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Yearnings For Earnings

Be Careful What You Wish For

By: Catherine Sage
Bridgewater State College

Recent widespread attention has been focused on reengineering the income statement. The Financial Accounting Standards Board (FASB) plans to issue an exposure draft in mid-1996 in which the inclusion of comprehensive income---defined as all non-owner changes in equity---into the income statement will be addressed (Beresford, p. 69). In 1994, The Special Committee on Financial Reporting (commonly known as the Jenkins Committee) of the American Institute of Certified Public Accountants (AICPA) issued a comprehensive report in which they recommended that the income statement include core earnings. Core earnings are historical earnings adjusted to exclude the effects of historical unusual or non-recurring items (AICPA, p. 82). While proposals such as these seek to improve the quality of business reporting, one major quality issue concerning the income statement is left relatively untouched. This area is known as earnings management and it has the power to negate the qualities of comparability, reliability, and relevance that the financial statements are presumed to contain.

A current example of how easily the theory of earnings management may be applied in practice resulted with the issuance of Statement of Financial Accounting Standards (SFAS) No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of." The statement, mandatory for financial statements for fiscal years beginning December 15, 1995, was designed by FASB to enhance the conservatism of balance sheets (Lowenstein, p. C1). It applies to those assets which are deemed impaired in value. It is implemented when it can be determined that the carrying value of the asset exceeds the asset's fair value. Impairment of value has been defined as the inability to fully recover the carrying amounts of assets (FASB DM, p. 65). SFAS No. 121, in itself, is a complex issue that involves forecasting future cash flows, grouping assets together in a specific manner (at their lowest level) and writing assets down to reflect their fair values. These measurements involve judgments, estimates, and projections (FASB, p. 31). Critics argue that it will inflate earnings, destroy comparability in the income statement, and will be an additional device used by managers and accountants to manage earnings. It is precisely these areas that require highly subjective calculations and give managers wide latitude that are prone to suspicion and earnings manipulations. Pat McConnell of Bear Stearn's commented that this standard is a blue print for creating future earnings. FASB Chairman Dennis R. Beresford noted that SFAS No. 121 "will make it more difficult to understand the quality of earnings."

The term earnings management falls under the umbrella of quality of earnings. Also under this umbrella are such terms as income smoothing, dividend smoothing, push-down smoothing, big bath accounting, and bonus-related earnings management. It is unfortunate that FASB chose not to define the term earnings in Statement of Financial Accounting Concepts (SFAC) No. 5. It is generally defined as a measure of entity performance during a period (Schroeder, p. 131). Therefore, the other terms related to earnings do not have official definitions but have taken on certain meanings from different studies, research, and texts.

Investors and security analysts are required to predict future cash flows. One process they use is the assessment of the quality of earnings. It is an attempt to convert accounting income into economic income in the evaluation of a company's economic health (Schroeder, p. 131). Their analysis is made more difficult when earnings management has occurred. Earnings management is the actions of a manager which serve 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 (Fischer, p. 434). Earnings management can be broken down into two different types, actions that involve changing accounting methods and actions which involve operating decisions (Fischer, p. 434).

Accounting manipulations can occur in a variety of ways. Examples include adjusting amounts in reserve accounts for losses (inventory obsolescence and bad debt), altering the point at which sales are recognized, and shifting costs between expense and capital accounts (Fudenberg, p. 76). It is the flexibility in generally accepted accounting procedures that allows for these types of actions which change reported earnings but do not change the underlying cash flows (Fudenberg, p. 76). FASB statement No. 121 is an example of a standard that does not have a cash effect but its practical effect is that assets will be "worth" less therefore companies will have less to depreciate against income (Lowenstein, p. C1). Jack Ciesielski, author of Analyst's Accounting Observer, stated that SFAS No. 121 provides "ample wiggle room for companies to use as a pruning shear or chainsaw, as their intentions dictate."

Operating manipulations are such things as selling excess assets, holding overtime to make shipments in a certain period, rescheduling maintenance, or holding end-of-period sales which have liberal payment terms (i.e., 120 days). These actions change operations and smooth the underlying cash flows (Fudenberg, p. 75). Income smoothing is the process of manipulating the time profile of earnings reports to make the reported income stream less variable, while not increasing reported earnings over the long run (Fudenberg, p. 75). The manager takes actions that increase reported income when income is low and takes actions that decrease income when income is relatively high; this differentiates income smoothing from the related process of trying to exaggerate earnings in all states (Fudenberg, p. 76).

In two separate studies, participants were gathered from the academic and business fields. They were asked to rate ethical acceptability of a variety of accounting and operating manipulations. In both studies the participants had less tolerance for the accounting distortions but the lack of agreement on any one practice was disturbing. In the study by Bruns and Merchant, the authors wrote that the liberal definitions revealed in many responses of what is moral and 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.

One reason for the greater acceptance of operating manipulations is that management does not have the same system of principles, rules, and laws that the accounting profession has. Also, many companies have unclear operating standards and most managers that engage in these practices think that, because these practices are legal, they are acceptable and proper. In some cases, the feeling is that these actions are legitimate managerial tools and in others, it may require some accounting expertise to recognize irregularities.

The major problem inherent in earnings management is the ethical ambiguity associated with its practice. Many, if not most, companies have an ethics code but that is no guarantee that the company will be operated ethically. The codes of ethics of some companies are nothing more than a listing of current laws, a public relations tool, or a set of obligations that the employee owes the company (Hill, p. 59). In fact, researchers found that the perceived pressure to achieve income and return-on-investment targets was greater in companies which had adopted a code, a fact they tentatively attributed to the larger size of the companies that had adopted ethics codes (Hill, p. 59). A code of ethics should represent all stakeholders: the company, employees, stockholders, the community, and society in general. It should set the ethical climate of the company, offer guidance, and go beyond strictly legal considerations. Legal rules are evolving constantly, and many companies have incurred crippling liability for actions that were legal when taken (Hill, p. 59). Most importantly, the code must be internalized and practiced, starting from the top down and it must be enforced. An ethics committee and/or corporate ethics audits should be established to identify situations in which policies, controls or evaluations are inconsistent with the company's code of ethics (Hill, p. 59).

The pressure to engage in earnings management can be enormous. It can come from internal or external sources or a combination of both. A manager or accountant may engage in earnings management for fear of being fired, having her division shut down, or in an attempt to thwart off interference from others. When a manager's compensation or performance evaluations are tied to earnings, there is a strong correlation between earnings management and the earnings figures. Bonus-related earnings management can occur in these instances. When earnings are unusually high, managers attempt to reduce earnings because their bonus plans have already generated maximum bonus and managers desire to shift some income to future years when additional bonus could be earned (Fischer, p. 443). When earnings are unusually low, managers have often foregone any bonus in the current year and they attempt to shift earnings to a future year when additional bonus could be earned; this phenomena is commonly known as the "big bath." (Fischer, p. 443). This behavior was also supported in a work done by Paul Healy in 1985. He examined how monetary compensation plans result in income smoothing. On one hand, if compensation is capped at a certain level, then a manager may be induced to underreport income when it is high. Conversely, if the compensation is not capped then a manager may be induced to exaggerate income by running down assets and deferring maintenance in order to claim a high bonus. This is called "take the money and run." (Fudenberg, p. 91). These motives are explained in the basic assumption of agency theory. It states that individuals maximize their own expected utilities and are resourceful and innovative in doing so (Schroeder, p. 65). This is evident in the multitude of earnings management practices.

Managers and accountants also face severe external pressures. They may feel pressured by a supervisor or the company to meet certain budget targets or they may feel an obligation to the shareholders to maximize share price. In Merchant's 1989 study, he concluded that managers are more fearful of missed budget targets or loss of credibility than they are of reduction of bonuses. Upper management sets the ethical tone of the company; if they reward or support unethical behavior, are too demanding, punish performance shortfalls or are too competitive, earnings management will likely take place. In push-down income smoothing, corporate headquarters pressure a whole division to improve performance to compensate for another division that is performing poorly (Fudenberg, p. 92). Corporate headquarters is also responsible for dividend smoothing. It is essentially the same thing as earnings management in that dividends are managed to send a message to stockholders and other users. A good example of dividend smoothing is a company that can not afford to pay dividends will borrow funds to pay them in order to appear that they are operating profitably in an attempt to control stock price.

Most people do not realize the costs and risks associated with earnings management. This may be one reason why it is allowed to continue. There are obvious costs such as overtime, poor profits on end-of-period sales, and resources expended to manipulate the company's financial data. But, when earnings management crosses the line into fraudulent financial reporting, the penalties are staggering. Guidelines under the U.S. Sentencing Commission for organizations convicted of violating federal laws can be as high as $290 million (Hill, p. 61). Even beyond the aforementioned costs and risks, the biggest loser of all may be the accounting profession.

The accounting profession's best assets are its integrity and reputation. It enjoys a unique position of trust and confidence in this country and globally. If it wishes to maintain its status it must not ignore the seriousness of earnings quality issues. Earnings management raises suspicion about accountants' and managers' integrity (Fischer, p. 434). When financial statements are issued that are imbedded with distortion and manipulation it reflects badly on the entity that is in charge of those statements. FASB must continue to establish standards that are based on sound accounting policy but it must also reconsider issuing standards that require inordinate amounts of subjectivity or management judgment. Proponents of SFAS No. 121 say that the new standard will improve comparability in the balance sheet. If one financial statement is improved at the expense of another and possibly the whole accounting profession, what is gained?

There are no easy answers to the problem of earnings management. The Report of the National Commission on Fraudulent Financial Reporting (commonly known as the Treadway Commission Report) made this recommendation: "The business and accounting curricula should emphasize ethical values by integrating their development with the acquisition of knowledge and skills to help prevent, detect, and deter fraudulent financial reporting" (Fischer, p. 433). The bottom line is that earnings management is an immoral and insidious practice that has the deadly potential to destroy the foundation upon which the accounting profession was built. Managers and accounting practitioners must work ethically whether their motives are based on virtue or survival.

Works Cited

AICPA Comprehensive Report of the Special Committee on Financial Reporting,
"Improving Business Reporting-A Customer Focus. Meeting the Information
Needs of Investors and Creditors," New York, N.Y.: AICPA, 1994.

Beresford, Dennis R. et al., "Is a Second Income Statement Needed?," Journal of
Accountancy April 1996: 69-72

Bruns, William J. Jr. and Kenneth A. Merchant, "The Dangerous Morality Of Managing
Earnings," Management Accounting August 1990: 22-24

FASB Discussion Memorandum, Accounting for the Impairment Of Long-Lived Assets
and for Long-Lived Assets to Be Disposed of. Stamford, Conn.: FASB,
December 1990.

FASB Statement No. 121, Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to Be Disposed Of. Stamford, Conn.: FASB, March 1995.

Fischer, Marilyn and Kenneth Rosenzweig, "Attitudes of Students and Accounting
Practitioners Concerning the Ethical Acceptability of Earnings Management."
Journal of Business Ethics 14 (1995): 433-444.

Fudenberg, Drew and Jean Tirole, "A Theory of Income and Dividend Smoothing Based
on Incumbency Rents." Journal of Political Economy 103 (1995): 75-93.

Healy, Paul M. "The Effect of Bonus Schemes on Accounting Decisions." Journal of
Accounting and Economics 7 (1985): 85-107

Hill, John W. et al., "How Ethical Is Your Company?" Management Accounting July 1992
1992: 59-61.

Lowenstein, Roger. "Earnings Not Always What They Seem," Wall Street Journal 15
Feb. 1996, eastern ed.: C1.

Merchant, Kenneth A. Rewarding Results: Motivating Profit Center Managers.
Boston: Harvard Business School Press, 1989.

Schroeder, Richard G., and Myrtle Clark. Accounting Theory. 5th ed. New York: John Wiley & Sons, Inc., 1995.

Smith, Kimberly J. "Asset Impairment Disclosures." Journal of Accountancy December
1994: 57-63.

 

Last Modified: April 6, 2004