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ima
The Naughty List or the Nice List? Earnings Management
in the Days of Corporate Watchdog Lists
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About the Authors
Erin L. Hamilton, Ph.D., CPA, is an assistant professor of accounting
and EY Faculty Fellow at the University of Nevada, Las Vegas. She
received her Ph.D. in business administration from the University of
South Carolina and her master of science in accounting and bachelor
of business administration in accounting from Kent State University.
She is a Certified Public Accountant in Ohio.
Rina M. Hirsch, Ph.D., CPA, is an assistant professor of accounting at
Hofstra University. She received her Ph.D. in business administration
from the University of South Florida, master of accountancy from
Florida Atlantic University, and bachelor of commerce in accounting
from Concordia University. She is a Certified Public Accountant in
Florida.
Uday S. Murthy, Ph.D., is the director of the Lynn Pippenger School
of Accountancy and Quinn Eminent Scholar at the University of
South Florida. He received his Ph.D. from Indiana University, master
of business administration from Drexel University, and bachelor of
commerce from the University of Poona. He is a chartered accountant
in India.
Jason T. Rasso, Ph.D., CFE, is an assistant professor of accounting
at the University of South Carolina. He received his Ph.D. in business
administration from the University of South Florida and master of
accountancy, BSBA in accounting, and BSBA in management from the
University of West Florida. He is a Certified Fraud Examiner.
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Introduction
Earnings management is the act of manipulating company earnings (such as through the use of
aggressive accounting techniques) in an attempt to achieve a personal or companywide goal.
It’s something that likely occurs on a relatively frequent basis at many publicly traded companies;
however, views differ quite considerably regarding the ethicality of such behavior. While some
may view the intentional manipulation of company earnings as akin to fraudulent financial
reporting, others believe that using the discretion allowed within U.S. Generally Accepted
Accounting Principles (GAAP) to achieve earnings goals is simply part of doing business and
appeasing shareholders.
Public perceptions of earnings management are particularly important in today’s
environment, given that the public now has access to various technologies that can be used to
assess the aggressiveness of a company’s accounting choices. Given the increasing ability to
detect earnings management, today’s managers must consider how their accounting decisions
may be perceived by the public. To this end, we set out to understand how the possibility of
being included on a corporate watch list (i.e., a public list that identifies companies engaged
in more aggressive accounting practices) influences managers’ decisions to engage in earnings
management. We distributed a survey to managers of publicly traded companies who have
considerable financial reporting experience. We found that:
• Managers engage in more aggressive (income-increasing) earnings management when
they believe such behavior will not be revealed publicly.
• The prospect of being included on a corporate watch list changes managers’ accounting
choices. When managers fear inclusion on a watch list, they are less likely to engage
in aggressive (income-increasing) earnings management and more likely to engage in
conservative (income-decreasing) earnings management.
• Managers generally view earnings management as unethical (particularly income-
increasing earnings management), but frequently engage in such behavior despite
these beliefs.
• Managers give considerable thought as to how their aggressive accounting choices might
be perceived by others (such as investors, regulators, and auditors).
Taken together, these observations suggest that managers are less likely to engage in
aggressive earnings management if they believe such behavior may cause their company to be
placed on a corporate watch list. The reduction in earnings management is something that could
theoretically improve earnings quality (particularly from a stakeholder perspective), but may also
reduce managers’ willingness to use accounting discretion for functional purposes like signaling
private information. On the positive side, making more conservative accounting decisions
increases a company’s chances of being placed on a list of trustworthy companies, which could
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result in a public perception that the firm is ethical and honest in its accounting choices. In the
following sections, we provide detailed results from our survey as well as suggestions regarding
the types of accounting practices that managers should avoid if they don’t want their companies
to be “flagged” publicly for engaging in aggressive accounting behavior.
Earnings Management Strategies and Ethicality
Earnings management can take many forms, but it’s typically divided into two broad categories:
1. Accruals-based earnings management, where the discretion allowed within GAAP is
used to manipulate company earnings, and
2. Real earnings management, which involves making operational or financing decisions
to achieve certain earnings outcomes, even though these decisions may harm company
operations.
There are various reasons why a corporate manager may choose to engage in earnings
management. Some of these reasons are more justifiable than others. In fact, it may sometimes
seem that manipulating company earnings is the “appropriate” or “ethical” thing to do given
the circumstances. For instance, imagine being the CFO of a company that has struggled over
the past few years to meet analysts’ earnings forecasts and to pay hardworking employees the
bonuses they deserve. It appears that this year your company’s earnings are on track to meet
or exceed analysts’ forecasts and trigger employee bonuses. At the last minute, though, an
important sale falls through. As the CFO, you know that failing to meet analysts’ expectations
will harm shareholder value, while failing to pay employee bonuses once again will harm
employee morale. In such a scenario, many managers would argue that the ethical thing to do
would be to find a way to boost company earnings. After all, isn’t it the job of management to
protect the interests of shareholders and company employees? Perhaps there’s an accounting
standard that could be interpreted a bit more aggressively to accelerate the recognition of
revenue, or the sale of outdated equipment that is currently in process could be delayed until
next year to avoid the loss that would occur.
Regardless of the approach used (see Table 1 for examples of various earnings
management techniques), it’s clear that individuals have very different views regarding the
ethicality of earnings management. Many parties have weighed in on this debate. Regulators
have cautioned companies against engaging in earnings management, arguing that such
practices are unethical as they skew a company’s “true earnings” and mislead the investing
public. Others view the discretion inherent in reported earnings as a valuable tool that can be
used by managers to incorporate their private information and company-specific circumstances
into accounting transactions, thus making financial statements more informative for users. Still
others have argued that earnings management falls along a continuum with less egregious and
more justifiable methods at one end of the spectrum (for example, interpreting an accounting
standard in a more aggressive manner) and outright fraud at the other, with many activities
falling somewhere in between.
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Given the frequency with which earnings management seems to occur in corporate
America, company stakeholders may actually expect managers to engage in such behavior. In
a 2013 survey, CFOs estimated that approximately 20% of firms manage earnings in a given
period and that the typical size of these manipulations is approximately 10% of reported
earnings.
1
If the perception is that “everyone else is doing it,” then managers may feel they
Accruals-based Earnings Management
• Manipulate the timing of revenues and expenses (for example, recognize revenue before goods are shipped
or defer expense recognition)
• Inappropriately capitalize expenses (for example, interest on construction projects or repair and
maintenance expense)
• Create “cookie jar reserves” (for example, over-accrue the allowance for bad debt in a “good year” and then
reduce the reserve and corresponding expense in future periods to boost income)
• “Big bath phenomenon” (i.e., take actions to further reduce earnings in a “bad year” to achieve higher earnings
in subsequent periods)
• Interpret accounting standards more aggressively than is warranted to accelerate revenues and/or
defer expenses
• Decide when to adopt a new accounting standard (i.e., early adoption vs. waiting until adoption is required)
based on its earnings effects
• Use discretion in accounting estimates to achieve higher earnings in certain periods (for example, through the
choice of depreciation method, salvage value, or useful life)
• Classify items based on their earnings effects (for example, reclassify a trading security as available-for-sale to
prevent an unrealized loss from being reported in net income)
Real Earnings Management
• Incentivize customers to purchase more product at year-end than they otherwise would (for example, by cutting
prices or offering sales discounts or more lenient credit terms)
• Decide when to purchase or sell assets based on the earnings effects that will result (for example, to avoid
recording depreciation on a new machine, avoid a loss on the sale of an investment, or achieve a gain on sale)
• Delay hiring employees to avoid recording various employee-related expenses in the current period
• Reduce or postpone research and development activities, advertising expenses, or discretionary selling, general,
and administrative (SG&A) expenses purely to boost income
• Increase production to build up excess inventory and reduce cost of goods sold (COGS) by spreading xed costs
over a larger number of units, thus reducing the cost per unit
Table 1: Earnings Management Techniques
1
Ilia D. Dichev, John R. Graham, Campbell R. Harvey, and Shivaram Rajgopal, “Earnings Quality: Evidence from the
Field,” May 7, 2013, http://dx.doi.org/10.2139/ssrn.2103384.
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are at a disadvantage if they choose not to engage in such behavior. Given that earnings
management resides in a gray area of the ethics continuum, we need to gain insights into the
practice of earnings management, specifically understanding when managers would choose to
engage in earnings management and when they would not.
Earnings Management When No One Is Watching
For many years, company stakeholders have only had a limited ability to gauge the extent of
earnings management taking place within companies. Managers have been relatively free to
engage in earnings management without having to worry about the practice being publicized.
After all, it’s easier to act in a manner you may feel is unethical if no one can call you out on
your behavior.
A commonly used benchmark of whether an action is right or wrong is to answer the
question, “Would you want this action publicized in the news?” If not, then don’t do it. We
conducted a survey to put this benchmark to the test and gain insights into the practice of
earnings management.
2
One hundred twenty-two managers of publicly traded companies,
with an average of 8.2 years of experience making financial reporting decisions, completed our
survey. The survey put the managers in charge of a hypothetical company preparing to issue its
quarterly financial statements and gave them the ability to engage in earnings management.
Some of the managers were told that their company’s unaltered earnings per share was set
to beat analyst expectations, while others found that the earnings per share would fall below
analyst expectations. To perhaps no one’s surprise, approximately 90% of the managers who
were told that their company was about to report earnings that would miss analysts’ forecasts
chose to engage in income-increasing earnings management (see Figure 1). Approximately 64%
of the managers beating analyst expectations decided to increase earnings even without an
explicit incentive to do so (see Figure 2).
2
See the Appendix for additional information about survey procedures and participant demographics.
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Thus, a high proportion of managers chose to engage in earnings management. It
would seem they either do not view earnings management as unethical or are able to justify
this behavior despite perceiving it as unethical. To clarify this point, we asked the managers
to rate the ethicality of earnings management on a scale ranging from 1 to 8, where 1 = not
morally right and 8 = morally right. The average response to this question was a 2.8, suggesting
that managers generally view earnings management to be relatively unethical. Furthermore,
90%
5%
5%
Figure 1: Earnings Management Decisions When Missing Analysts’
Forecasts and Actions Not Publicized
n
Increase Earnings
n
Decrease Earnings
n
No Change to Earnings
64%
9%
27%
Figure 2: Earnings Management Decisions When Beating Analysts’
Forecasts and Actions Not Publicized
n
Increase Earnings
n
Decrease Earnings
n
No Change to Earnings
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managers predominantly expressed the belief that income-increasing earnings management is
more unethical than income-decreasing earnings management, as illustrated in Figure 3.
The results of the survey so far suggest that, despite perceiving earnings management
as relatively unethical, the majority of managers will engage in some amount of earnings
management when they believe that their actions will not be observed. What happens, then,
when managers do believe that their accounting choices will be revealed to the public?
Earnings Management When the Public Is Watching:
Inclusion on a Watch List
In recent years, the ability of company stakeholders to gauge the extent to which companies
employ aggressive accounting practices has increased. New technologies, such as online
investment tools, now make it possible for investors, creditors, regulators, and others to obtain
information regarding the aggressiveness of a company’s accounting choices and compare
the accounting practices of one company to others in the same industry. For example, Audit
Analytics, an independent research firm, developed the Accounting Quality + Risk Matrix,
an online investment tool that can be used to screen companies for “indicators of potential
earnings management and other accounting quality issues.” Another commercially available
investment tool is the Accounting and Governance Risk (AGR) score, which was originally
developed by GMI Ratings and is now offered by MSCI Inc.
3
The AGR score is a summary
72%
12%
16%
Figure 3: The Perceived Ethicality of Income-Increasing and
Income-Decreasing Earnings Management
n
Income-increasing
more unethical
n
Equally unethical
n
Income-decreasing
more unethical
3
GMI Ratings was acquired by MSCI Inc. in 2014. MSCI subsequently renamed GMI Ratings’ AGR score the “Accounting
Risk Metric.” Further details are available at www.msci.com/esg-ratings.
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measure that reflects the risk associated with a company’s financial reporting and corporate
governance practices. AGR scores have been used to compile watch lists of companies with
the most aggressive accounting practices, for example, the Forbes Corporate Risk List and GMI
Ratings’ “Risk 50 List,” as well as lists of companies that are the most conservative or trustworthy,
such as the Forbes list of “The 100 Most Trustworthy Companies in America.”
To better understand how AGR scores are determined and what kind of information
these scores provide, we obtained a white paper by GMI Ratings (before it was acquired by
MSCI) that describes how AGR scores are used to classify companies into one of four possible
categories based on their level of accounting aggressiveness: very aggressive, aggressive,
average, and conservative.
4
Companies move from very aggressive to conservative as their AGR
scores increase, with AGR scores ranging from 1 to 100. According to the paper, approximately
10% of all companies are classified as very aggressive, 25% are aggressive, 50% are average,
and 15% are conservative.
All of the metrics used in calculating an AGR score come from publicly available
information, such as company financial statements. The metrics are classified into two broad
categories: governance risks and accounting risks. Governance risks include risks associated
with corporate governance (such as late filings, class action lawsuits, and officer changes) and
high-risk events (such as divestitures, mergers and acquisitions, and restructuring). Accounting
risks consist of risks associated with revenue recognition (for example, ratios such as accounts
receivable over sales, operating revenues over operating expenses, and unusual income over
revenues), expense recognition (such as ratios like cost of goods sold over revenues, inventory
over cost of goods sold, and accounts payable over operating expenses), and asset-liability
valuation (such as asset turnover, cash ratio, and working capital over assets). Approximately 55
metrics are used to determine a company’s AGR score, and about two-thirds to three-quarters of
these metrics are strictly accounting ratios.
5
Regulators have also started using analytical tools to identify companies most likely to
be engaged in aggressive accounting practices. One example of this is the Accounting Quality
Model (AQM) from the U.S. Securities & Exchange Commission (SEC). To identify companies
most likely to be engaged in earnings management, the tool screens for companies with large
discretionary accruals and those whose accounting practices don’t align with those of their
industry peers. The SEC intends to use this tool to identify high-risk companies that may warrant
further investigation.
Given the increasing ability of company stakeholders to detect earnings management
through the use of technology and published watch lists that identify risky companies, today’s
4
GMI Ratings, “The GMI Ratings AGR Model: Measuring Accounting and Governance Risk in Public Corporations,”
2013. This white paper was originally retrieved from www3.gmiratings.com/wp-content/uploads/2013/11/gmiratings_
AGR3.0Whitepaper_102013.pdf. This link is no longer active, and the information in the white paper is not available on
MSCI’s website. While we can’t be certain if the same metrics are used today, we have no reason to believe these inputs
have changed.
5
The 2017 Forbes list of “The 100 Most Trustworthy Companies in America” can be found at www.forbes.com/sites/
karstenstrauss/2017/04/07/the-100-most-trustworthy-companies-in-america-2017/#517b649b4b17.
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managers must consider how their accounting decisions may be perceived by stakeholders
and the general public. To investigate whether managers behave differently in this type of
environment, we put some of the managers in our survey into a situation where aggressive,
income-increasing earnings management would place their companies on a watch list and
put them at risk of an SEC investigation. Similar to the first scenario, we gave some of these
managers an incentive to engage in earnings management by telling them that their companies’
earnings currently do not meet analysts’ expectations for the period, while others were told their
earnings exceeded analysts’ expectations.
Recall that when managers believed their earnings management behavior would not
be observed by the public, approximately 90% chose to engage in income-increasing earnings
management in an effort to meet or beat analysts’ earnings forecasts. In contrast, we find that
when managers are told their aggressive (income-increasing) earnings management behavior
will cause their company to be included on a watch list of aggressive companies, only 47% of
managers decided to engage in such behavior (see Figure 4). This significant 43% difference
suggests that the fear of having their aggressive accounting behavior observed by stakeholders
decreases the managers’ desire to engage in earnings management.
To further explore the extent to which managers would go to avoid being placed on a
watch list, we also gave the managers in our survey the ability to engage in income-decreasing
earnings management to reduce the chance that their company would be placed on the watch
list. Our reasoning was that accounting decisions that decrease earnings should be viewed as
more conservative and, thus, would be much less likely to be flagged as aggressive. Of the
managers who believed their company was at risk of being placed on the watch list and at
risk of missing analysts’ earnings expectations, 37% chose to engage in income-decreasing
earnings management even though this would further decrease their company’s earnings (i.e.,
the analyst forecast would be missed by a larger amount). These managers appeared to fear
the consequences of being included on a publicly available watch list more than they feared the
consequences of missing analyst expectations.
Furthermore, when managers in our study were told that their company was
beating analyst expectations but it appeared the company would be placed on a watch list,
approximately 71% chose to engage in income-decreasing earnings management in an effort to
appear less aggressive (which is much higher than the 9% who made this decision when there
was no risk of being included on a watch list). Interestingly, the desire to avoid inclusion on a
watch list led to one-third of the managers in this environment to decrease their earnings so
much that they no longer met analyst expectations (see Figure 5). In general, there is a drastic
reduction in aggressive (i.e., income-increasing) earnings management behavior and an increase
in conservative (i.e., income-decreasing) earnings management behavior when managers fear
their actions will be publicized.
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47%
37%
16%
Figure 4: Earnings Management Decisions When Missing Analysts’
Forecasts and Actions Publicized (via Inclusion on a Watch List)
n
Increase Earnings
n
Decrease Earnings
n
No Change to Earnings
24%
71%
5%
Figure 5: Earnings Management Decisions When Beating Analysts’
Forecasts and Actions Publicized (via Inclusion on a Watch List)
n
Increase Earnings
n
Decrease Earnings
n
No Change to Earnings
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The Naughty List or the Nice List?
As children, we’re often told to be wary of our behavior around the holidays to ensure we are
classified as “nice” as opposed to “naughty” and will reap the rewards of our good behavior.
Similarly, managers appear to moderate their aggressive accounting behavior when they believe
their behavior will be observed and evaluated by the public. Yet what are the disincentives
(“punishments”) managers anticipate from being included on a watch list? To obtain some
insight into this question, we asked the managers in our survey to describe what they believe
the negative outcomes would be if their company was included on a watch list that identifies
companies engaged in aggressive (or potentially fraudulent) accounting practices. The
consequence most frequently cited was the damage that would be done to the company’s
reputation. Other frequently cited consequences include damaged shareholder perceptions,
loss of trust, negative stock market reactions, and damaged relationships with customers and
suppliers. See the results in Table 2.
(N = 122 nancial reporting managers)
Negative Consequences of Being included Percentage of Managers
on a Watch List of Aggressive Companies Citing this Consequence
Sample Participant Quote
“It would harm our reputation and negatively impact our
Damage to company reputation
22.1%
ability to attract investors.”
Shareholder perceptions of company would “It would be less attractive to investors. The pillars of our brand
be negatively affected
19.7%
would be undermined in the public’s eye.”
“Shareholders and our clients would not have the same level
Loss of trust in company
16.4%
of trust (and faith) in us that we will do the right thing.”
Negative stock market reaction (e.g., stock “Decreased investors/analyst trust. Resulting share price
price decline, selling of shares)
15.6%
declines.”
Damage to customer and vendor perceptions
of (and relationship with) company
13.9%
“People would be less likely to do business with us.”
Increased scrutiny/oversight (in general) 4.9% “More scrutiny from all parties (creditors, analysts. etc.).”
“You would open yourself up to more attention from the SEC
Increased scrutiny/oversight by regulators
3.3%
about possible fraud.”
Increased scrutiny/oversight by auditors 1.6% “Ding to credibility; heightened auditor scrutiny.”
“Would potentially show that the company is manipulating
Employee perceptions (and retention) would
the books and would have an adverse affect on the company
be negatively affected
1.6%
in the view of stockholders and employees.”
Table 2: Consequences of Being Included on a Watch List
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Consistent with some of the concerns expressed by managers in our survey, other
research has found that companies typically face severe stock market declines when faced with
allegations of accounting fraud (such as by the SEC or the business press).
6
This suggests that
investors lose confidence or trust in companies when the ethicality of their accounting practices
is called into question. For example, several years ago, fraudster Barry Minkow alleged that
Lennar Corporation, a home builder based in South Florida, was committing fraud. Based solely
on Minkow’s allegations, Lennar’s stock lost $500 million in value. Minkow knew that the decline
in stock value would happen, and his scheme was to short-sell the stock in anticipation of the
decline. Lennar’s stock eventually regained its value after authorities uncovered Minkow’s scheme,
but this example shows just how much a single allegation of fraud can affect a company. We posit
similar effects might occur for companies being placed on a corporate watch list that identifies
companies most likely to be engaged in aggressive and/or fraudulent accounting practices.
How to Avoid Being Flagged
Given what we know about existing accounting risk metrics, here are some suggestions for how
corporate managers can avoid receiving an “aggressive” AGR score, avoid being flagged by
the SEC’s AQM or Audit Analytics’ AQRM model, and increase their likelihood of making it onto
Forbes’ “100 Most Trustworthy Companies in America” list:
• Be aware of the accounting practices and ratios considered typical or average for your
industry. Risk metrics flag companies that employ practices and ratios different than those
from their peers.
• Avoid unusual fluctuations in account balances and financial ratios when compared to
prior periods.
• Avoid abnormal levels or changes in discretionary accruals (such as sales return allowance,
allowance for doubtful accounts, and reserve for inventory obsolescence) when compared
to prior periods and industry peers.
• Avoid onetime adjustments (such as changes in accounting estimates and out-of-period
adjustments).
• Avoid late filings, restatements, material weaknesses, and unusual changes in audit fees.
• Avoid abnormal levels of share repurchases and issuances of debt or equity.
• Avoid CEO and CFO turnover and excessive levels of executive incentive compensation
as a percentage of overall compensation.
• Avoid accounting policies that result in relatively high reported book earnings while at the
same time selecting alternative tax treatments that minimize taxable income.
• Avoid off-balance-sheet transactions.
6
For example, the most recent Committee of Sponsoring Organizations (COSO) fraud report indicates that the initial
news of an alleged fraud results in an abnormal stock price decline of approximately 17% in the two days surrounding
the announcement within the business press. See “Fraudulent Financial Reporting: 1998–2007” by Mark S. Beasley,
Joseph V. Carcello, Dana R. Hermanson, and Terry L. Neal, available at https://www.coso.org/Documents/COSO-Fraud-
Study-2010-001.pdf.
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Implications for CFOs
Our survey found that managers are more willing to engage in income-increasing earnings
management when they believe they can do so without being observed. This tendency toward
aggressive accounting decreases when managers believe their accounting decisions will be
revealed to the public (via inclusion on a watch list). In fact, managers are even willing to
decrease their company’s earnings by making overly conservative accounting decisions (i.e.,
income-decreasing earnings management) in order to avoid being placed on a watch list—even
if that behavior will cause the company to miss the analysts’ earnings forecast for the period.
Based on these results, it appears that the decision to engage in earnings management
involves a trade-off between the incentive to meet the earnings expectations of stakeholders
and the incentive to avoid appearing overly aggressive. Managers indicated that when both
incentives are present, they are more concerned with avoiding the appearance of engaging
in aggressive or fraudulent accounting practices. These findings suggest that earnings
management behavior is largely contingent on the extent to which the public is able to detect
such behavior through the use of investment tools, company watch lists, and other means.
Specifically, the more observable a company’s accounting practices are to the public, the less
likely managers are to engage in aggressive (or potentially fraudulent) financial reporting.
In this report, we have also provided information to make corporate managers aware
of the kinds of technologies that exist for evaluating and comparing companies’ accounting
practices and how these technologies work. Specifically, we documented several of the metrics
used to calculate accounting risk metrics (such as AGR scores) as well as several activities that
managers should avoid in order to achieve a score indicative of more conservative, trustworthy
accounting practices. Being aware of the types of activities that may cause a company to
be flagged as aggressive may give managers pause when considering one of these “high-
risk” activities. Managers interested in being included in a list of trustworthy companies can
increase their chances by using the information we provided to avoid high-risk activities and
select more conservative accounting practices. Managers should keep in mind, however, that
some of the events that negatively impact accounting risk metrics (such as issuance of debt or
equity, officer changes, and large fluctuations in account balances) simply occur in the normal
course of a business. As such, it isn’t always possible for managers to avoid the appearance of
aggressiveness. Nonetheless, managers should consider how their accounting choices may be
perceived by the public because, in today’s environment, someone is always watching.
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Appendix: Participant Demographics and Survey Procedures
Survey participants were recruited using Qualtrics Panels, and the survey was administered
online in July 2015 using the Qualtrics platform. To qualify for the study, participants needed
to work for a publicly traded company; hold a mid-, upper-, or executive-level management
position; and have experience making financial reporting decisions. A total of 122 qualifying
managers participated in the study. Participants had an average of 15.2 years of management
experience and 8.2 years of experience making financial reporting decisions. Approximately 40%
of participants had earned a graduate degree. Additionally, 39% of participants had majored
in accounting or finance, 25% majored in a business area other than accounting or finance, and
13% held an MBA.
