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Ethics in Corporate Finance Earnings Management

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.

A Research Paper on IFRS and Its Implications

International Financial Reporting Standards (IFRS) is a comprehensive, globally accepted set of accounting standards utilizing a principles-based approach with a greater emphasis on interpretation and application of those principles, aiming at best reflecting the economic substance of transactions. It is a less extensive body of literature than U.S. GAAP with limited industry guidance and lesser detailed application guidance. IFRS requires a much greater exercise of judgement, supported by detailed analysis and documentation. In other words, U.S. GAAP gives us a detailed instruction to the location where we would like to go where us IFRS will just guide us to the destination by showing us the direction.
Today, more than 40% of the Global Fortune 500 are using IFRS. Stock exchanges in the 85 countries that require IFRS comprise 35% of the global market capitalization, compared to 25% of the global market capitalization held by U.S. exchanges [1] . IFRS is most likely to become mandatory by beginning of 2014.
The question facing companies is not “If to adopt IFRS”, it is of “when and how” to adopt IFRS. With so many companies focused on managing through the economic downturn, few leadership teams are eager for one more big thing to do. Especially when that thing involves something as pervasive as International Financial Reporting Standards (IFRS). But IFRS continues to be adopted by jurisdictions around the world.
Taking the organization to IFRS will require managing change in multiple areas: technical accounting and tax, internal controls and processes, management and statutory reporting, technology infrastructure, and organizational issues. They’re all interconnected, which makes things a bit more complicated than imagined.
IFRS relies more on general principles than detailed rules and bright lines. This means that the finance people will end up working much more closely with others in the organization to make judgments about accounting based on the underlying economics of transactions.
A flurry of operational changes could be triggered by IFRS as well. Companies may have to re-examine contracts and debt agreements, treasury policies, employee benefits, education and training, and communications. Opportunities to centralize statutory accounting functions into shared service centers might also have to be looked at. A revisit of the offshoring, outsourcing, and tax planning decisions might also be required.
Principle or Rule Based?
At a global symposium held in the month of January where the Peter Wyman, a partner of PwC noticed a sea change in the debate surrounding the adoption of a uniform international accounting standard. The feeling was that IFRS will be adopted across the globe, the issues which were present were only of how it was to be done.
There have been primarily been two major approaches to accounting namely rule based and principal based. UK and Europe have a principal based accounting system which allows greater discretion and use of professional judgement. On the other hand, US has been following rule based accounting system which was further strengthened after seeing the light of scandals such as Enron, etc. The major challenge for International Accounting Standards Board (IASB) is to adapt IFRS so that it is agreeable to all the parties involved.
ACCA’s head of financial reporting believes that the use of principles-based approach should be the way forward as principles is a more practical way of pushing standards across the globe. The six accountancy firms which used the symposium to showcase their whitepapers expressed that principle based will limit the size and complexity of the rule book.
View from the US
According to the director of Financial Accounting Standards Board (FASB), due to the scandals it has become necessary to ensure that regulators don’t apply unfair pressure on the people who prepare the accounts. This has led to the development of a culture of Second Guessing which the rule based approach tries to rectify, making it an extended rulebook. The enforcement is also talked of as a problem because Securities and Exchange Commission (SEC) does not hesitate to criticize, but empirical data shows that out of the restatement of accounts which were ordered by SEC, very few companies share price showed any movement.
View of the Users
What the users want is principles based approach because the aim of the financial reports and statements is to give a clear view of the way the company is run and its future prospects for success. Investors are worried that US may influence the new IFRS regime too much and create principles having unending exceptions, clarifications and rules.
IASB is consulting all the stakeholders and hearing out the point of view of each one of them. They assure the investors that no party will be able to influence any decision and that they would like to hear to all sides of view before taking any decision.
All of the following points towards the steady adoption of IFRS. The greatest danger will be that of to please all the stakeholders. It would be interesting to note what substance US wants to put in the rulebook as US has agreed to adopt IFRS.
From a macroeconomic perspective, the benefits of using one global financial reporting language are evident: increased comparability across global investment options, fewer barriers of entry to non-US markets, and potentially, a lower cost of capital. Moving to a single global accounting and reporting language will also reduce complexity – a welcome improvement for the companies that prepare financial reports and for the investors and other stakeholders who rely on them.
From a capital markets perspective, many multinational companies believe that IFRS offers an opportunity to lower their cost of capital. Widespread acceptance of IFRS financial statements allows companies to seek capital across a broad base of global funding without having to incur additional-financial reporting costs based on the source of funding. Anticipating increased competition among global investors and financers for attractive investments, strong companies expect their cost of capital to decrease. Because of conversion of major capital markets to IFRS is relatively young, it is too soon to tell whether the decrease in anticipated cost of capital will prove out. However due to the sheer size of most capital raising efforts and long term nature of the payoff, even slight improvements in transaction terms such as interest rates can translate into significant dollar savings.
Within individual companies, the ability to centralize and streamline accounting functions and move financial personnel freely around the world will lower costs and strength internal controls. Today multinational corporations with numerous statutory filing requirements around the world need to employ staff with expertise in each national GAAP to prepare filings and then translate financial statements from National GAAP to the parent-company GAAP. Use of IFRS will reduce these reporting efforts and related costs and decrease the risk of errors.
IFRS Implementation
The change of financial reporting standard is just not of moving from one standard to another, rather it will influence the way in which financial information is shared throughout the organisation. Thus it tells that it will take not just a few weeks before the deadline, it would require significant time and commitment from the management to make the change.
Collection of data to prepare the financial reports needed for IFRS will be a very big challenge as the data which will need to be collected has to be reliable and has to be subject to sufficient level of control to be taken as a reportable data. This article talks about two separate but related approaches which needs to operate so as to make the process an effective one:
A top down definition of the IFRS reporting requirement where in a thorough understanding of the accounting policies and associated data requirements required to achieve IFRS-compliant financial reporting. This will help develop financial reports early in the conversion process and would help identify the gaps in the available data.
A bottom up review at the business unit level of the precise impact of IFRS requirements on individual business processes and financial systems. This would make sure if the reporting requirements could be possible with the right level and quality of information within an acceptable time period.
Implementation [2]
Phase 1: Preliminary study-During this phase, companies perform a broad-based assessment of the impact of IFRS on financial reporting, long-term contracts, supporting business processes, systems and controls, and income tax compliance, planning and reporting. They also determine a strategy for the road ahead.
Phase 2: Initial conversion-This phase includes much of the legwork of a conversion effort-setting up and launching the project, thoroughly evaluating the IFRS and US GAAP differences for specific financial statement line items, evaluating accounting policy alternatives, selecting IFRS accounting policies, performing the initial conversion, and creating IFRS financial statements during the dual reporting period. In-depth assessments of operational issues, such as the IFRS impact on significant business contracts (e.g., financing, leasing, joint venture agreements), and income tax compliance and reporting issues also take place during initial conversion. Stakeholder communication should be a constant consideration throughout this phase.
Phase 3: Integrate change-Critical to the conversion process is incorporating IFRS changes into the day-to-day operations, processes, and systems of the business (known as “embedding”). This phase helps to ensure a smooth transition to the new reporting framework so the company can use its new IFRS language on a sustainable basis in a well-controlled environment as of the IFRS adoption date.
The role of professional judgment
Although many accounting policies will be derived directly from IFRS standards and interpretations, the appropriate way to apply those standards or interpretations might not be obvious in all cases. Because IFRS is less prescriptive than US GAAP, there may be a wider range of acceptability under IFRS in certain areas. Therefore, sound, well-documented professional judgment becomes especially important in an IFRS reporting environment.
Management will need to exercise judgment to develop and apply accounting policies that faithfully present the economics of transactions and are decision-useful to the readers of the financial statements. Selection of the most appropriate accounting policies is a critical step, since that decision will impact the company for the foreseeable future. Continual dialogue with the company’s independent accountants will leverage their IFRS expertise and ensure that, in principle, they agree with the company’s new financial reporting policies. The independent accountants will also want to understand any related changes to internal controls and ensure that the changes are auditable. Keeping independent accountants involved in a timely manner will avoid potential pitfalls later in the conversion process.
Implementation Issues
Companies beginning to scope their IFRS conversions are often surprised by the volume of disclosures, and how different they are from their national GAAP [3] . The data which is required by IFRS is not being collected, even if it is collected; the amount of data being collected is insufficient. According to an executive of BASDA, IFRS will hardly require any changes to the back office systems, whatever changes will be required would be on the reporting side as IFRS according to him focuses on reports.
Organisations using Enterprise Resource Planning systems to prepare management accounts will be in a better position to the ones which use different systems for each office or business unit. Recalibration of ERP systems will be relatively easy than to upgrade legacy systems. One of the biggest barriers to conversion identified by a survey conducted by PWC was the alignment of internal reporting systems with the external reporting systems.
Looking at IFRS as only a change in reporting could turn out to be very expensive rework for the organisation at a later date. The extent of changes which might be required will depend on the size of the business, the number of applications collecting financial data and the capabilities of the current applications. IFRS implementation could provide a good opportunity for firms to streamline their reporting systems and could provide a good platform for making strategic improvements in the systems, processes and controls.
As a lot of vendors have solutions for IFRS, technology will greatly help as an enabler for IFRS. It will also provide a great cost saving opportunity due to standardisation, improved communication, improved controls and better cash management. It concludes by telling us that technology change should not be underestimated and it will be critical for the firm to address the technology point of view early in the process as changes in the systems must be sustained along with a detailed understanding of the new accounting language.
Impact of IFRS
Convergence to IFRS will greatly enhance an Indian entities’ ability to raise and attract foreign capital at a low cost. A common accounting language, such as IFRS, will help Indian companies benchmark their performance with global counterparts.
There will be escape from multiple reports for global Indian companies that have to prepare their financial statements under multiple GAAPs. With the knowledge of IFRS, the Indian Chartered Accountant would be globally acceptable.
Experience has shown that the conversion from Indian GAAP to IFRS requires significant efforts. The preparers, users and auditors continue to encounter practical implementation challenges. Conversion to IFRS is more than a mere technical exercise.
The consequences are far wider than financial reporting issues and extend to various significant business and regulatory matters including compliance with debt covenants, structuring of ESOP schemes, training of employees, modification of IT systems and tax planning. Companies also need to communicate the impact of IFRS convergence to their investors to ensure they understand the shift from Indian GAAP to IFRS.
IFRS and India
As the capital markets become increasingly global in nature, more and more investors see the need for a common set of international accounting standards. About 109 countries presently require or permit use of IFRS in preparation of financial statements in their countries. By 2011, the number is expected to reach 150.
In India ICAI has issued a document titled “Concept paper on convergence with IFRS in India” to evaluate the need for Indian GAAP to change to IFRS. In the paper, the ICAI notes that as the world globalises, it has become imperative for India to make a formal strategy for convergence with IFRS with the objective of harmonise with globally accepted accounting standards.
Keeping in view of the complex nature of IFRS, the ICAI in its concept paper has expressed the view that IFRS should be adopted for the public interest entities, banks and insurance entities and large sized entities from the accounting periods beginning on or after 1st April, 2011. The countries which have adopted IFRS have done so for similar type of entities.
A few illustrative examples of fundamental changes that can impact wider business considerations have been discussed below.
A comparison between IFRS