Ethics in Corporate Finance Earnings Management

Published Date: 23 Mar 2015

For many years, the ethics of finance has been a concern in the corporate world. With the flexible accounting standards under the Generally Accepted Accounting Principles (GAAP) and International Accounting Standards (IAS), there are many grey areas of what is, and is not, ethical, including earnings management. All fraud is earnings management, but not all earnings management is fraud, which makes earnings management fall in this grey area.

Earnings management is the term used to describe the process of manipulating earnings of the firm to meet management's predetermined target. The flexibility of accounting standards may cause some variability in earnings to occur as a result of the accounting choices made by management. However, earnings management that falls outside the generally accepted accounting choice boundaries is clearly unethical. The intent behind the earnings management also contributes to the questionable ethics of the practice. Some managers use earnings management as a means of deceiving shareholders or other stakeholders of the organization, such as creating the appearance of higher earnings to increase compensation or to avoid default on a debt covenant (Kavousy 456). The intent to use earnings management to deceive stakeholders implies that it can be unethical, even if the earnings management remains within the boundaries of GAAP or IAS.

Everyone has their own definition of earnings management, and therefore, there is no standard definition. It has been defined as management's exploitation of accounting flexibility to meet earnings expectations of shareholders. It has also been defined as the misuse of discretionary judgment in financial reporting and in the way transactions are structured to either mislead stakeholders or to influence the outcome of negotiations, such as contracts, with third parties (Elias 34). Another definition of earnings management indicates that it involves choosing a method accounting for or structuring a transaction that is either opportunistic or economically efficient (Ronan 25). The common elements in the definitions of earnings management related to ethics are the intention of the action and the consequence of the action. In these definitions, earnings management is unethical when the intention of the managers' decision concerning accounting treatment or transaction structure is to deceive a stakeholder and the outcome of action has a material effect on the financial statements issued by the organization. The definitions imply that earnings management may be ethical in some situations when the intention is to provide a benefit and the earnings management results in an actual benefit. It is difficult, however, to reconcile earnings management with ethical behavior because it involves accounting manipulation to produce the appearance of a stronger financial position of the firm than may actually be the case.

The way in which earnings management occurs has many variations because of the flexibility of GAAP or IAS accounting standards. The most common approaches to earnings management involve a choice of accounting treatment that results in higher earnings. For example, the revenue recognition policy adopted by the firm could result in improper matching of income and expenses for a transaction, with the income accelerated into the current period while the expenses are accounted for in a future period. This creates the appearance of higher income (Yaari 31). Another common approach is to use an inflated estimate of the value of an asset when the accounting standards permit estimation. A less common approach is to structure transactions in a way that increases current income or current assets, but postpones costs or liabilities. An example of this type of structured transaction approach to earnings management is issuing contingent convertible debt instruments that do not dilute earnings per share until the contingency occurs at some point in the future. Earnings management is also frequently found in certain accounting periods in which stock options issued to managers as part of their compensation package are about to expire, with the manager attempting to increase the value of the firm's stock to maximize their return on the options.

The definitions of earnings management that emphasize intention and consequence, as well as the attitudes of various stakeholders towards the practice, suggest that earnings management is generally evaluated with a consequentialism framework. In addition, it appears that it may be assessed using the principles of motive-consequentialism. In consequentialism, the ethics of each situation is determined according to the specific circumstances without the use of a specific legal or moral standard. Traditional utilitarian ethical theories based on consequentialism are evaluated based on its effects or consequences on others, with acts that produce more benefit than harm ethically desirable. In this approach to analyzing earnings management, the reasons the managers engage in earnings management are not relevant. If the earnings management produces a benefit to more individuals, such as stakeholders, than the harm it produces to other individuals, such as creditors, the earnings management may be ethically permissible. In the utilitarian approach, earnings management to benefit only managers at the expense of other stakeholders is inherently unethical. With the motive approach to consequentialism, the reasons that an individual performs an action take precedence over the consequences, with the motives ranked as ethical or unethical (Darwall 110). In the context of earnings management, a motive to foster the growth of a firm that benefits the majority of stakeholders, including shareholders, employees, and suppliers, could be considered ethical, whereas a motive to obtain a personal benefit at the expense of other stakeholders would be unethical.

One of the difficulties with assessing earnings management based on consequentialism is that it a subjective evaluation of its ethicality made by various stakeholders based on the consequences of the action. Research investigating attitudes towards earnings management indicates that shareholders perceive it as appropriate and ethical behavior when it benefits the company as a whole, but considers it unethical when it benefits managers at the expense of shareholders (Elias 35). In contrast, creditors consider any form of earnings management as unethical because it results in a distortion of the true financial position of the firm, which can change the risk profile of the company. This research suggests that stakeholders evaluate earnings management on the basis of the benefit they receive, which creates an inherent conflict of interest among stakeholders. In effect, the various stakeholders may only consider the personal benefit resulting from earnings management and ignore the harm it may cause to others.

When examined from a deontological perspective, the risk of conflict of interest suggests that earnings management is unethical in any situation, even if it remains within the accounting boundaries permitted by GAAP or IAS. In the deontological theories of ethics, the focus is on examining the morality of an action based on rules and duties rather than the consequence. Managers have a specific fiduciary duty to shareholders to conduct the affairs of the firm in the best interests of the shareholders, which arises from the nature of the relationship between managers and shareholders (Malachowski 168). In addition, managers have a general duty to others to avoid causing harm to others and to make reparation if others are harmed because of their decisions.

Earnings management breaches the specific and general duties of managers to shareholders because it conceals or alters information that investors, creditors, and other stakeholders should know about an organization to make an informed decision, providing a benefit for one group of stakeholders at the expense of the information needs of another group of stakeholders. As a result, earnings management increases the possibility that managers will breach a duty to the shareholders. Earnings management used to create the appearance of higher corporate earnings in order to increase compensation for managers, or to reduce shareholder criticism for failing to meet earnings expectations, places the personal interests of the manager above the interests of the shareholders. As a result, it is a breach of the general duty owed by managers to the shareholders. When examined from deontological perspective, earnings management that provides a temporary benefit to the shareholder is also a breach of the fiduciary duty of managers. Earnings management intended to influence the decisions of creditors that may benefit shareholders could result in harm to all stakeholders when the actual financial condition of the firm becomes apparent. The negative effects of earnings management on all stakeholders over the long run suggest that any form of earnings management inherently involves a breach of fiduciary duties that can lead to harm to all stakeholders.

General Electrics has yet to admit ever practicing earning management, but it is believed that they are an aggressive practitioner. It is said that they used earning management to become "one of America's Best Loved Stocks", with 100 consecutive quarters of increased earnings. (McKee 2) The use of earnings management helped GE smooth out any bumps or declines in their earnings, therefore, creating a steady increase. GE's stock became one of the most predictable on the market. Many people, including GE's stakeholders, felt that GE's practices were ethical, even though they had reason to believe that they used earnings management, because the consequence of the action produced a positive effect for majority of the people involved.

Enron became famous for abusing earnings management. Unlike GE's scenario, Enron's earnings management was viewed as being unethical and fraudulent. Enron's management neglected their fiduciary duty to the stakeholders for their own personal gain. For example, they added one or two pennies to the earnings per share, which result in higher stock prices, and therefore, gave them a higher profit when cashing in their stock. They also moved their debts and losses to offshore accounts to avoid having to include them in their financial reporting. (Fowler 1) This ultimately led to the bankruptcy of the company. Of course, Enron was not the only company to have misused earnings management. This led to many people losing confidence in the corporate leadership and created a need for stricter rules. In 2002, the government passed the Sarbanes Oxley Act of 2002, which made top executives more accountable for their financial reporting and created stricter guidelines for earnings management.

Despite the unethical nature of earnings management, it is embedded in the culture of many organizations. Managers often do not consider earnings management a breach of their fiduciary duties to stakeholders because they rationalize that it provides a benefit to the organization. Managers may believe that it is their duty to shareholders to maintain the highest possible price for stock, with earnings management as a means to maximize the value of the firm's stock. These managers consider any benefit they receive from higher compensation as the result of maximizing value for shareholders rather than the result of unethical behavior. The problem with these rationalizations can lead to increasingly expansive earnings management activities that ultimately lead to a restatement of income, and harm to the shareholders.