Ethics and Its Ties to Earnings Management

 “Ethics and Its Ties to Earnings Management”

INTRODUCTION

        Many professionals and accounting researchers have raised the question -Is ethics directly linked to the practice of earnings management? Earnings management is defined by Beaudoin, Cianci, and Tsakumis (2012, p.507), as “the manipulation of revenues and/or expenses to obtain a desired financial reporting outcome.”  He and Yang’s article offers that the definition of earnings management is “a process in which 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” (He and Yang 2013). So either way one looks at it, earnings management is a form of deceit. In Shafer’s (2013, p.45) paper, the author defines ethical climate by referencing Victor and Cullen (1988) as, “the prevailing perceptions among employees of organizational practices and procedures that have ethical content.” Frequently, findings have shown that companies tend to engage in earnings management through management’s actions, and not just through accounting choices. Corporations tend to conduct earnings management to meet earnings forecasts, as well as to decrease financing and tax costs.

        One side of the spectrum would argue that it is perfectly fine to manage earnings, as long as it is within the generally accepted accounting principles. Others would argue that managing earnings is unethical from any standpoint. Furthermore, some would find it okay to manage earnings if it were in the best interest of shareholders, but find it is unethical if interest lied in the hands of the manager’s wealth. It is clear that there is a fine line between what is accepted as earnings management and what is accepted as fraudulent. It is also clear that not all earnings management practices are considered to be fraudulent activity. Since scandals, such as Enron, have occurred, many investors have become uneasy about deciding whether chief executive officers are looking out in the best interest of the shareholder or if they are solely worried about their personal bonus. We pose the thought - maybe regulators should take a second look at the current standards and be a little less lenient on the subject. As we look at manipulation of financial statements (earnings management), we will take the standpoint that any type of manipulation may cause a stakeholder to make the wrong assumption about a company’s economic health. It’s like looking through a telescope with your eyes closed.

Furthermore, since ethics and earnings management are geared towards perception, most researchers have used qualitative means of study, such as surveys, to establish their conclusions. In this paper, we will use qualitative stats from the KLD STATS database. KLD STATS will be discussed further on in the paper.

The purpose of this paper is to prove that there is a direct link between ethics and earnings management. This paper will look at entities that contain high ethical standards in comparison to entities that have low ethical standards. In the following, we will explain our hypothesis and research methods; then in our conclusion, we will offer final comments and suggestions for future researchers, regulators, and standard-setters.

PRIOR LITERATURE

        Many researchers would agree that earnings management is considered an unethical practice and would relate it to the self-fulfilling prophecies of the managers. Nevertheless, are CPAs equipped to determine if earnings management is going on in an entity? Will a CPA read between the lines or simply accept it because it complies with the generally accepted accounting principles? Although accounting academia may consider teaching students to become more aware of earnings management and the different types of methods an entity can use to manipulate earnings. We believe that it is up to the company to established strict ethical policies and initiatives to ensure that there is a positive effect on the environment and social welfare. Corporations and auditors should not accept what regulators and standard setters have established; however, they should follow the golden rule to ensure that there is a lack of earnings management.

Recent studies conducted by Beaudoin, Cianci, and Tsakumis’ (2012) have shown that when bonuses are involved for CFOs, the CFO will record larger discretionary expense accruals and vice versa. These authors also concluded that CFOs with low earnings management ethics will record larger discretionary expense accruals in comparison to those who have high earnings management ethics. Enron was a great example of how there are issues regarding corporations’ ethics (Chih, Shen, Kang 2008). Chih, Shen, and Kang also noted, “With a greater commitment to corporate social responsibility, the extent of earnings smoothing is mitigated, that of earnings losses and decreases avoidance is reduced.” In contrast, some researchers have expressed that the reliance on individual ethics may not be sufficient to fix the current issues regarding earnings management (Chen and Sheng 2013, p.1). However, we do not offer that the acknowledgement of ethics will solve the issues; we only conclude that entities with higher ethical standards will commit less earnings management.

We agree with William Shafer’s four hypothesis: “(1) A stronger perceived emphasis on corporate profitability and the pursuit of self-interest will lead accountants to less strongly support the importance of corporate ethics and social responsibility (2) A stronger perceived emphasis on serving the public interest and following laws or professional code of conduct will lead accountants to more strongly support the importance of corporate ethics and social responsibility (3) Stronger support for the importance of corporate ethics and social responsibility will lead professional accountants to judge aggressive actions as more unethical and decreased the likelihood that they will express an intention to engage in similar actions (4) Accountants’ ethical judgments regarding earnings management will influence their expressed intentions of engaging in similar behavior” (Shafer 2013, p.49-51). Shafer set up his study by conducting surveys of professionals geared towards different scenarios and then conducted a correlation analysis. Shafer found that beliefs in the importance of ethics and corporate social responsibility were linked with ethical decisions regarding both accounting and operating earnings management (Shafer 2013, p.57).

        Barton, Kirk, Reppenhagen and Thayer (2012) offered that firms with high ethics will also participate in earnings management. Barton et al. discovered that firms with high ethics will conduct earnings management to meet forecasts versus doing it to increase their managers’ compensation. Ethics is typically based off of perception; therefore, Barton et al. looks at the fact that some will find it okay to manage earnings if it is for the “right reasons.” Nevertheless, the matter still stands that ethics is linked to earnings management processes; however, their study simply looks at firms with high ethics, whereas we are sought out to prove that firms with low or no ethics standards/policies in place will overpass these highly ethical firms. Barton et al.’s study was a good one; however, they failed to look at firms that do not behave ethically.