Ethics in Finance: Corporate Earnings Management

Earnings management is the term used to describe the process of manipulating earnings of the firm to meet management’s predetermined target. Earnings management that falls outside the generally accepted accounting choice boundaries is clearly unethical. 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.

Intention behind Earnings Management

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. 
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 definition 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.

Common Practices

A common approach is to structure transactions in a way that increases current income or current assets, but postpones costs or liabilities. 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.

Traditional utilitarian ethical theories are evaluated based on its effects or consequences on others, with acts that produce more benefit than harm ethically desirable. 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.

Why it is unethical?

Earnings management is unethical in any situation, even if it remains within the accounting boundaries permitted by GAAP or IAS because managers have a 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. 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.
 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.

Control Measures

• One way to control earnings management (by accounting techniques) is setting more rigorous Accounting standards. However, this may have the unwanted effect that manager’s turn to ‘real earnings management’, which consists of abnormal business practices in order to change reported earnings·
• Corporate governance practices signal the potential for earnings management. Permissive structures indicate that manipulation is more likely. The board of directors sets overall policy & provided oversight for operating activities. Boards are composed mainly of owners, managers & other insiders.Therefore a majority of independent board member is essential for effective oversight.
• Moreover, if accounting standards as well as governmental scrutiny do not completely eliminate earnings management then auditors should be confronted with attempts to alter financial reports. Increased audit quality could or should lead to increased quality of reported earnings. 

Conclusion:

Earnings management is a tool for satisfying self interest of the managers. But, it can be used for the welfare of the stake holders, if it is ethically used. So, to get the optimum benefit of earnings management, steps should be taken to improve corporate governance. Accounting standards should be revised and set in such ways, that there remain no loopholes for manipulate earnings. Auditors should be more careful in detecting earnings manipulation and their independence should be ensured. 
Finally, the consciousness and the morality of the stake holders can turn this malpractice into a good one if the motivations behind the earnings management are free from evil intensions.