; approximately 34% (106/308) thought it not acceptable (with various degrees of condemnation), and approximately 17% (52/308) were not sure. These data indicate far less than unanimous agreement about where the line between right and wrong should be drawn, and these differences existed even among personnel filling identical roles in the same firm. Similarly, we learned in subsequent discussions that many individuals were not confident in their judgments. For example, one indicated that he was not happy with his responses and knew he needed ethics education.
K. A. Merchant and J. Rockness
92
This suggests that the use of questionnaires such as the one we used can provide a useful vehicle to communicate corporate managers’ positions on the acceptability of various forms of managing earnings. If these findings are borne out in subsequent studies, they can be used by those who wish to take a normative stance and argue that the prevailing morality needs improvement. One obvious potential problem is the lack of agreement among the respondents, even among those within a single corporation. None of the actions described in the questionnaire would be transparent to external financial-statement users, and users can assess the ethical stands of a firm’s dominant coalition only over a long period of time. Thus their abilities to judge the quality of a firm’s short-term earnings reports are severely hindered. These findings are also troubling because, as the National Commission on Fraudulent Financial Reporting (1987, pp. 24-25) concluded, a danger exists that over time the financial reporting practices within a firm will sink to their lowest, most manipulative level. The managers who engage in earnings management practices the most will appear to be more effective because they will have smoother earnings patterns and will have achieved their budget targets more often. Thus these are the managers who will be promoted, and the manipulative culture will grow exponentially. We believe that other tentative but critical, normative statements can be made based on these findings, but we regard them as being outside the scope of our study.
6. Limitations
and Suggestions
for Future Research
Our study was intended to explore empirically the controversial issue of earnings management, probably the most important ethical issue facing the accounting profession. We have provided some preliminary evidence which helps to place some common earnings management practices on the “acceptability continuum (Merchant 1987, p. 42).” And we presented some data suggesting that the ethical climate varied between Corporation A and Corporation B. Our findings must be treated as tentative, however, because the study had a number of limitations. First, the questionnaire format permitted the provision of only short scenario descriptions, and some of the variation in responses might have been caused by differences in assumptions the respondents made about some of the unmentioned contextual variables (e.g., whether the action was within the manager’s area of authority). It is likely that the large variances in responses would have been smaller if more scenario context had been provided. Second, the sampling was opportunistic. The cooperation of two corporations and the IIA chapter provided us an opportunity to get useful samples from those populations, but the responses from personnel from other populations might have been different. Among the groups which
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The Ethics of Managing Earnings
might provide different answers are external auditors, regulators, and representatives from other corporations and other types of organizations. Respondents from non-U.S. populations would also likely be different (e.g., Becker and Fritzsche 1987, pp. 92-95; Karnes et al. 1989, pp. 34-38). And third, although all the responses were anonymous, some response biases, such as social-desirability bias or question-order biases, may have been present in the responses. And the timing of the use of the questionnaire may have affected the responses, as for all three respondent groups the questionnaire was distributed in conjunction with an invitation to a meeting to discuss the findings. These data are only an incomplete first step toward understanding a complex set of issues-the bases of people’s ethical judgments about earnings management practices. In some ways the findings raise more questions than they answer. The questions assessed only a limited set of the many forms of earnings management actions which managers can and have used; for example, none of the questions referred to changes in accounting policies because the questionnaire setting was at the division level of organization, and division managers rarely have the discretion to make such changes. And we were able to say little about why the respondents’ judgments varied so much. Such issues should provide good motivations for further research. Clearly much more remains to be done, as studies could usefully employ different examples of manipulative accounting practices, on different samples of respondents, and with better controls on the data collection. We appreciate the comments by seminar participants at Arizona State University, North Carolina State University, University of California (Los Angeles) and University of Glasgow (Scotland) and, particularly, Kirsten Ely, Larry Grasso, and Paul Williams.
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