Reference no: EM131004057

The dangerous morality of managing earnings

Occasionally, the morals and ethics executives use to manage their businesses are examined and discussed. Unfortunately, the morals that guide the timing of nonoperating events and choices of accounting policies largely have been  ignored.

The ethical framework used by managers in reporting short-term earnings probably has received less attention than its operating counterpart because accountants prepare financial dis- closures consistent with laws and generally accepted accounting principles (GAAP). Those dis- closures are reviewed by objective auditors.

Managers determine the short-term reported earnings of their companies  by:

• Managing, providing leadership, and directing the use of resources in operations.
• Selecting the timing of some nonoperating events, such as the sale of excess assets or the place- ment of gains or losses into a particular reporting period.
• Choosing the accounting methods that are used to measure short-term earnings.

Casual observers of the financial reporting process may assume that time, laws, regulation, and professional standards have restricted accounting practices to those that are moral, ethical, fair, and precise. But most managers and their accountants know otherwise-that managing short-term earnings can be part of a manager's   job.

To understand the morals of short-term earnings management, we surveyed general man- agers and finance, control, and audit managers. The results are  frightening.

We found striking disagreements among managers in all groups. Furthermore, the liberal def- initions revealed in many responses of what is moral or ethical should raise profound questions about the quality of financial information that is used for decision-making purposes by parties both inside and outside a company. It seems many managers are convinced that if a practice is not explicitly prohibited or is only a slight deviation from rules, it is an ethical practice regard- less of who might be affected either by the practice or the information that flows from it. This means that anyone who uses information on short-term earnings is vulnerable to misinterpreta- tion, manipulation, or deliberate deception.

The Morals of Managing Earnings

To find a "revealed" consensus concerning the morality of engaging in earnings-management activities, we prepared a questionnaire describing 13 earnings-management situations we had observed either directly or indirectly. The actions described in the incidents were all legal (although some were in violation of GAAP), but each could be construed as involving short-term earnings management.

A total of 649 managers completed our questionnaire. Table 2-1 classifies respondents by job function. Table 2-2 summarizes the views on the acceptability of various earnings-management practices.

A major finding of the survey was a striking lack of agreement. None of the respondent groups viewed any of the 13 practices unanimously as an ethical or unethical practice. The dispersion of judgments about many of the incidents was great. For example, here is one hypothetical earnings-management practice described in the questionnaire: