Australian School of Business School of Accounting. Semester 2, Paul Coram. The University of Melbourne

Transcription

1 Australian School of Business School of Accounting School of Accounting Seminar Series Semester 2, 2012 Earnings management decisions: The role of economics and ethics Paul Coram The University of Melbourne Date: Friday, 3 rd August 2012 Time: 3.00pm 4.30pm Venue: Tyree Energy Technologies Building LGO5 (Refer to campus map reference H6 here)

2 Earnings Management Decisions: The Role of Economics and Ethics Paul Coram The University of Melbourne James Frederickson Melbourne Business School Matt Pinnuck The University of Melbourne July 20, 2012 ABSTRACT: This study through a survey of 225 CFOs and CEOs of listed companies attempts to better understand earnings management (EM) decisions. We extend Graham et al. (2005) by providing participants with a case study scenario which asked them to decide on whether to manage earnings when earnings were not expected to meet market expectations. The survey then evaluates how they incorporate economic factors such as costs and benefits to various stakeholders in their decision making, as well as evaluating whether their perception of whether EM is ethical makes a difference. We find the most significant economic factor affecting the EM decision is to avoid the costs to current shareholders from not managing earnings to meet the market expectations. However, the perception of whether EM is ethical and the related issue of whether EM is perceived as lying are also significant factors that affect the decision to manage earnings. Finally, we provide evidence that the choice by managers on the method of accrual compared to real operational EM is primarily driven by ethical perceptions of these alternative actions. [Draft please do not quote without permission] 1

3 I. INTRODUCTION Earnings management (EM) is a pervasive aspect of corporate reporting which accounting researchers attribute to contracting or market based incentives. However, despite the wealth of archival literature on this topic there is relatively little research on the decision making processes of managers who undertake these actions with the exception of Graham et al. (2005). Motivated by the lack of understanding of the decision making processes by managers we conduct a survey of 225 CFOs and CEOs of listed companies (hereafter managers ) in relation to EM to examine how they weigh up the various economics factors in making their decisions. We also evaluate whether factors beyond economics such as ethical considerations affect these decisions as recent economic research has questioned the assumption of economic man (Benabou and Tirole 2011) and notes there is ample evidence that people often behave morally. EM refers to situations where managers apply accounting standards and/or structure transactions to alter the company s financial statements with the intent of either misleading some stakeholders about the company s true economic performance or influencing contractual outcomes that are based on reported accounting numbers (Healy and Wahlen 1999). Prior archival research has documented that managers are more likely to manage earnings in certain situations such as when unmanaged earnings are below an important benchmark or when the firm is in danger of violating an accounting-based debt covenant and commonly have used a version of the Jones (1991a) model to measure EM (see, e.g., Fields et al. 2001, Dechow and Skinner 2000, or Healy and Wahlen 1999 for summaries). However, documenting situations where managers are likely to manage earnings provides only a partial picture of factors that influence managers. A complete picture requires that we understand the specific factors that managers consider when deciding whether to manage earnings in a particular situation. Through a variety of mechanisms that are based on accounting numbers 2

4 (e.g., debt covenants, investment decisions, and so forth), EM redistributes wealth across a range of stakeholders (e.g., the manager, current shareholders, current debtholders, future shareholders). Presumably, the decision whether to manage earnings in a particular situation is based on managers undertaking an expected cost-benefit analysis that incorporates the effects on the various stakeholders potentially affected in that situation. Understanding which stakeholders (and the expected costs and benefits to those stakeholders) managers consider when deciding whether to manage earnings and how they trade off the expected costs and benefits is critical for designing governance structures and compensation packages that will curtail EM. To better understand the EM decision, a prominent survey by Graham et al. (2005) attempted to address a number of important questions from the prior literature such as which benchmarks are most important to managers and what factors motivate managers to manage earnings or make real operational adjustments. Their survey provided a rank ordering of CFOs perceived importance of each motive to manage earnings and found managers were most interested in meeting or beating earnings benchmarks to influence stock prices and their own reputations. A surprising finding to emerge from their study is that managers prefer to manage earnings via real operational methods rather than by accounting adjustments. In considering this finding Graham et al. (2005) speculated that these responses may have been affected by ethical considerations, which had been found in an earlier study by Bruns and Merchant (1990). These findings as well as recent economics research that has questioned the assumption of economic man (Benabou and Tirole 2011) raise the issue of whether considerations beyond economics are factored into managers decisions, which is part of what we examine in this paper. This research project will disentangle the effects of the various competing economic factors as well as ethical considerations that may affect managers decisions to engage in EM. 3

5 Our approach to address these questions is by a survey that places managers in a situation where there is pressure created by earnings being below market expectations and then asking them to make a decision on whether they would manage earnings, and if so, whether they would use real operational or accounting adjustments. The specific motives of managers are then identified by asking questions on the magnitude of costs to various stakeholders from the various available alternatives of: doing nothing; managing earnings using accounting adjustments; or managing earnings using real operational adjustments. Questions were also asked about managers perceptions on whether undertaking EM is ethical and also whether they think it is lying. This enabled us to model factors that influence managers in deciding whether to manage earnings, and also factors that affect the approach they would use to manage earnings (i.e., real versus accounting adjustments). We can therefore more explicitly examine how managers consider the effects on various stakeholders as well as the relative importance of economics and ethics in their decision making on EM. This study is the first to try and more comprehensively understand managers decision making in this area. It provides several important new insights. First, we document the evaluation of economic costs and benefits to stakeholders by managers in deciding on whether to undertake EM. Second, we show managers perceptions of the ethics of EM actions and the related concept of whether they perceive EM as lying both provide significant explanatory power in the decision to manage earnings. Finally, we examine the factors that affect the choice between real operational and accounting EM or alternatively, why some firms decide to do nothing. Again, economics is important but ethical considerations also affect this choice. In summary, for both the decision to manage earnings and the method of managing earnings we find that economics and ethical factors are important. 4

6 II. LITERATURE REVIEW Earnings Management The question of why and when managers manage earnings has been the subject of significant research over many years. It is an important topic that is of interest both to the accounting profession and regulators as high profile cases of earnings management have resulted in significant negative publicity for the accounting profession. The main motivations for undertaking EM documented in the prior literature has come from either contracting or capital markets based incentives. From a contracting perspective, studies on the effect of being close to breaching a lending covenant have generally found little evidence of EM (Healy and Palepu 1990; DeAngelo et al. 1994). The effect of management compensation contracts on EM has however found evidence consistent with expectations from contracting theory (Healy 1985; Guidry et al. 1999). DeChow and Sloan (1991) also observed real operational EM by observing CEOs in their final years reducing R&D spending to increase reported earnings. More recently, the EM research has focused more on capital market incentives. Evidence shows that managers overstate earnings prior to initial public offering of stock (Teoh, Welch and Wong 1998). There has also been research that has observed EM to meet the expectations of analysts (Kasznik, 1999). The focus on the importance of meeting these targets does suggest that the decision to manage earnings is a more complex decision with a number of possible costs to various stakeholders compared to if it is based solely on contracting factors alone. Graham et al (2005) find that two of the most important benchmarks for managers are meeting analysts expectations and prior earnings. The contracting and market based studies have identified situations where EM is expected to occur and then observed whether it does. It has examined a number of separate 5

7 and different factors that are associated with EM. However the situations provides no understanding of the underlying economic motivations of the corporate manager. Positive accounting research (Watts and Zimmerman 1986; Christie and Zimmerman 1994), under which research on EM is typically classified, assumes that when deciding what decision to make, managers maximize an objective function. Given that the manager s objective function is unknown, the only way to fully understand the EM decision in an unbiased manner is to specify and test an objective function that meets two conditions. The first is that the objective function includes all key stakeholders likely to be affected by the EM decision. Without including these stakeholders, it is impossible to identify and understand how managers trade-off different stakeholders when deciding whether to manage earnings. Further, if the net expected costs or benefits from EM are correlated across two or more stakeholder groups, including all potentially relevant stakeholders is necessary to avoid a correlated omitted variable problem. From a broad stakeholder theory perspective (Jensen 2001), managers objective functions could potentially reflect the expected costs and benefits to the following stakeholders: the manager, current shareholders, current debtholders, other current stakeholders (e.g., suppliers, employees, customers), and future stakeholders. The second necessary condition is that the empirical test must reflect both the expected costs and benefits to each stakeholder group if earnings are managed versus if they are not. For example, assume that the benefit to the manager from managing earnings is a bonus while the costs are job and reputation loss if the EM is detected. If the empirical test includes only the expected benefits or only the expected costs, as is common in the existing research, the net expected cost/benefit is measured asymmetrically, which in turn will yield significantly biased inferences about the relative importance of each stakeholder. Graham et al. (2005) attempted to answer some of these questions about the EM decision through a survey. However, in doing so they raised more questions, particularly relating to 6

8 other considerations such the role of ethics in these decisions and the use of real operational EM both of which are addressed in this present study. Ethics Defining ethics is difficult, although it relates to a basic question of What ought one to do? 1 In examining the effect of ethics on EM, Merchant and Rockness (1994) noted that most EM acts were legal, however the ethical perspective raised the question of whether they were the right things to do (p.81). The difficulty in determining what one ought to do or the right thing to do comes from the fact that people bring morality and values to their ethical decision making, which comes from traditions or theories which will vary between individuals. Further complexity in evaluating an ethical dilemma can be due to important values held by individuals may conflict. For example, two important values that many cultures and traditions agree upon as morally right would be to tell the truth and to not cause others harm. What happens when these two values conflict? The answer to this might then depend on the ethical theory that an individual ascribes to. A teleological approach assesses the rightness or wrongness of something by the consequences, therefore they would choose lying over harming others. A deontological approach relates to universal laws, therefore if they think that lying is always wrong, they would tell the truth under all circumstances. A recent experimental paper by Johnson et al. (2012) provides some evidence that for many managers, the ends may justify the means in relation to EM, thereby suggesting that managers may adopt a teleological approach to this decision. There is limited research that has examined ethical considerations on managers decision making relating to accounting. This may be partially due to the assumption underpinning positive accounting theory that managers actions will only be in their own self interest (Watts 1 This question was raised by Socrates in the fifth century BC. 7

9 and Zimmerman 1986). Erhard and Jensen (2012) have proposed a positive model of integrity which relates to honoring ones word. They assert their definition of integrity has nothing to do with morality and ethics, which are normative concepts. While it is true that they are normative concepts, there has been significant interest in ethics in recent years due to the perceived lack of ethics in some of the high profile corporate collapses in the early 2000s, as well as in the current global financial crisis. In addition, some have recognized that in order for economic settings to function smoothly, ethics and trust are necessary (e.g., Holmstrom 2005; Noreen 1988). In discussing their finding that US CFOs prefer to manage earnings via real operational methods, Graham et al. (2005) speculate but do not test that this effect could be due to ethical considerations. In this discussion, Graham et al. make reference to the study by Bruns and Merchant (1990) who found that managers perceive managing earnings via real operational methods to be more ethical than using accounting methods. A number of studies have examined the ethical dimension in decision making and Loe et al. (2000) provide a good review of this literature. However, from this review, it is apparent that the majority of this research has focused on the role of awareness, individual and organizational factors in ethical decision making. An exception was Merchant and Rockness (1994) who examined the morality of EM with a focus on the moral issue itself. They found some evidence that the acceptability of various EM practices varied with the type, size, timing, and purpose of actions. Their reasoning for applying an ethical perspective is because many types of EM behaviors are not obviously acceptable or unacceptable. Therefore the concept of whether the actions are the right thing to do can become important. In the evaluation of an ethical decision, it is a determination of what is acceptable, or therefore what is right. Our study will be the first to evaluate whether the decision making of managers goes beyond the traditional economic considerations to explain EM. It will 8

10 address the question of how managers see these decisions. Are these purely economic decisions in that the actions by managers are solely in their self interest? Due to contract design, this self interest is also usually linked to the short term effect on the company. Alternatively, does ethics in determining what is right beyond personal self interest come into these decisions. Jones (1991b, p.367) defined an ethical decision as a decision that is both legal and morally acceptable to the larger community, and a moral issue as being present when a person s actions, when freely performed, may harm or benefit others (from Velasquez and Rostankowski, 1985). Jones developed the concept of moral intensity as a framework to evaluate the moral issue itself itself over six dimensions, which are: magnitude of consequences; social consensus; probability of effect; temporal immediacy; proximity; and concentration of effect. Most of these are specific considerations on the effect of the decision on others although social consensus might include other aspects, e.g., whether the action is perceived as lying or not. Our study takes into account some of these other considerations (which we define as economic factors in the survey) to provide a comprehensive understanding of the factors affecting managers decision making in relation to EM. In determining what is right a deontological approach to ethical decision making would expect that individuals should tell the truth under all circumstances whereas a teleological approach would take the view that the consequences were most important. 2 Both of these approaches contrast with a purely economic perspective where it would be assumed that a lie would be told whenever it benefits the liar and irrespective of the effect on any other party. 3 Gneezy (2005) experimentally evaluated whether people do behave in this way or whether the propensity to lie is affected by differing gains to the individual or consequences to others. He found that people are sensitive to the amount of their gain when deciding to lie and are 2 Erhard and Jensen s (2012) concept of integrity would seem to be much more focused on the former rather than the latter. 3 The economic approach is concerned with some consequences that is, those related to the individuals self interest. 9

11 also sensitive to the level of harm to others from the lie. In relating this to EM, this would suggest that whether the manager thinks that EM is lying will have a significant effect on his or her behavior. We will test these findings of Gneezy (2005) in this study by evaluating whether those who think that EM is lying will still undertake these actions based on variations in the benefits and consequences to others. Recent accounting studies have shown that managers decisions on EM can be affected by more than the traditional motivations as would be expected based on economic theory. McGuire et al. (2012) found that greater levels of religiosity are associated with less EM. Although not explicit in that paper, for many religious people lying is perceived to be wrong in an absolute sense, which may the reason for this finding. A recent survey by Abernathy et al. (2012) found an ethical work climate that focuses on self yields agents who are more likely to manipulate accounting earnings. Hunton et al. (2011) found an association between perceived tone at the top and accruals quality. Dikolli et al. (2012) found a positive association between the managerial trait of integrity as defined by Jensen (2009) and accruals quality. In summary, these studies provide some evidence to suggest exploring factors that might explain decision making beyond economics can be important. As well as consideration of the ethics of deciding to manage earnings or not, the choice of EM method also appears to be one partly driven by ethical considerations and we consider this issue in the next section. Real Earnings Management Real earnings management (REM) is when managers undertake actions that change the timing or structuring of an operation, investment, and/or financial transaction in an effort to influence the output of the accounting system (Gunny, p.855, 2010). Studies have shown that REM exists, such as Roychowdhury (2006) who developed empirical proxies for REM 10

12 and found that managers avoid reporting losses by undertaking REM. There is also evidence of an increase in REM in recent years as the method by which to undertake EM (Bartov and Cohen 2009). This is consistent with the findings by Graham et al. (2005), who found 80 percent of their sample of CFOs said they would undertake REM to meet an earnings target. Graham et al. expressed surprise at these findings as they reasonably assert that these decisions are ones that sacrifice economic value. However, interestingly, recent archival research seems to suggest that firms undertaking REM perform at least as well or better than those who do not in the longer term (Gunny 2010). It should be noted that REM studies still suffer from the measurement issues associated with studies on accrual EM (see Fields et al. 2001) and also the problem of determining whether the changes in actual decisions are undertaken solely for financial reporting reasons. Archival studies are not able to evaluate why the decision to make the real operational adjustments occurred. Irrespective of some of the recent changes in preferences for managers to use real rather than accrual EM, the key questions about the factors that affect their decisions of this nature are largely unexplored. Some experiments have examined these questions relating to motivations for REM, such as Bhojraj and Libby (2005) who showed evidence of managerial myopia to meet earnings benchmarks. Further, Seybert (2010) found that allowing capitalization of research and development would lead to REM through overinvestment in continuing projects so managers could avoid reputation damage from asset impairment. As noted earlier in this paper, the survey by Graham et al. (2005) found a preference by managers to use REM. McGuire et al. (2012) found religiosity is negatively associated with abnormal accruals, but positively associated with proxies for REM. For religious people values that inform ethical decision making can be guided by prescribed moral rules (such as lying is always wrong), this therefore provides some evidence consistent with prior research 11

13 that suggests managers perceive REM to be more ethical than accrual EM (Bruns and Merchant 1990; Graham et al 2005). III. RESEARCH QUESTIONS Our study examines a decision by managers on whether to manage earnings and how they will manage earnings when they are below market expectations. In evaluating the economic considerations that affect manager s EM decisions the first order effect that we examine is the economic considerations of the likelihood of success of the action and the direct effect on the manager. We then explore whether the direct effect on the manager is due to consideration of shareholders and other stakeholders and the relative importance of these groups in the decision making process. This has not been done before and will provide insight into some important questions on why managers make these decisions. We also ask managers their perceptions on the ethics of EM to see whether it plays a part in their decision making process. In discussing the fact that CFOs stated they were more willing to report taking real decisions rather than accounting decisions, Graham et al (2005) suggest that this effect could be due to ethical considerations. This present study will also explore the effect of ethical considerations on managers decision making process. Merchant and Rockness (1994) examined the ethics of EM but took a very different approach to our study. 4 We will evaluate whether the harm to others affects decision making and whether managers see this effect as an ethical consideration. Due to contracts, sometimes the harm to others has a direct effect on the manager. We will evaluate whether some considerations of 4 Merchant and Rockness used a questionnaire that consisted of 13 potentially questionable earnings management activities, these varied by: type of action; consistency with GAAP; the direction of the effect on earnings; materiality; the period of effect; and the purpose in mind. They then asked participants the ethical acceptability of each case presented and they found that ethical judgments were affected by the type of earnings management and that using real compared to accounting methods to adjust earnings was much more ethically acceptable. 12

14 the harm to others takes on an ethical dimension, beyond managers self interest. As there have been very few studies to try to understand the decision making processes of managers associated with EM, we will frame our study in terms of research questions. The first research questions therefore relates to the question of why managers manage earnings: RQ 1: What economic factors are important in the decision to manage earnings? RQ 2: What is the relative importance of economics and ethics on the decision to manage earnings? By determining whether ethics makes a difference beyond the potential harm to stakeholders, we are moving towards exploring values that inform ethical decision making that are not related to economics at all such as whether the action seems the right thing to do or whether it involves lying or not. As noted by Gneezy (2005), extreme economic theory would suggest that lies will be told whenever it is beneficial to the liar (p.384). This would seem to be contrary to the positive notion of integrity which means to honor ones word as proposed by Erhard and Jensen (2012). By definition as per Healy and Wahlen (1999) earlier in this paper, EM involves deception therefore technically it could be construed as lying. We therefore raise the question that has not been previously considered in the literature: whether managers (a) view EM actions as lying, and if so (b) will they still do it? RQ 3a: RQ 3b: Is earnings management perceived as lying? Does perceiving earnings management as lying affect the decision to manage earnings? 13

15 Gneezy (2005), showed that inconsistent with an economic theory, individuals are sensitive to the harm that lying may cause to others. The third research question therefore examines whether this finding applies to the EM decision to see whether the decision to manage earnings for those who think EM is lying is affected by the costs and benefits to other parties. We address this as follows: RQ 4: Where EM is viewed as lying, is the decision to undertake EM affected by the costs and benefits to other parties? The final issue that we examine is how managers decide whether to adjust earnings by real or accrual earnings adjustments? Graham et al. (2005) provided the interesting finding that managers prefer real over accrual EM techniques. In evaluating their findings, they thought that the response of managers to their survey question on this issue may have been affected by whether they perceived the two approaches as ethically different. Studies in recent years have examined REM and found some evidence of it being associated with future firm value (Gunny, 2010). However, even if the decision is made for financial reporting reasons, for many firms it is quite possible that reductions in expenditure for the purposes of managing earnings (REM) might also be beneficial to the efficiency of the firm in the longer term anyway. That is, the requirement to reduce real expenses to manage earnings may act as an impetus to improve efficiencies in the longer term. This argument would support the findings of Gunny (2010). We will be able to evaluate whether managers choosing to undertake REM are doing it with consideration of future shareholders. Our study will be the first to examine perceived costs and benefits to stakeholders and whether ethics are considered by managers when actually making a choice of real versus accrual EM. 14

16 We evaluate whether ethics affects this choice as follows: RQ 5: What is the relative importance of economics and ethics on the choice of method to manage earnings? IV. RESEARCH DESIGN A difficulty inherent in the archival studies of EM that examine specific incentives to manage earnings is due to endogeneity and correlated omitted variables problems, as a result this makes it difficult to draw strong causal influences to explain this behavior (e.g., Fields et al. 2001). As pointed out by Libby and Seybert (2008) in a review of behavioral studies of EM, the advantage of experiments and surveys is that they can address unanswered questions from prior archival research. They further state that behavioral studies of EM are able to isolate specific motives for EM and causally link them to EM attempts. How managers actually consider these economic and ethical factors and make these tradeoffs are empirical questions which will be examined by a survey in this research paper. Participants A survey was sent to all the CFOs and CEOs of approximately 1200 of the largest public companies in Australia. 5 This was done by obtaining a mailing list as well as significant hand collection of data. For all of the CEOs we attempted to find the related CFO if we did not have them already, similarly for all of the CFOs we attempted to find the related CEO. This process ultimately resulted in a list of 1044 CFOs and 1180 CEOs who were sent the surveys. 5 Australia has a similar corporate governance framework and institutional environment to the United States (see Leuz et al. (2003)). Prior research has also shown that earnings benchmark beating is important in the Australian environment (Carey and Simnett 2006). Although SOX was obviously not introduced in Australia, there were significant regulatory changes imposed at about the same time through CLERP 9. There is no evidence to suggest that they CFOs and CEOs would respond in any differently from an equivalent group in the US to a survey of this type. 15

17 The first survey was mailed out in December To encourage responses a donation would be made on their behalf on completion of the survey. The number of responses (response rate) from the first mail out was 82 CFOs (7.9%) and 59 CEOs (5.0%). A second request was sent in April 2010, this resulted in the sample increasing to 146 CFOs (14%) and 90 CEOs (7.6%) to give a total sample size of 236. The final number analyzed in this paper was 225 as we excluded any respondents who did not answer the majority of questions. For this type of participant group the response rate is reasonable, for example, Graham et al. (2005) achieved an overall average of 10.4% in their survey of financial executives. Of the respondents, 62% were CFOs and 38% were CEOs. As would be expected they were very experienced with an average of 23 years of professional work experience, including an average of 4.8 years in their current positions. A significant number (65%) had professional accounting qualifications, with 20% CPAs and 45% Chartered Accountants. Ninety-two percent of respondents were male. Survey Task The participants were provided with information about a hypothetical company facing a situation where the earnings per share is not going to meet the markets expectations by 4%. 6 Some extracts from the survey are presented in the Appendix. They were then told there were two possible actions that were available under these circumstances. First, take no special action, or second, try to improve reported performance by either accounting or operational adjustments. They were then asked in Question 1 the likelihood that their firm would improve reported performance using accounting or operational adjustments on a scale of 0 (certain not to happen) to 100% (certain to happen). This was then followed by a direct question (Qu. 2) 6 Considerable feedback from practitioners and academics was incorporated in determining this amount. Four percent was decided on because: (a) it was a significant amount; (b) achievable to be adjusted by real or accounting means in the time frame outlined in the case study materials; and (c) it was less than 5%, which is an important materiality benchmark for auditors. The responses to the survey would suggest that the percentage chosen was reasonable. 16

18 on the decision their firm would actually make in this situation to either take no special actions or try to improve reported performance. If they selected the latter, they were further asked whether they would rely solely on accounting adjustments (0%) or operational adjustments (100%). In the final part of this section in Question 3 they were asked their perceived likelihood that their firm could increase reported earnings by each of the possible options of: only accounting adjustments; only operational adjustments; or a combination of both. The next part of the task was to evaluate the magnitude and likelihood of costs for each of the stakeholder groups that might be affected by each of the three possible alternatives (Questions 4, 5 & 6). The stakeholder groups comprised: CFO and CEO; company in the short term; company in the long term; company s current shareholders; company s future shareholders; company s debtholders; and other stakeholders (e.g., employees, customers, or general public). 7 To assess the ethics associated with the options available, we asked how ethically questionable the participant assessed each course of action (Qu. 13), which was to get an overall sense of the participant s perceived rightness or wrongness of the action. Second, we asked whether the participant thought that manipulating earnings through accounting or operational adjustments was lying (Other Questions 2 & 3), which is an important value many people bring to their ethical decision making. Extensive time was spent on developing the survey with reference to the prior literature on EM. An important criteria in this development was that the participants had to make a decision so that modeling of the factors that were associated with that decision could occur. The draft survey was circulated to a number of experts for comment before it was finalized. 7 Other questions were asked about corporate governance. However, these responses are not included in this paper. 17

19 The experts who perused the materials and provided us with comments, included: three academics, two regulators, two business professional association members, one technical audit partner, and one retired CFO of a top 100 Australian company. The feedback from the experts was considered by the research team and incorporated where appropriate into the case materials. V. RESULTS Descriptive Statistics Table 1 reports descriptive statistics relating the various questions from our survey about EM. Question 1 asked managers the likelihood that they would manage earnings and the mean response of 54% indicates it is more likely on average that managers would choose to manage earnings. In Question 2 they were asked to actually make a decision and 68% said that they would manage earnings. For those who would manage earnings, the clear preference was to use operational adjustments with an overall average of 74%. Question 3 asked perceptions on the likelihood of success of each of the methods to manage earnings and using a combination of accounting and operational adjustments is most likely to be successful (62%), followed by operational (51%), and then accounting adjustments (38%). INSERT TABLE 1 ABOUT HERE Questions 4, 5 and 6 asked about the costs to various stakeholders of the options available on a scale of 0 = absolutely no costs to 100 = very large costs. Question 4 related to the costs of taking no special action rather than managing earnings. This question by addressing the costs of taking no action provides a measure on the benefits of EM. The three questions where the costs are perceived as most significant (>40) are on the CFO and CEO, company in the short term, and the company s current shareholders. Question 5 asked about 18

20 the costs of accounting adjustment. Costs to the company in the long term are highest with a mean of 41, which is consistent with accrual reversal of these types of adjustments in the longer term. The effect on the CFO and CEO were also high with a mean of 38, which is consistent with the potential consequences of these types of actions if they are detected. Question 6 asked about costs of operational adjustments and generally the perceived costs are lower than those for accounting adjustments. The highest cost is for the company in the long term, with a mean of 34. This is consistent with the proposition that real operational EM sacrifices economic value. Table 2 presents correlations between the some of the variables reported in Table 1. There is a high level of correlation between the various costs associated with doing nothing (Qu 4). There is also a correlation between perceptions of EM actions as unethical (Q13_2) and perceptions of whether they are lying for both accounting adjustments (OQ2, 0.33) and operational adjustments (OQ3, 0.77). Another correlation of note is that if participants thought that operational earnings adjustments were unethical or lying they were less likely to adjust earnings and also much less likely to use it as a method of managing earnings. INSERT TABLE 2 ABOUT HERE Why Do Corporate Managers Manage Earnings? A conceptual model of the EM decision was developed that included all economic and ethical reasons for the decision. OLS regressions were then estimated that included all of the economic and ethical responses of participants as independent variables. We estimated two regressions with: (i) the decision to manage earnings as the dependent variable; and (ii) the decision on the method of managing earnings as dependent variable. The estimated regressions are as follows: 19

21 (a) EM (Q1) = (Economic Consequences, Ethics and Lying) (b) EM (Q2-2) = (Economic Consequences, Ethics and Lying) To evaluate the first and second research questions five regressions were run with the decision to manage earnings as the dependent variable and they are reported in Table 3 below. These regressions are to try and explain the tradeoffs between stakeholders and other considerations by managers in their decisions on whether to manage earnings. INSERT TABLE 3 ABOUT HERE The first regression (a) in Table 3, includes the likelihood of success of the various EM actions (Q3) as well as the benefits and costs of taking the actions on the CEO/CFO (Q4A_1, Q5A_1, Q6A_1). The overall R 2 for this first regression is The likelihood of success through accounting adjustments (Q3_1, p=0.077), operational adjustments (Q3_2, p=0.001), or and a combination of operational and accounting adjustments (Q3_3, p=0.002) are all significantly associated with the decision to manage earnings. If managers perceive there is a cost to themselves to doing nothing they are more likely to manage earnings (Q4A_1, p=0.002). However, they also are more likely to manage earnings if they think there is a low cost to themselves from accounting adjustments (Q5A_1, p=0.10). The second regression (b) incorporates the benefits and costs to shareholders and other stakeholders from the decision to manage earnings and the R 2 increases to The interesting finding from this regression is that once these other factors are included, the significant effect for self interest to CEO/CFOs goes away. The most significant benefit of EM to emerge from the second regression is the avoidance of costs to current shareholders by managing earnings (Q4A_4, p<0.001). This suggests that current shareholders are the mediating factor in manager s consideration of the effect on themselves. The other costs to emerge as significant are if there are perceived low costs to future shareholders (Q5A_5, p=0.102) or debt-holders (Q5A_6, 20

22 p=0.046) from accounting adjustments, then managers will be more likely to undertake EM. Therefore in addressing Research Question 1, the high R 2 does confirm economic factors are important, further this analysis shows the overriding economic factor of importance in deciding on whether to undertake EM is through consideration of the effect on current shareholders from doing nothing when earnings are not going to meet market expectations. The next two regressions address Research Question 2, which evaluates whether ethical factors also affect managers decisions to undertake EM. The third regression (c) in Table 3, shows the first regression (a) plus inclusion of the perceived ethics of the various EM options (Q13). As can be seen the R 2 increased from 0.24 to When ethics are included, the affect of benefits and costs to CEO/CFOs themselves becomes insignificant. If managers think that taking no special action is ethically questionable, they are more likely to manage earnings (Q13_1, p<0.001). If they think that operational adjustments are ethically questionable, they are less likely to manage earnings (Q13_3, p<0.001), which could be driven in part by the fact that the majority who choose to manage earnings do so by operational methods. The fourth (d) regression, shows the first regression (a) with the inclusion of whether managers perceive the EM methods as lying or not (OQ2&3). Again, this provides an increase in explanatory power over the first regression (R 2 increased from 0.24 to 0.33), although it is not as much of an increase as from inclusion of the ethics questions. If managers think that accounting (OQ2, p<0.001) or operational adjustments (OQ3, p=0.015) are lying they are less likely to manage earnings. In this regression, unlike the third one, if the managers perceive a cost to themselves to doing nothing, it is still a significant factor in their decision to manage earnings (Q4A_1, p=0.042), indicating that this consideration has an ethical component but does not relate to lying. The fifth regression (e) includes all questions from the previous four regressions. The overall R 2 increases to This shows that there is incremental explanatory power from all 21

23 of the various components measured by this survey to understand the EM decision. In this overall model, the effect on current shareholders from doing nothing remains an important consideration in deciding whether to undertake EM or not (Q4A_4, p<0.001). If there are low costs to future shareholders and debt-holders from accounting adjustments, managers are more likely to undertake EM. A significant effect comes through only in the complete model for the effect on current shareholders from operational adjustments. That is, if there are low costs perceived to current shareholders from operational adjustments, managers are more likely to manage earnings (Q6A_4, p=0.057). In relation to the ethical factors in the complete regression (e), the perceived ethics of taking no action or operational adjustments continues to be a significant factor relating to the EM decision. However, the ethical perception of accounting adjustments was not significant in the third regression (c) and becomes even more insignificant in the complete regression (e). Whether accounting adjustments are perceived as lying remains very significant (OQ2, p=0.003), however whether operational adjustments are perceived as lying becomes insignificant with inclusion of all questions in the complete regression (OQ3, p=0.302). A regression was also run (not reported) that only examined the effect of ethics on the EM decision. This provided an R 2 of 0.35, however, 0.25 of that explanatory power was correlated with economic factors, indicating that an important part of managers ethical evaluation is the harm to others. However, there was still 0.10 of pure ethics beyond any economic considerations, which helps explain the significant effect from perceptions of lying on the EM decision found in this study. Is EM Lying and Does Perceiving EM as Lying Affect the Decision to Manage Earnings? Research Question 3a addresses whether EM is perceived as lying, which has not been examined in the literature before. In Table 1, the descriptive responses to these questions is 22

24 presented. Other Question (OQ) 2 shows a mean of 60% who think accounting adjustments are lying compared to OQ 3 with a mean of 27% who think that operational adjustments are lying. Question 13 relates to perceived ethics of the available options, as can be seen, taking no action is the most ethical with a mean of 24 (scale of 0 = not (ethically) questionable at all to 100 = Extremely (ethically) questionable), followed by operational adjustments (34), then accounting adjustments (67) as least ethical. From the correlations in Table 2, it is shown that a major reason accounting adjustments are seen as unethical is because they are seen as lying (0.33). In relation to RQ3b, which relates to whether if perceiving EM as lying affects the decision to manage earnings, results presented on Table 3 showed that perceiving accounting adjustments as lying (OQ2) means that managers will be less likely to manage earnings (p=0.003). Research Question 4 is an evaluation of whether for those who think EM is lying, the economic costs and benefits of the EM makes a difference to their decision on whether to manage earnings. Table 4 provides an analysis by splitting the sample into whether they think that accounting EM is lying or not. 8 Table 4, Panel A provides details of the economic benefits of EM (through avoidance of the costs of doing nothing on stakeholders Question Set 4). As can be seen the R 2 is relatively low for those that think accounting EM is lying (R 2 = 0.05), however it increases significantly for those who do not think accounting EM is lying in Panel B (R 2 = 0.16) indicating economic benefits are more important for the group who do not think that accounting EM is lying. For this group the significant individual factor is the effect on current shareholders as a reason for undertaking EM (Q4A_4, p=0.038). The second regression in Table 4, Panel A, incorporates the economic benefits and costs (costs to stakeholders of accounting adjustments - Question Set 5) of accounting adjustments. For those who think accounting EM is lying, the inclusion of consequences increases the R 2 to 8 The focus is only on accounting EM because for the majority of managers they do not perceive operational EM as lying. 23

25 0.10. One of the specific consequences of accounting adjustments relating to the company in the short term is marginally significant (Q5A_2, p = 0.08), which indicates this negative consequence of accounting adjustments is associated with managers choosing to engage in EM. This finding may come about because most managers who choose to engage in EM use operational not accounting adjustments. For the group who think that accounting EM is not lying, the explanatory power hardly changes with the inclusion of consequences in Panel B (R 2 from 0.16 to 0.18), and none of the individual consequences are significant. Overall, our findings show that for those who think EM is lying, that economic factors do not affect their propensity to undertake these EM actions, which is not consistent with Gneezy (2005). However, it does also illustrate there are a significant group of managers whose actions seem to be primarily determined by whether they think accounting EM is lying. This does seem to indicate that the view by management on this issue is an important management trait that has economic consequences, which is explored further in the next research question. INSERT TABLE 4 ABOUT HERE Table 5 controls for ethics to evaluate the decision of the groups who think that accounting is lying compared to those who do not. In Table 5, Panel A, for those who think that accounting is lying, the ethical factors (Q15) have significant explanatory power in the regression (R 2 of 0.40). When economic considerations are introduced into this regression the explanatory power barely changes (R 2 of 0.41), which is consistent with findings in Table 4. If accounting EM is perceived as lying, the ethics of taking no action or operational adjustments makes a difference to the EM decision but nothing else does. Specifically, for this group, if they think that taking no action is unethical, they are more likely to manage 24

26 earnings, and if they think that operational adjustments are unethical they are less likely to manage earnings. INSERT TABLE 5 ABOUT HERE Table 5, Panel B shows the group who do not think that accounting is lying and also controlling for ethics. In this case, ethics alone has a much lower explanatory power for those who think that accounting is lying (R 2 of 0.25). However, inclusion of economics has a much more significant effect on the decisions of this group (R 2 of 0.37). In evaluating specific costs and benefits that are considered in deciding to manage earnings, the benefits are to current shareholders (by avoiding costs of doing nothing) from EM actions (Q4A_4, p=0.001) and the potential costs are to the CEO or CFO (Q5A_1, p=0.076). Therefore in addressing RQ 4, where EM is viewed as lying, the economic costs and benefits to other parties do not matter. However, if it is not viewed as lying economic costs and benefits do affect managers decisions. Choice of Earnings Management Technique Research Question 5 evaluates the relative importance of economics and ethical factors in the choice of EM technique (i.e., for those who have decided to manage earnings). Three regressions are run as shown in Table 6. INSERT TABLE 6 ABOUT HERE The first regression in Table 6 shows economic factors that affect this choice. The main economic determinant on this choice is the likelihood of success of a particular EM technique. If managers do not think that accounting EM can achieve the required increase in earnings then they are more likely to use operational adjustments (Q3_1, p=0.002). Similarly, if managers do not think that operational EM could achieve the required increase in earnings 25