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By Kenneth Rosenzweig, CMA, and Marily Fischer

Reprinted with permission of the Institute of Management Accountants, from Management Accounting, March 1994; permission conveyed through Copyright Clearance Center, Inc.

Is managing earnings through accounting methods ethically acceptable? That’s the question we recently asked a sample group of management accountants. The response to the survey was enlightening.

Our survey was designed as a follow-up and extension of the research done by Bruns and Merchant and published in Management Accounting ® in August 1990. l They found that managers disagreed considerably on whether earnings management is ethically acceptable. They also found that in general the respondents thought manipulating earning via operating decisions was more ethically acceptable than manipulation by accounting methods. Bruns and Merchant were disturbed by these findings. They were concerned that these practices could be misleading to users of the information and, over time, reduce the credibility of accounting numbers and thereby damage the reputation of the accounting profession.

Bruns and Merchant surveyed managers, but accountants as well can influence the level of reported earnings either directly by means of their impact on the choice of accounting methods or indirectly by monitoring the actions of managers who influence reported earnings. To learn more about accountants’ attitudes toward earnings management, we surveyed 265 members of a regional organization of accountants (approximately 38% of the total membership). Our questionnaire was adapted from the one used by Bruns and Merchant and included 13 descriptions of managerial actions. The accountants were asked to rate these actions on a 5-point scale from "ethical" to "totally unethical." (See "Earnings Management Questions," p. 62.)

For the purpose of this study, we define earnings management in terms of the actions of a manager that are intended to increase (decrease) current reported earnings of the unit for which the manager is responsible without generating a corresponding increase (decrease) in the long-term economic profitability of the unit. Our definition is consistent with the way Bruns and Merchant used the term, although there is no standard, widely accepted definition of earnings management.

The 13 questions on the survey can be grouped by categories (called "factors") of earnings management actions. Two of these factors involve accounting manipulation, and two involve operating decisions designed to influence reported earnings. The accounting factors include actions that influence earnings by changing accounting methods. Examples include recording an expense in the wrong year or changing an inventory valuation in order to influence earnings. Examples of operating decision manipulations are deferring necessary expenditures to a subsequent year or offering unusually attractive terms to customers at year-end to draw next year’s sales into the current year.

Accountants’ Attitudes: Survey Results

Table 1 lists the mean score for the 13 questions, grouped by factors. To calculate factor scores, we averaged accountants’ ethical ratings for the managers’ actions that were included in that factor. The table shows that the accounting practitioners participating in the survey rated accounting manipulation much less acceptable ethically than operating decision manipulation. This finding parallels the attitude Bruns and Merchant found among managers. In our survey the accountants gave accounting manipulation an average rating between a moderate and a serious ethical infraction. They saw manipulation of inventory as being just as questionable ethically as other forms of accounting manipulation.

Generally, the practitioners had few ethical qualms about operating decision manipulation. For these factors, the practitioners’ scores indicated an average rating between (fully) ethical and questionable. The practitioners, however, generally felt that operating decisions that influenced expenses were somewhat more suspect than those that influenced revenues.

We also looked at whether there was a correlation between the accountants’ answers and their experience and level of responsibility. Table 2 suggests that accountants with more years of accounting experience are more tolerant of operating decision manipulation that affected reported expenses than are their less experienced colleagues. Consistent with this finding, Table 3 shows that accountants with higher levels of organizational responsibility rate operation decision manipulations of both types as more ethical than do accountants with less responsibility.

Ethically Troubling Results

Like Bruns and Merchant, we are disturbed by these findings. That accountants are more sensitive to accounting manipulation than operating manipulation is understandable in light of their training and experience. Several of the situations in the survey dealing with accounting manipulation not only involved ethically questionable practices, but they also involved violations of accepted accounting practice. For example, in survey question Number 4, the deferral of the recording of supplies received to a future accounting period is clearly a violation of generally accepted accounting principles. Analogous professional standards do not exist for the situations described in the operating manipulation questions.

The fact that the profession does not have explicit standards against operating manipulation does not mean that operating manipulation is any more ethical than accounting manipulation. Accountants’ basic ethical concern here should be whether such practices involve distortions that mislead users of financial statements. Both accounting and operating manipulations can lead stakeholders to make inaccurate assessments of a company’s economic health.

Given the kinds of decisions stakeholders make in light of reported earnings, both accounting and operating manipulations can be damaging to their interests. Stakeholders rely on financial statements, assuming that current reported earnings indicate long-term profitability. When earnings are managed so that financial statements do not reflect the economic health of the company accurately, stakeholders may make decisions they otherwise would not have made. Because of its distorting effects, earnings management is contrary to the "Standards of Ethical Conduct for Management Accountants," which states, "Management accountants have a responsibility. . . to disclose fully all relevant information that could reasonably be expected to influence an intended user’s understanding of the reports, comments and recommendations presented." 2

Our findings that accountants with more experience and higher positions in the organization are more tolerant of earnings management also is distressing. It could be that persistent pressure for short-term earnings growth tends to diminish accountants’ ethical values particularly with regard to manipulation of earnings. Perhaps accountants’ ethical sensitivity weakens as they move up in a company, or, in some cases, accountants who already have loose standards regarding earnings management may be more likely to be promoted.

This finding suggests that it is crucial for accountants with a high level of responsibility in an organization to set a clear example concerning earnings management and truthful reporting. Newly hired accountants look to their more senior colleagues for guidance concerning ethical behavior. If senior-level accountants engage in considerable earnings management, those at lower levels on the promotion ladder will learn quickly that the route to success in the organization is not facilitated by truthful reporting.

The Profession’s Response

Our survey points out the need for individual accountants to become more sensitive to the ethical dimensions of earnings management. For example, accountants may feel pressured by their organization to engage in earnings management in order to make quarterly reports look more favorable. Also, accountants may be concerned that their own performance evaluations will be based more on how favorable their prepared statements appear than on accuracy. Individual accountants need a clear understanding of the distorting effects of earnings management and the judgment and courage to resist these pressures.

Because decisions by operating managers can distort reported earnings significantly, management accountants need to assume responsibility regarding operating decision manipulation of earnings. Management accountants are held responsible by their organizations for the integrity of the financial reporting process. Distorted earnings as a result of operating decision manipulation reflect negatively on the performance of management accountants. Thus, management accountants have a stake in the organization’s implementing procedures to deter earnings management by means of operating decisions. As management accounting traditionally has been seen as a staff function, accountants may think it is not appropriate for them to "meddle" in the decisions of operating managers. But to the extent that the decisions of operating managers affect their ability to carry out their responsibilities with integrity, management accountants should be involved.

A number of things can be done to help accountants and managers become more aware of the ethically damaging effects of earnings management. For example, organizations could institute ethics awareness seminars and workshops. Ethical analyses of specific earnings management situations could be included as case studies in professional publications.

Also, a number of specific measures could be adopted to deter earnings management. Company recruitment policies could be revised to attract employees who already have ethical sensitivity to issues such as earnings management. Ethical codes that include explicit policies on both accounting and operating manipulation could be adopted. Management accountants and their organizations could adopt specific monitoring procedures regarding operating manipulation.

Because of its potential to distort reported earnings and mislead users of financial information, earnings management is a significant ethical concern. Individual practitioners, their organizations, and professional associations should take steps to identify and deter this practice.
Discussion Questions
  1. What is the definition of earnings management? Give some examples.
  2. What level of accountants are most tolerant of earnings management? Do you agree that earnings management is acceptable to achieve business goals?

  1. W. J. Bruns and K. A. Merchant, "The Dangerous Morality of Managing Earnings," Management Accounting, August 1990, pp. 22–25.  back
  2. "Standards of Ethical Conduct for Management Accountants," SMA 1C, Institute of Management Accountants, Montvale, N.J., 1983.  back

Table 1: Mean Scores of Answers to Earnings Management Questions, Grouped by Factors
Factor Question
Manager Actions Mean Variable
Inventory valuation 9 Write down inventory 1.68
10 Write up inventory-product development 1.50 1.49
11 Write up inventory-profit target 1.29
Other 4 Record supplies next year 1.71
8 Prepay next-year expenses 1.73
12 Delay consultant's invoice-small 1.76 1.51
13 Delay consultant's invoice-large 0.85
Operating expense 1 Paint ahead of schedule 3.82
2 Defer expenditures-month 3.38 3.44
3 Defer expenditures-year 3.12
Operating revenue 5 Pull sales-liberal terms 3.19
6 Overtime to maximize shipments 3.70 3.55
7 Sell excess assets-profit 3.75

4 = ethical; 3 = questionable; 2 = moderate; 1 = serious; 0 = totally unethical.
Table 2: Differences in Means of Ethical Ratings of Operating Decision Manipulation Affecting Operating Expense at Different Experience Levels
Experience Level Number of Respondents Mean
Operating Expense
Six years or less 56 3.1310
Greater than six years 209 3.5231

4 = ethical; 3 = questionable; 2 = moderate; 1 = serious; 0 = totally unethical.
Table 3: Differences in Means of Ethical Ratings of Operating Decision Factors at Different Job Levels
Job Level Number of Respondents Mean
Operating Expense
Operating Revenue
Entry-level or junior accountant 14 2.7381 3.1905
Experienced employee or senior accountant 55 3.4061 3.4667
Supervisor or manager 124 3.5242 3.6129
Executive or partner 56 3.5119 3.6012

4 = ethical; 3 = questionable; 2 = moderate; 1 = serious; 0 = totally unethical.

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