Accounting is the process of collecting, aggregating, validating, and reporting information about business performance. Until the last century, accountants focused almost exclusively on financial information generated from double-entry bookkeeping.
Since then, their purview has expanded to many other financial and nonfinancial measures. Subfields are typically defined by the audience an accountant reports to: outside investors (financial accounting), employees (managerial accounting), tax authorities (tax accounting), citizens (governmental accounting), or regulatory agencies (regulatory accounting).
The central practical issues in accounting arise from the difficulty of devising systems that report performance measures accurately, understandably, and cheaply. The central ethical issues in accounting arise because many parties involved in the reporting process can distort measures to their own benefit, at the expense of the reporting audience. What can firms or regulators do to minimize such distortions?
IDEAS TO APPLY (Based on research covered below)
Be on the look out for measure management. Is your organization engaging in it? If so, how, why, and what are will the long-term impacts be for your organization and other stakeholders?
Apply best practices. Ensure that your companies accounting systems has:
- An effective system of internal controls to make it hard for a single person to distort any step in the reporting process
- An independent party to audit reports and attest to their validity
- People who represent a diverse set of interests to oversee the entire reporting process.
Carefully weigh consequences of encouraging “underpromising and overdelivering.” As discussed below, “sandbagging” behavior is common in many large organizations, however as a practice it generally prioritizes short-term goals over long-term objectives.
AREAS OF RESEARCH
- How does the very act of measuring performance distort performance?
People engage in measure management when they focus on improving measures of their performance, rather than improving the true performance those measures are intended to represent (Bloomfield, 2013). People can “manage” measures by distorting either the reporting process itself or the operational decisions that generated the raw data to be processed. For example, a principal who wants to improve her school’s performance on standardized tests can change students’ answers, or she can direct teachers to stop teaching topics that aren’t being tested (see, e.g., Freakonomics). Depending on the specific context and behavior, measure management can be illegal, simply unethical, or completely ethical. Interference with the reporting process is typically viewed more negatively than distortion of operations, even though the latter often creates more direct harms. For example, changing test answers is often illegal, even though it does not alter how much students actually learn. “Teaching to the test” is typically considered ethical, even when it robs students of a good education in untested subjects.
- What are the special problems with earnings reports?
A great deal of accounting research focuses on the detection and determinants of earnings management, in which firms manipulate the earnings numbers reported to outside investors. Earnings management need not violate civil or criminal law to be damaging to investors and the economy. Documenting earnings management is difficult, because “true earnings” is a slippery concept, but researchers continue to improve their detection methods using detailed performance data (see Dechow et al., 2012). Recent research has analyzed voice stress and word choice to detect when executives are discussing managed earnings numbers in conference calls (Mayew and Venkatachalam, 2012). Earnings management appears to be influenced by managerial incentives; it is most severe immediately before firms issue new equity (Teoh, Welch, and Wong, 1998), and when Chief Financial Officers are given equity incentives.
- How do managers obfuscate performance when releasing information to the public?
Financial markets respond more completely to information that is more widely known (The “Incomplete Revelation Hypothesis,” Bloomfield (2002), and to information that is more salient and easy to process (Hirshleifer and Teoh, 2003)). Managers frequently make operational and reporting decisions that boost reported earnings. This inflated “good news” is often featured prominently in the financial press, while the corresponding bad news is released in ways that relegate it to little-read footnotes. Furthermore, firms disclose pro forma earnings (non-standard earnings measures) in press releases, and these numbers are almost always higher than standard earnings based on GAAP (Generally Accepted Accounting Principles). Li (2006) shows that managers also strategically obfuscate bad news by writing longer and less readable annual reports when financial performance is poor or temporarily bolstered by transient factors.
- Do managers exploit inside knowledge of the firm for personal gain?
Early studies indicate that insiders sell (or delay purchases) before significant price decreases and buy (or delay sales) before significant price increases (Jaffe 1974, Seyhun 1986). Subsequent studies link insider trading to various information releases, including dividend initiation announcements, repurchases of stock, equity offerings, bankruptcy filings, and 10-Q/10-K filings. Research also connects insider trading with opportunistic disclosure behavior. Penman (1982) provides initial evidence that managers benefit from timing their trades around their forecasts of annual earnings. Cheng and Lo (2006) provide evidence that managers opportunistically delay purchases until after they issue bad news warnings, while Cheng, Luo and Yue (2013) find that managers strategically choose the precision of their forecasts in an effort to increase their trading returns.
- How might managers’ opportunistic behavior harm investors?
Negative news earnings warnings reduce firms’ litigation risk (Field, Lowry and Shu 2005). Yet managers often remain silent when facing impending earnings disappointment (Skinner 1994). Billings and Cedergren (2014) find that insider selling helps to explain this silence. In so doing, they find that strategic silence combined with opportunistic selling by managers increases the litigation consequences borne by the firm and investors. Collectively, these findings highlight the tension between manager-level trading incentives and firm-level disclosure incentives.
- What are the pros and cons of granting managers judgment and discretion in reporting?
Many reporting systems require the reporter to make difficult judgments, or to choose among alternatives. For example, financial reporting standards issued by the Financial Accounting Standards Board and International Accounting Standards Board require managers to estimate the proportion of accounts receivable that won’t be collected, and to estimate whether an unfavorable judgment on a lawsuit is probable or only a remote possibility. Reporting standards also allow managers the discretion to choose between different methods of depreciating buildings and equipment, and whether to report financial assets based their current fair value or their original cost (suitably modified for changing circumstances). Extensive research shows that judgments such as these are frequently distorted by incentives, often unconsciously. Managers use their discretion to improve reported performance. (See our pages on Conflicts of Interest and on Contextual Influences.) However, allowing judgment and discretion can also allow managers to communicate more information than they could under one-size-fits-all reporting rules (Dye and Verrecchia, 2005).
- How can the reliability of reports be increased?
Accountants have devised many practices to make reports more reliable. The most important are: 1) to have an effective system of internal controls that make it hard for a single person to distort any step in the reporting process; 2) to have an independent party audit the reports and attest to their validity; and 3) to have people who represent a diverse set of interests oversee the entire reporting process. These practices typically improve reporting reliability and reduce fraud (Association of Certified Fraud Examiners, 2012), but failures are frequent and often staggeringly costly, as in the case of Enron, WorldCom, and Lehman Brothers.
- How does personal accountability impact audit quality and earnings management?
Laws that require a partner to sign off on audits, with their own name, rather than merely the firm’s name, improve audit quality and reduce earnings management. (Carcello & Li, 2013; and see this related story and summary in the New York Times.)
- The University of Oklahoma awards the Glen McLaughlin Prize for Research in Accounting and Ethics each year, for the “best unpublished paper on ethics in any area of accounting.” A few of the past winners (some of which are now published) include:
2013: Honoring One’s Word: CEO Integrity and Accruals Quality (Dikolli, Mayew, and Steffen).
2012: Hush Money: The Impact of Rank and File Stock Options on Employee Whistle-Blowing (Call, Kedia, & Rajgopal).
2010: Internal audit outsourcing and the risk of misleading or fraudulent financial reporting: Did Sarbanes- Oxley get it wrong? (Prawitt, Sharp, & Wood).
2009: Why do CFOs become involved in material accounting manipulations? (Feng, Ge, Luo, and Shevlin).
2008: Whistle-Blowing: Target firm characteristics and economic consequences (Bowen, Call, and Rajgopal).
2007: Corporate governance ratings and financial restatements: pre and post Sarbanes-Oxley Act (Abdolmohammadi and Read).
2006: The relation between executive compensation and earnings management: changes in post-Sarbanes-Oxley era (Carter, Lynch, and Zechman).
- Sunshine Fashion: Fraud, Theft and Misbehaviour among Employees
- Accounting Fraud at WorldCom
- Fixing a Hole
- When Should Measure Management Be Discouraged?
Consider a firm that rewards managers for achieving budgeted income targets. Most firms discourage managers from underestimating expenses to push income up to the target. But what about a manager who overestimates expenses because performance is strong this quarter, in order to ensure that hitting the target next period? What if a manager boosted earnings by reducing discretionary R&D and marketing expenses? Such operational measure management is often explicitly encouraged, even though it achieves short-term goals by sacrificing long-term success. What about managers who provide pessimistic budget forecasts so they can more easily hit their targets? Such ‘sandbagging’ behavior is widespread in large organizations and often viewed as evidence of wise and effective management (underpromise and overdeliver) rather than punishable misrepresentation.
- Principles or Rules?
Reporting standards can be stated in the form of general principles or detailed rules. For example, assume a division leases a factory building for many years. When should the division capitalize the lease (i.e., report as if it owns the building and has a liability for future payments, rather than simply expensing the lease payment each year)? The reporting authority (whether the FASB or division headquarters) could state a principle like “capitalize if you are using the asset for substantially all of its useful life.” Alternatively, they could state a set of specific rules, such as “capitalize the asset if the lease term is 75% or more its useful life.” Both approaches are problematic, but in different ways; the principle allows the manager to avoid capitalization by making a favorable judgment that is costly to monitor, while the rule allows them to do so by writing a lease contract for 74.99% of useful life, pushing up to but not over the edge of the bright line (Nelson, 2003).
- When Is High-Stakes Reporting Worthwhile?
High-stakes reporting is ubiquitous. In some schools, teachers are fired when their students score poorly on standardized tests. Investors dump stocks that report unexpectedly low earnings. Managers receive large bonuses for hitting financial targets—and are fired for failing to do so. Workers are promoted or fired based on any number of nonfinancial performance reports. While high stakes can motivate high performance, they also motivate measure management, as powerfully stated by Donald T. Campbell, in a phrase that has become known as Campbell’s Law: “The more any quantitative social indicator (or even some qualitative indicator) is used for social decision-making, the more subject it will be to corruption pressures and the more apt it will be to distort and corrupt the social processes it is intended to monitor.” Context and details typically determine whether the motivational benefits of high-stakes reporting outweigh the costs of the inevitable distortions.
- When Do Controls Backfire?
Reporting controls can limit measure management through brute force, but they can also create counterproductive norms about reporting ethics. People often reciprocate trust with honesty; controls that intrude on their privacy or restrict their discretion breach that trust and encourage them to game the system with whatever limited tools they retain (Tayler and Bloomfield, 2011).
- How Does Culture Matter?
Some companies and countries consistently show reliable reporting habits, while others are plagued with distortion. To what extent are these tendencies driven by cultural forces, religion, and ‘tone from the top’? Research has found some preliminary evidence, but no firm conclusions. How do moral attitudes affect accounting practices such as earnings management, nondisclosure, or misleading disclosure? How do moral attitudes affect regulation and standard setting? Does a moral norm for prudence attract firms and regulators to conservative accounting practices? Does the desire to find scapegoats after financial and economic crises shape reporting regulation?
Miscellaneous Links & References
- Andrew Ceresney, Financial Reporting and Accounting Fraud, U.S. Securities and Exchange Commission, September 19, 2013. Speech at American Law Institute regarding the SEC’s renewed focus on accounting fraud and the inception of the Financial Reporting and Audit Task Force.
- Gonzalez, Schmid, & Yermack (2013), Smokescreen: How managers behave when they have something to hide.
- The 10 Worst Corporate Scandals of All Time.
- Hirshleifer, D. and Teoh, S.H. (2016). How Psychological Bias Shapes Accounting and Financial Regulation, Behavioural Public Policy Journal.
- Are ethical versus unethical financial reporting practices contagious? Kedia, K., and Rajgopal, S. (2008), Geography and the incidence of financial misreporting: University of Washington.
- Shane S. Dikolli and William J. Mayew and Thomas D. Steffen, Honoring One’s Word: CEO Integrity and Accruals Quality, Working Paper, Duke University, 2012.
- Peng-Chia Chiu and Siew Hong Teoh and Feng Tian (2013), Board Interlocks and Earnings Management Contagion, Accounting Review.
- Billings, M. and M. Cedergren (2014). Strategic silence, insider selling and litigation risk. Working paper.
- Cheng, Q. and K. Lo (2006). Insider trading and voluntary disclosures. Journal of Accounting Research 44: 815-848.
- Cheng, Q., T. Luo, and H. Yue (2013). Managerial incentives and management forecast precision. The Accounting Review 88: 1575-1602.
- Field, L., M. Lowry, and S. Shu (2005). Does disclosure deter or trigger litigation? Journal of Accounting and Economics 39: 487−507.
- Huddart, S., B. Ke, and C. Shi (2007). Jeopardy, non-public information, and insider trading around SEC 10-K and 10-Q filings. Journal of Accounting Research 43: 3-36.
- Jaffe, J. (1974). Special information and insider trading. Journal of Business 47: 410-428.
- John, K. and L. Lang (1991). Strategic insider trading around dividend announcements: theory and evidence. Journal of Finance 46: 1361-1398.
- Karpoff, J. and D. Lee (1991). Insider trading before new issue announcements. Financial Managerment 20: 18-26.
- Lee, D., W. Mikkelson, and M. Partch (1992). Managers’ trading around stock repurchases. Journal of Finance 47: 1947-1961.
- Penman, S. (1982). Insider trading and the dissemination of firms’ forecast information. The Journal of Business 55: 479-503.
- Seyhun, H.N. (1986). Insiders’ profits, costs of trading, and market efficiency. Journal of Financial Economics 16: 189-212.
- Seyhun, N. and M. Bradley (1997). Corporate bankruptcy and insider trading. Journal of Business 70: 189-216.
- Skinner, D. (1994). Why firms voluntarily disclose bad news. Journal of Accounting Research 32: 38−60.