ACCT 340 Week 7 Group Discussion Board Forum 5 Example

Group Discussion Board Forum 5: Earnings Management and the Quality of Financial Reporting

ACCT 340 Accounting Ethics, Group Discussion Board Forum 5

Thread by [Student Name]

The chemicals company, its figures and the classmate are composites; the textbook, Scripture and the peer-reviewed sources cited are real.

In early December, the manager of a composite specialty chemicals company's coatings division receives a call from the chief financial officer. The company is on track to report earnings of $1.38 a share for the year, four cents below analysts' consensus of $1.42. The division can close the gap. It can postpone a $2.6 million maintenance shutdown of its main reactor from December to March, and it can freeze two research projects for six weeks, saving another $700,000. Neither choice violates GAAP. Expenses not incurred are simply not recorded, and the auditors will find nothing to adjust, because every number in the ledger will be accurate. The question is not whether the books are right but whether the decisions behind them are. The savings total $3.3 million, which after tax is almost exactly four cents a share. The company would report exactly $1.42, the stock would avoid the drop that usually follows a miss and the manager would earn her full bonus.

Mintz and Morris (2019) define earnings management as judgment exercised, inside the rules or past them, to achieve a desired level of reported earnings, and they distinguish accrual-based techniques, such as adjusting reserves and estimates, from real techniques, which change the timing or substance of business activity. The division manager's plan is real earnings management. It is often seen as safer, because no auditor can challenge an expense that was never incurred. But the chapter's concern with the quality of financial reporting asks a deeper question: do the reported earnings still reflect the company's economic performance? Here they do not. The reactor still needs its maintenance, the research still needs doing and the company's long-run earning power has been reduced to make one quarter look better.

This is not an unusual choice. Graham et al. (2005), drawing on a survey of over 400 financial executives plus interviews, reported that most were willing to sacrifice economic value to hit an earnings target or smooth earnings, usually by trimming spending on items like R&D, advertising and upkeep, and that many would delay a valuable project to avoid missing a quarterly number. Roychowdhury (2006) found evidence in financial data that firms near zero earnings cut discretionary expenses, offer price discounts to boost sales and build excess inventory so that fixed costs leave cost of goods sold, all to avoid reporting losses.

Regulation may have made the problem worse in one sense. Cohen et al. (2008) found that accrual-based earnings management increased steadily before the Sarbanes-Oxley Act and declined after it, while real earnings management, which had been declining, increased after the Act. As accrual manipulation became riskier, firms appear to have substituted decisions that change the business itself. Real earnings management leaves the books accurate and the company poorer; it passes an audit by doing its damage in the plant instead of the ledger. That is why I believe the division manager's plan may be more harmful, not less, than adjusting a reserve. A reserve adjustment reverses next year with no lasting damage; a postponed maintenance shutdown can turn into an unplanned outage, an environmental release or a safety incident, and frozen research may never be restarted. Investors also lose something they cannot see: the reported $1.42 suggests the company is performing as expected, when in fact it has borrowed from next year's maintenance budget and next decade's products. The financial statements are accurate in every line and misleading as a whole.

Scripture warns that wealth gained hastily will dwindle, while money gathered steadily, a little at a time, grows (English Standard Version Bible, 2001/2016, Proverbs 13:11). Meeting a quarterly target by eating into the company's future is a modern form of haste. A Christian view of stewardship asks managers to care for the resources entrusted to them over the long run, including the safety of workers at the plant and the interests of shareholders who will own the company long after this quarter. It also asks honesty about motives. The manager would be postponing maintenance not because March is the better time, but because December is the better time for her bonus.

What should she do? She can tell the chief financial officer that the maintenance should proceed as scheduled, explain the operational risk and suggest that the company explain the shortfall to analysts as the cost of protecting its main production asset. If the company's incentives make that conversation impossible, the problem lies with the board, which could tie bonuses to multi-year results and to measures such as safety and research milestones that short-term cuts would harm. Analysts generally forgive a small miss that comes with a credible explanation far more readily than a later surprise.

Reply to Leah

Leah, your thread defined earnings management as any accounting choice made to change reported profit, and you argued that it is always unethical. I agree with much of your argument, but I think a more precise definition would make it stronger. Healy and Wahlen (1999) define earnings management as occurring when managers use judgment in financial reporting and in structuring transactions to alter financial reports, either to mislead some stakeholders about the company's underlying economic performance or to influence contractual outcomes that depend on reported numbers. Two features of that definition matter. It includes structuring transactions, so it covers real decisions like the maintenance delay in my thread, not only accounting choices. And it centers on the intent to mislead or to influence contracts.

That second feature is important for your claim. Not every judgment that changes earnings is management in this sense. A company that raises its warranty reserve because claims have genuinely increased is using judgment to make earnings more accurate. What makes earnings management wrong is the purpose of misleading people who rely on the numbers. In your example of the retailer that shifted markdowns into the next quarter to meet a bonus target, that purpose was plainly present, so your conclusion holds. I would just suggest framing the ethical line around honesty of purpose rather than around whether a choice affects earnings at all, since almost every accounting choice does. Under that framing, your retailer and my chemicals company fail the same test, even though one changed an accounting entry and the other changed a maintenance schedule.

References

Cohen, D. A., Dey, A., & Lys, T. Z. (2008). Real and accrual-based earnings management in the pre- and post-Sarbanes-Oxley periods. The Accounting Review, 83(3), 757-787. https://doi.org/10.2308/accr.2008.83.3.757

English Standard Version Bible. (2016). Crossway. (Original work published 2001)

Graham, J. R., Harvey, C. R., & Rajgopal, S. (2005). The economic implications of corporate financial reporting. Journal of Accounting and Economics, 40(1-3), 3-73. https://doi.org/10.1016/j.jacceco.2005.01.002

Healy, P. M., & Wahlen, J. M. (1999). A review of the earnings management literature and its implications for standard setting. Accounting Horizons, 13(4), 365-383. https://doi.org/10.2308/acch.1999.13.4.365

Mintz, S. M., & Morris, R. E. (2019). Ethical obligations and decision making in accounting: Text and cases (5th ed.). McGraw-Hill Education.

Roychowdhury, S. (2006). Earnings management through real activities manipulation. Journal of Accounting and Economics, 42(3), 335-370. https://doi.org/10.1016/j.jacceco.2006.01.002