Attitudes of Students and Accounting

Practitioners Concerning the Ethical Marilyn Fischer

Acceptability of Earnings Management Kenneth Rosenzweig

ABSTRACTs. There are man}, ways that accountants edge and skills to help prevent, detect, and deter
and managers can influence the reported accounting fraudulent financial reporting" (page 82). The
results of their organizational units. When such influ- American Accounting Association has called
ence is directed at changing the amount of reported for increased efforts in accounting education to
earnings, it is known as earnings management. The foster students' sensitivity to ethical and social
purpose of this paper is to present the results of
responsibilities (American Accounting Asso-
surveys of undergraduate students, MBA students, and
ciation C o m m i t t e e on the Future Structure,
practicing accountants concerning their attitudes on
the ethical acceptability of earnings management. Content, and Scope o f Accounting Education,
Analysis of the survey results reveals how the attitudes 1986). Donnelly and Miller (1989) found empir-
of the three groups differ and what variables are asso- ical support among accounting professors for
ciated with these differences. Based on the analysis, changing accounting curricula to include greater
the authors suggest changes in accounting education discussion o f ethics as r e c o m m e n d e d by the
curriculum and ethics awareness programs in business Treadway Commission. 1
which might: increase students' and practitioners' In order to address these concerns, specific
sensitivity to the ethical ramifications of earnings topics in ethics and accounting need to be: iden-
management. tified for curricular development. Earnings man-
agement is one such topic because of ethical
ambiguities associated with the practice. The
Leading associations in accounting have called purpose of this paper is to present information
for increased emphasis on ethics education in collected from undergraduate students, MBA
accounting curricula. For example, the Report of students, and practicing accountants concerning
the National Commission on Fraudulent Financial their attitudes on the ethical acceptability of
Reporting (commonly known as the Treadway various earnings management actions. Analysis
Commission Report) made this recommenda- of this information will reveal which types of
tion: " T h e business and accounting curricula earnings management activities respondents
should emphasize ethical values by integrating consider to be ethically objectionable and
their development with the acquisition of knowl- which groups o f respondents find the various
earnings management activities to be most
objectionable.
Marityn Fischer, is Assistant Professor of Philosophy at Knowing current attitudes toward earnings
the University oarDayton in Dayton, Ohio. She spe- management will be helpful for educators inter-
cializes in workplace ethics, particularly in the nonprofit ested in integrating ethical concerns into
sector, and has published articles in business ethics, and accounting programs. It will also be useful
social and political philosophy.
to businesses and professional associations as
_Kenneth Rosenzweig, is Associate Professor of Accounting
they develop their o w n policies, standards
at the University of Dayton in Dayton, Ohio. He spe-
cializes in a!eaching management accounting, and has and educational programs regarding earnings
published articles in a wide variety of accounting management.
areas.

Journal of Business Ethics 14: 433-444, 1995.

© 1995 KIuwer Academic Publishers. Printed in the Netherlands.
434 M. Fischer and K. Rosenzweig

Background on earnings m a n a g e m e n t investment decisions. Suppliers may use them to

decide which companies to do business with.
While public respect for the accounting pro- Banks rely on t h e m in making loan decisions.
fession is quite high compared to many other Communities use them in long-term community
professions, public confidence in the profession planning, such as decisions concerning which
has been shaken by recent events involving types of businesses to try to attract to the
accountants, such as the savings and loan scandal. area, infrastructure development, and so on.
Accountants perform the crucial function o f Prospective employees may refer to them in
preparing organizational statements which are making employment decisions. Managers utilize
fair representations o f the organization's finan- the statements o f lower level units to evaluate
cial status; they are in effect gatekeepers of the their performance and make decisions con-
public's trust in our institutions. Therefore, it cerning resources to be allocated to them. s
is critically important that members of the W h e n earnings are managed so that financial
accounting profession have a reputation of solid statements do not accurately reflect the economic
integrity, and that this reputation be deserved. health o f the company, stakeholders' trust is
Earnings management is one practice which violated. Stakeholders may make decisions
raises suspicion about accountants' a n d / o r contrary to their own best interest, which they
managers' integrity. Although earnings manage- would not have made, had they had undistorted
ment has been examined in many empirical figures. U n d e r s t o o d in this context, earnings
studies, 2 there is no widely accepted definition of management is contrary to the "Standards o f
earnings management. 3 For purposes of this Ethical C o n d u c t for Management Accountants"
paper, we define earnings management as refer- which states, "Management accountants have a
ring to actions o f a manager which serve to responsibility to . . . disclose fully all relevant
increase (decrease) current reported earnings of information that could reasonably be expected to
the unit for which the manager is responsible influence an intended user's understanding o f the
without generating a corresponding increase reports, comments, and recommendations pre-
(decrease) in the long-term economic prof- sented" (Institute, 1983).
itability of the unit. 4 Such actions can be classi- Given the discretion and j u d g e m e n t
fied into two types: those which involve accounting practitioners and managers must
changing accounting methods and those which exercise, it is desirable for them to have knowl-
involve operating decisions. An example o f edge o f and ethical sensitivity regarding earnings
changing accounting methods is adjusting the management practices. 6 There can be consider-
amounts of reserves, thereby changing reported able pressure on managers or accountants to
net income. Offering special terms to customers engage in earnings management. With an eye
at yearend to advance sales from next year to this on the stock market, employers may pressure
year is an example of earnings management by accountants and managers to distort quarterly
means o f an operating decision. reports.to make them look more favorable. Also,
Some managers may view these practices as accountants and managers may worry that their
legitimate managerial tools, useful for fulfilling o w n performance evaluations will be linked
their responsibilities to maximize returns to less to the accuracy of their prepared statements
shareholders. However, others view earnings than to how favorable those statements appear. 7
management as involving distortion in ways These practitioners need the knowledge, good
which mislead users of financial statements. j u d g m e n t and moral courage to resist such pres-
There are ethical reasons to be wary of sures. If the educational program of accountants
earnings management practices. Stakeholders rely and managers can inculcate ethical sensitivity
on financial statements assuming that current to earnings management, then perhaps it c a n
reported earnings are indicative o f l o n g - t e r m help reduce their tendency to engage in these
profitability. For example, stockholders and practices. 8
potential investors use these statements in making
 Ethical Acceptability' of Earnings Management 435

Research design membership a wide variety of practicing accoun-

tants engaged in various different types of" work,
Data was collected by means o f a questionnaire such as industrial accounting, public accounting,
administered to the respondents. The question- government accounting, etc. Since the Chapter
naire, which is adapted from one developed by membership is approximately 700, the response
Bruns and Merchant for general managers, and rate to our survey was about 38%.
finance, control and audit managers, includes T h e 13 dependent variables were analyzed
questions describing various situations in which utilizing Principle-Components Analysis with
a subordinate manager engages in earnings man- Varimax Rotation. Four factors were extracted
agement. T h e respondent is asked to rate the which had Eigenvalues greater than one. T h e
ethical acceptability o f the actions on a five-point rotated factor matrix is presented in Table tI. The
scale from totally unethical to completely ethical. four factors, taken together, account for approx-
The thirteen earnings management questions are imately 62% of the variance o f the 13 depen-
listed in the Appendix of this paper. dent variables. All of the dependent variables load
The three groups of respondents are listed in highly (have large correlations) on one o f the
Table I. Undergraduate and graduate student four factors. All o f the large correlations are
responses were obtained with the cooperation o f positive, indicating the factors have the same
course instructors. In most classes, questionnaires directionality as the original variables (i.e., large
were distributed and collected during the same values indicate an ethical rating and small values
ctass. Students took about 15 minutes on average indicate an unethical rating). Furthermore, the
to complete the questionnaire. The undergrad- factors seem to represent dimensions discussed by
uates surveyed were in sophomore, junior, or Bruns and Merchant. T h e first two factors
senior level accounting courses at the University ( A C C M A N I P and I N V M A N I P ) load highly
o f Dayton. Virtually all o f t h e m are full-time on variables that Bruns and Merchant called
students between the ages o f 18 and 22. T h e accounting related while the second two :factors
graduate students surveyed were taking MBA ( O P E R E X P and O P E R R E V ) load on variables
courses at the University of Dayton and Wright that they called manipulation of operating deci-
State University. Most of them have full-time sions. With respect to the accounting manipula-
jobs and are enrolled part-time in the MBA tion factors, I N V M A N I P loaded highly on all
program. Practitioner responses were obtained by inventory change variables, while A C C M A N I P
means of a survey mailed to all members of the loaded highly on all other variables that could be
Dayton Chapter o f the Institute o f Management interpreted as different forms o f accounting
Accountants. That organization includes in its manipulation. For the operating manipulation
factors, O P E R E X P loaded highly on those
operating decisions that changed expenses, while
TABLE I OPE1KREV loaded highly on those operating
Numbers of respondents in different groups
decisions that changed revenues. In this regard,
there was one slightly anomalous finding. Vari-
Number of
respondents able #1, Paint ahead o f schedule, loaded m o d -
Group
erately more highly on O P E R R E V than on
Undergraduate 122 OPEIKEXP, even though it involves manipula-
accounting students tion o f an expense. However, it has a substantial
loading on O P E K E X P and it was therefore clas-
MBA students 113 sified with that factor.
Four normalized factor scores were calculated
Accounting 265 by SPSS for each respondent. R a w factor scores
practitioners are a linear combination o f the original 13
dependent variables utilizing the respective, coef-
Total 500
ficients in Table II. After their calculation, the
436 M. Fischer and K. Rosenzweig

TABLE II
Rotated factor matrix

Factor name

Accounting Operating decision

manipulation manipulation

Vat# Dependent var name ACCMANIP INVMANIP OPEREXP OPEKREV

1 Paint ahead of schedule -0.09561 0.10903 0.37999 0.38895
2 Defer expend-month 0.04465 -0.02350 0.93490 0.14084
3 Defer expend-year 0.04986 -0.01924 0.92547 0.13049
4 Record supplies next yr 0.59951 0.09524 0.32273 -0.00023
5 Pull sales-liberal terms 0.27353 0.08844 0.00577 0.67378
6 Overtime to max ships. -0.00577 0.03296 0.09603 0.78812
7 Sell excess assets-profit 0.00471 -0.00801 0.14547 0.63606
8 Prepay next yr exps 0.63007 0.27530 -0.03885 0.03572
9 Write down inventory 0.21716 0.52467 0.05152 0.17370
10 Write up inv-prod dev 0.17294 0.90216 -0.07746 -0.00888
11 Write up inv-profit targ 0.23840 0.86899 0.05224 -0.01085
12 Delay consult inv-small 0.82781 0.17408 -0.04354 0.07273
13 Delay consult inv-large 0.78630 0.17613 -0.05860 0.08019
Variance expl 17.56% 15.48% 15.60% 13.16%

Bold print coefficients indicate dependent variables which are highly correlated with the respective factors.

raw factor scores are normalized by subtracting earnings by means o f operating decisions is
the mean and dividing the result by the standard strongly supported by our data. Furthermore,
deviation of the raw factor scores. The resultant within the operating decision manipulation area,
normalized factor scores have a mean o f zero and our respondents felt that manipulation o f deci-
a standard deviation of one. These normalized sions which changed the timing of expenses
factor scores are utilized as dependent variables (OPEREXP) was somewhat more questionable
in the subsequent analysis in place o f the original ethically than manipulation which changed
thirteen dependent variables. revenue timing (OPER2KEV). In the accounting
manipulation area, there was little difference
between respondents' ratings o f the ethical
Findings acceptability o f manipulation by means o f
adjusting inventory valuations (INVMANIP) and
Prior to analyzing the normalized factor scores other forms o f accounting manipulation
mentioned in the paragraph above, we examined (ACCMANIP).
the means of the original 13 earnings manage-
ment variables, grouped by the factors on which Differences among groups of respondents. For each
they loaded highly. Table III lists the mean of the earnings management factors, a one-way
responses to these original thirteen dependent ANOVA was calculated to determine if there
earnings management variables and the mean of were significant differences among the mean
the variable means for each factor. Bruns and responses o f the three groups of respondents. If
Merchant's (1990) finding that manipulating the ANOVA indicated significant differences
accounting methods is much less acceptable existed, Tukey tests were performed to determine
ethically to respondents than manipulating if each pair o f group means was significantly
 Ethical Acceptability of Earnings Management 437

TABLE III
Mean scores of earnings management variables, grouped by factors 1

Form of earrAngs Var Mean Mean of factor

management Factor # Dependent var name (Std dev) variable means

9 Write down inventory 1.79

(1.13)
10 Write up inv-prod dev 1.89
INVMANIP 1.75
(1.17)
11 Write up inv-profit targ 1.57
(1.09)
ACCOUNTING
4 Record supplies next yr 1.73
(1.01)
8 Prepay next yr exps 2.04
(1.20) 1.78
ACCMANIP
12 Delay consult inv-small 2.11
(1.11)
13 Delay consult inv-large 1.25
(1.07)

1 Paint ahead of schedule 3.80

(0.52)
2 Defer expend-month 3.02
OPEREXP 3.1,8
(1.02)
3 Defer expend-year 2.71
OPERATING (1.25)
DECISION
5 Pull sales-liberal terms 3.30
(0.94)
6 Overtime to max ships. 3.58
OPERREV 3.49
(0.75)
7 Sell excess assets-profit 3.59
(O.80)

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

different. All tests were p e r f o r m e d at the 95% T h e four survey questions (#4, 8, 12 & 13)
confidence level. all involved violations o f standard accounting
Table IV presents the mean o f the factor scores practice. A c c o u n t i n g practitioners w o u l d have
for A C C M A N I P , manipulation o f earnings by the greatest knowledge o f what these standards
means o f accounting methods, broken d o w n are; M B A students the least. Also, because o f
by the three main groups o f respondents in their experience with accounting measurements,
our study. As can be seen, accounting practi- accounting practitioners, and to a lesser extent
tioners view accounting manipulation as ethi- accounting students, are aware o f the o p p o r t u -
cally much more objectionable than do students. nities for distortion o f accounting numbers, and
438 M. Fischer and K. Rosenzweig

TABLE IV TABLE V
Differences in means of ACCMANIP among Differences in means of INVMANIP among
practitioners, undergraduate students, and practitioners, undergraduate students, and
graduate students graduate students

Group Mean Group Mean

ACCMANIP l INVMANIP I

Accounting practitioners -0.3374 Accounting practitioners -0.2470

Undergraduate 0.1011 MBA students 0.0539
r

accounting students Undergraduate 0.4894

MBA students 0.5347 accounting students

Tukey test indicated all pairs of groups are signifi- Tukey test indicated all pairs of groups are signifi-
cantly different at the 0.05 level. cantly different at the 0.05 level.
0 = mean of responses; positive numbers indicate a 1 0 = mean of responses; positive numbers indicate a
more ethical rating; negative numbers indicate a more more ethical rating; negative numbers indicate a more
unethical rating. unethical rating.

may recognize the deleterious effects of such are more aware o f the opportunities for earnings
distortions. MBA students, with their more management by means o f inventory valuation
limited background in accounting courses and changes than undergraduate accounting students
practices, may lack this awareness. w h o have limited experience in business.
Table V presents the means of the factor scores Inventory manipulation is apparently well k n o w n
for INVMANIP, earnings management by means among business managers as a source of oppor-
of altering inventory valuations, also broken tunities for earnings manipulation, while some of
down by the three main groups of respondents the other forms o f accounting manipulation
in our study. Similar to the findings for account- which loaded highly on A C C M A N I P are less
ing manipulation in general, accounting practi- well known.
tioners view manipulation by means o f inven- Table VI presents means o f the factor scores
tory changes much more adversely than do for OPEP(EXP, manipulation of earnings by
students. Practitioners' experience with the means of operating decisions which alter the
distorting effects of inventory valuation changes timing o f expense incurrence, broken down by
on accounting numbers may sensitize them to the the three respondent groups in our study. In
unethical dimension o f this practice. Students, on contrast to the findings for the two accounting
the other hand, have little experience with such manipulation factors, students view operating
valuation change opportunities and are thus less expense manipulation m u c h more harshly than
repelled by it. It is interesting that, contrary to do accounting practitioners. MBA students'
the case o f general accounting manipulation, attitudes toward operating expense manipulation
MBA students are more sensitive to the ethical fall in the middle between the accounting
dubiousness of inventory manipulation than are practitioners and the undergraduate accounting
undergraduate accounting students. For example, students.
with respect to question #9, MBA students as Several interpretations are consistent with
experienced managers know that j u d g m e n t is these findings. O n e could argue that as people
inevitable because the size o f the w r i t e d o w n work in business, they lose the ethical idealism
depends u p o n appropriate assessments o f the more c o m m o n among students and become
current market value of inventory which can vary either "more realistic" or more "calloused." An
considerably. It appears that, as a result of their alternate explanation focuses on the ambiguity
practical experience in business, MBA students present in the survey's questions regarding oper-
 Ethical Acceptability of Earnings Management 439

TABLE VI lowing are two possible interpretations o f this

Differences in means of OPEREXP among finding.
practitioners, undergraduate students, and
(1) Those surveyed may have had a rule-based
graduate students
view o f ethics, rather than one based on
Group Mean ethical assessments o f the decision's effects
OPER_EXP ~ on stakeholders. Many people in our
culture think o f ethics as a list o f
Undergraduate -0.6149 rules, such as the Ten C o m m a n d m e n t s or
accounting students explicit organizational codes o f ethics.
MBA students -0.0308 They assume that if something is not
expressly prohibited, one need not 'worry
Accounting practitioners 0.4391 about ethics. Based on this view, earnings
management is not problematic if it is not
Tukey test indicated all pairs of groups are signifi- explicitly prohibited - one does not break
candy different at the 0.05 level.
any rules by engaging in it. Several of the
t 0 = mean of"responses; positive numbers indicate a survey's questions regarding accounting
more ethical rating; negative numbers indicate a more manipulation involved a violation o f
unethical rating. accepted accounting practice, while anal-
ogous standards do not exist for the
ating expenses (#1, 2, 3). These cases could be situations described in the operating
interpreted as, involving either questionable man- manipulation questions. If a respondent
agement practices or questionable ethics. 9 The has this rule-based view of ethics, he or
students may have taken the latter interpretation. she would judge accounting manipulations
Accounting practitioners and MBA students may as more unethical, since they violate
have read these questions as involving questions explicit rules, while operating manipula-
o f good management, more so than questions tions do not.
o f ethics. E~ecause o f their experience, the However, using a stakeholder perspective, it is an
accounting practitioners and MBA students are open question whether accounting manipulation
more aware o f the legitimate discretion needed is more unethical than operating manipulation.
by managers in order to conduct business effec- Financial statement users may be misled as much
tively and therefore may have been unwilling to by operating as by accounting manipulation.
second guess the manager who had responsibility
(2) The accounting profession has a longer
for making the decision.
history o f ethical codes and concern for
We could find no significant differences among
standardizing practices than does manage-
our groups of respondents with respect to the
ment as an organized profession. Deserved
factor, OPEKREV, manipulation on earnings by
or not, accounting has a reputation for
means o f altering the timing of revenues. As is
being more "cut and dry" than does
indicated, in Table III, it had the highest means
managing. Being more "cut and dry" may
for its high loading variables, indicating that all
be the o u t c o m e o f a history o f ethical
groups of respondents concurred in finding few
concern. "Honesty" is a fundamental
ethical problems with its use.
ethical value. Accounting standards,
adopted to ensure that financial reports
Interpretation of findings give an accurate reflection of an organi-
zations' economic health, reflect an insti-
O u r study confirms Bruns and Merchants' (1990) tutionalization o f ethical concern for
findings in that all the groups surveyed have a honesty. Respondents' greater ethical sen-
greater tolerance for operating expense manipu- sitivity to accounting manipulation may
lation than accounting manipulation. T h e fol- reflect this history.
440 M, Fischer and K. Rosenzweig

Although there were differences among our In general, accounting and MBA curricula
groups with respect to operating expense manip- need to place greater emphasis on the ethical
ulation, virtually all respondents concurred that responsibilities o f managers and accountants to
there was no ethical problem with earnings report financial information in a fair and undis-
management by means of altering the timing torted manner. More specifically, students need
o f operating revenue. O u r respondents may to be clearly aware o f the opportunities available
have felt that controlling revenues is a vital for earnings management and earnings distortion
managerial function and that any restrictions even within the parameters of acceptable
on that function might risk damaging organiza- accounting standards. Particular stress should be
tional competitiveness. Furthermore, they may placed on opportunities for distortion in choos-
have felt the task of distinguishing ethically ing alternative inventory valuations. Further-
appropriate revenue enhancement programs from more, accounting students need to be educated
ethically inappropriate earnings management in organizational methods o f deterring earnings
is almost impossible. For example, a sales pro- management on the part o f operating managers.
m o t i o n campaign conducted in the last m o n t h The question of how and where in the cur-
of the accounting year would be ethically accept- riculum to address the ethical implications of
able if it created new sales that would otherwise earnings management needs to be addressed.
not have been made, but would be ethically There is an ongoing debate about whether ethics
unacceptable earnings management if it simply should be integrated into business courses or
drew sales from the subsequent accounting year. taught in a separate course on business ethics] °
Accounting professors are well equipped to
explain the m e t h o d o l o g y o f earnings manage-
Implications m e n t and the contexts in which earnings
management practices arise. However, many
The results of this study show that while business accounting professors feel ill-equipped to lead a
students and practitioners have some ethical sen- sustained discussion of the ethical issues involved.
sitivity to questionable earnings management Alternatively, a specific course in business ethics
practices, the level o f sensitivity is uneven. Given can be valuable in acquainting students with
how important the availability of accurate, ethical theory and inviting them to think about
relevant and reliable information is both to business issues in a wider societal and ethical
business success and to maintaining the public context. However, most people w h o teach
trust in the accounting profession, the authors business ethics, primarily philosophers and the-
believe that accounting educators should seek to ologians, lack accounting expertise, and do not
increase students' ethical sensitivity to earnings have the knowledge and experience needed to
management practices. For example, undergrad- understand the context in which earnings man-
uate accounting students need to be made more agement pressures arise. To resolve this problem,
aware o f the "real world" context within which accounting and ethics professors need to become
managers make business decisions. They need more acquainted with the tools and perspectives
to appreciate that creativity and effectiveness of each others' fields. Another alternative is for
in managerial decision-making require some ethics and accounting instructors to team teach
latitude, and that it is undesirable to rely on accounting courses, u
explicit policy restrictions, such as those designed One difficulty with integrating ethics into the
to prevent earnings management by means of accounting curriculum is the scarcity o f teaching
restricting the choices available in operating materials and case studies. T h e Treadway
decisions. This underscores the need for students Commission recommended that business faculty
to be acutely aware that ethics and personal be given incentives and opportunities to develop
integrity are deeply intertwined in everyday such material. The American Accounting Asso-
business decisions. Following the law and explicit ciation's Project on Professionalism and Ethics,
business policies is not and cannot be a sufficient and the Institute o f Management Accountants
guarantee that one's behavior is ethical. have developed case studies; the American
 Ethical Acceptability of Earnings Management 441

Accounting Association and Arthur Andersen nizations could institute ethics awareness seminars
and Co. conduct seminars on accounting and and workshops. Company recruitment policies
ethics education (Langenderfer and Rockness, could be revised to attract employees with ethical
1989, p. 59). sensitivity to issues such as earnings management.
In additicm to accounting education, our Explicit ethical codes which include policies
research also has implications for accounting on earnings management could be adopted
practitioners. Our findings indicate that practi- and made a living presence in the day-to-day
tioners need to become more aware of opportu- business environment] 2 Ethical analyses of spe-
nities for manipulation of reported earnings by cific earnings management situations could be
means of operating decisions. It is especially trou- included as case studies in professional and busi-
bling that all groups seem to lack sensitivity to ness publications. 13 Making these changes should
operating revenue manipulation. Accountants and help to decrease the dissonance practitioners feel
managers need to become more sensitive to their between their professional ideals and organiza-
ethical responsibilities with respect to operating tional pressures to increase profits. In light of
manipulations. They should be able to recognize Sorensen's (1967) findings that such dissonance
how harmfut such activities are to stakeholders was correlated with job dissatisfaction and like-
and the public trust. With that awareness, alI lihood of job turnover, decreasing the dissonance
groups need to develop a sense of persona1 might increase the satisfaction and retention of
detachment from the very real pressures they may practitioners with high professional ideals.
feel to distort reported earnings, and the moral
courage to resist such pressures.
To achieve these changes, companies should Acknowle dgement
introduce policies and procedures regarding
earnings management. A goal of business and The authors greatly appreciate the extensive and
professional organizations should be to arrange insightful assistance in the development and
their policies and practices so that persons of refinement of this paper of Tom Ferratt, Faculty
ordinary decency are supported and encouraged Research Coordinator for the School of Business,
to act in an ethical manner. For example, orga- University of Dayton.

Appendix
Dependent earnings management questions
For each question, mark in pencil the letter on the General Purpose Data sheet that best reflects your
assessment of the ethical nature of the action, as supervisor of the General Manager (GM) of the
division.
A = Ethical; B = Questionable; C = Moderate; D = Serious; E = Totally Unethical

1. The division's headquarters building was scheduled to be painted in 1992. But since profit
performance was way ahead of budget in 1991, the GM decided to have the work done in t991.
Amount: $150 000.

This information applies to the following two questions. The GM ordered division employees
to defer all discretionary expenditures (e.g., postpone employee travel, advertising, hiring, main-
tenance) into the next accounting period, so the division could make its budgeted profit targets.
Expected amount of deferrals: $150 000.
2. The expenditures were postponed from February and March until April in order to make the
first quarter target.
3. The expenditures were postponed from November and December until January in order to
make the annual target.
442 M. Fischer and K. Rosenzweig

4. O n December 15, a clerk ordered $3 000 o f office supplies, and the supplies were delivered
on December 29. This order was a mistake because the GM had ordered that no discretionary
expenses be incurred for the remainder of the fiscal year, and the supplies were not urgently
needed. The company's accounting policy manual states that office supplies are to be recorded
as an expense when delivered. The GM learned what had happened, and to correct the mistake,
asked the accounting department not to record the invoice until February.

This information apphes to the following three questions. In September, the GM realized the
division would need strong performance in the fourth quarter to reach its budget targets.
5. The GM decided to implement a sales program offering liberal payment terms to pull some
sales that would normally occur next year into the current year; customers accepting delivery in
the fourth quarter would not have to pay the invoice for 120 days.
6. The GM ordered manufacturing to work overtime in December so that everything possible
could be shipped by the end o f the year.
7. The GM sold some excess assets and realized a profit o f $40 000.

This information applies to the following two questions. At the beginning of December 1991,
the GM realized the division would exceed its budgeted profit targets for the year.
8. The GM ordered the division controller to prepay some expenses (e.g. hotel rooms, exhibit
expense) for a major trade show to be held in March, 1992 and to b o o k them as 1991 expenses.
Amount: $60 000.
9. The GM ordered the division controller to write down the inventory due to obsolescence (i.e.,
reduce its asset value and record a corresponding loss in the income statement). By taking a
pessimistic view o f future market prospects, the controller was able to identify $700 000 worth
of finished goods that conservative accounting would say should be written off even though the
GM was fairly confident the inventory would still be sold at a later date at close to full price.

This information applies to the following two questions. The next year, the division sold 70%
o f the written-off inventory, and a customer had indicated some interest in buying the rest o f
that inventory the following year. The GM ordered the division controller to write the inven-
tory back up to full cost. This would involve a $210 000 increase in the inventory asset value
(which had been previously written down due to obsolescence) and a corresponding increase in
net income. The GM's motivation for recapturing the profit was:
10. To be able to continue working on some important product development projects that might
have been delayed due to budget constraints.
11. To make budgeted profit targets.

This information applies to the following two questions. In November, 1991, the division was
straining to meet budget. The GM called the consulting firm that was doing some work for the
division and asked that the firm not send an invoice until next year. The firm agreed. Estimated
work done but not invoiced:
12. $30000
13. $500 000
 Ethical Acceptability of Earnings Management 443

Notes ethical principles or rules have limited applicability,

ethics is a matter requiring "practical wisdom" Hence
There is empirical support for the efficacy of possessing virtuous character traits is critical to making
education and particularly liberal arts education in wise ethical decisions.
increasing cognitive abilides in making moral judg- v See Merchant and Rockness (forthcoming) for
ments. See Rest (1986), and Ponemon and Glazer additional reasons researchers have explored for
(t990). managers' engaging in earnings management.
2 For example, see Mendenhall and Nichols (1988), s We can understand pressures on accountants to
Jones (1991), and Merchant and 1Kockness (forth- engage in earnings management as one manifestation
coming). of "the professional's dilemma" Members of profes-
3 McNichols and Wilson (1988) discuss and test sions are noted for their loyalty to the professional
for two alternative forms of earnings management: standards of their disciplines. These standards relate
income smoothing and bonus related. With in- both to the knowledge base of the professional's dis-
come smoothing, managers choose income-reducing cipline and ethical standards with respect to the per-
accruals when income would otherwise be unusually formance of services for clients. Often there is a
high and they choose income increasing accruals conflict between those professional standards and the
when income is expected to be low. Bonus related demands placed on the professional by bureaucratic
earnings management predicts that managers will organizations. Decisions which advance the interests
choose income-decreasing accruals whenever earn- of the organization, such as profit maximization, may
ings are expected to be either unusually high or low. be contrary to accounting standards requiring un-
When earnings are unusually high, managers attempt distorted earnings reports. For example, Sorensen
to reduce earnings because their bonus plans have examines conflicting professional and bureaucratic
already generated maximum bonus and managers orientations of accountants working in large public
desire to shift some income to future years when addi- accounting firms and finds that dissonance between
tional bonus could be earned. When earnings are the accountants' expectations and their actual work
unusually low, managers have often foregone any environment with regard to these orientations, often
bonus in the current year and they therefore attempt leads to lowered job satisfaction and increased likeli-
to shift earnings to a future year when additional hood of job turnover (Sorensen, 1967).
bonus could be earned. This phenomena is commonly 9 "Good ethics" and "good management" may not
known as the "big bath." McNichols and Wilson be conceptually separable ideas. For discussions of the
found evidence in their study for bonus related view that good ethics is an integral part of good man-
earnings management'but not income smoothing. agement, see Solomon and Hanson (1985), and Pastin
Trueman and Titman (1988) discuss management's (1986).
rationale for smoothing earnings. Managers smooth 10 See Loeb (1988) for a discussion of how best to
earnings in order to reduce claimants' estimate of the teach ethics to accounting students.
volatility of the underlying earnings of the enterprise. 1t Langenderfer and IKockness (1989) discuss the
Claimants associate less volatile earnings with reduced importance of integrating ethics into the accounting
risk and thereJTore the cost of capital is reduced (i.e., curriculum and offer a method for doing so. For an
interest rates are lowered). assessment of the strengths and weaknesses of this
4 This definition is consistent with Bruns and method, see Armstrong (1990).
Merchants' (1990) use of the term, although it is 12 See Hill, et al. (1992) for a discussion of what needs
never explicidy defined in their study. Our defini- to be done to make an ethics code a living presence.
tion is consistent with the definition given in 13 For discussions of how ethical considerations can
Merchant and Rockness (forthcoming). be integrated into an organizations's structure, see
s See Griffiths, Creative Accounting (1986), a highly Goodpaster and Mathews (1982), Hoffman (1980),
readable account of market pressures to engage in Buchholz (1989), and Murphy (1988).
creative accounting techniques, including earnings
management, lit includes a description of the effects
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