The Ethics of Earnings Management: Perceptions after Sarbanes-Oxley

Abstract

The ethics of financial reporting has long been a concern of the accounting profession. A significant increase in business failures and fraudulent financial reporting in the 1980s led to the creation of the National Commission on Fraudulent Financial Reporting. Also referred to as the Treadway Commission, it defined fraudulent financial reporting as intentional or reckless conduct, whether act or omission, that results in materially misleading financial statements. (1) Attention to the ethics of accounting practice and financial reporting further intensified following the collapse of the market for technology stocks in 2000 and the flurry of accounting scandals that received public attention in 2001 and 2002, including Adelphia, Enron, Kmart, Homestore.com, Global Crossing, Qwest, Xerox, AOL Time Warner, Bristol-Myers Squibb, Duke Energy, Merck, Nicor, WorldCom, CMS Energy, Dynegy, El Paso, Halliburton, Peregrine Systems, Reliant Energy, Tyco International, and others. The Sarbanes-Oxley Act of 2002 (SOX) was passed in response to those scandals to hold top executives more closely accountable for their firms' financial reporting. Fraudulent financial reporting can happen when managers and accountants are involved in the practice of earnings management. Consequently, earnings management behavior has also been an area of concern and subject of study in the accounting profession. In fact, almost all fraudulent financial reporting could be characterized as earnings management, but not all earnings management is considered fraudulent. Kenneth Merchant observes that evidence suggests earnings management is common in practice, while Steven M. Mintz and Roselyn E. Morris explain that there is no consensus as to when earnings management is unethical behavior as opposed to being poor or even desirable managerial behavior. (2) Thus, many managers believe that some types of earnings management behavior are acceptable or even desirable. Prior research has looked at the theory of planned behavior to understand factors related to earnings management. (3) Research has shown that the theory of planned behavior can help explain unethical and fraudulent financial reporting. (4) It states that behavior can be explained by intentions, which are shaped by three factors: attitude toward the behavior, the subjective norm, and perceived control over the behavior. In regard to earnings management behavior, the first factor, attitude toward the behavior, may be influenced by knowledge of SOX. The second factor, the subjective norm for earnings management behavior (as perceived by accountants and managers) may be influenced by the general attitude of society concerning the ethics of earnings management as well as by the general attitude toward earnings management within individuals' organizations. Organizational cultural or social norms regarding the ethics of earnings management may vary significantly, with the views of top management playing a significant role in shaping the organizational social norm. The passage of SOX may change individual perceptions of the societal norm regarding the ethics of earnings management. If the organization has not reduced its tolerance for earnings management in response to SOX, accountants or managers (particularly those familiar with SOX) may see a greater difference between the perceived societal norm and the organizational cultural norm for earnings management behavior. In that case, an individual may judge the organization and earnings management behavior within the organization more harshly. Finally, in accounting it is likely that the third factor, perceived control over the behavior, is relevant only for those directly involved in earnings management. For example, internal auditors are not usually in a position to manage earnings and would have little incentive to do so unless they are cooperating in a fraud. SOX requires that company management guarantee the fairness and accuracy of an organization's financial reporting and attest to the adequacy of its internal control system to provide reasonable assurance of fair and accurate reporting, disclosing any material weaknesses in the control systems. …

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