An Annotated Bibliography by Todd Benschneider

Johnson, Eric. Fleischman, Gary et al. Managers’ Ethical Evaluation of Earnings Management                         

              And Its Consequences. Contemporary Accounting Research. Fall 2012, Vol. 29 Issue 3,                                         p 910-927. 18p. Database: Business Source Premier.

A 2012 study performed by the Universities of Wyoming and North Dakota questioned 264 experienced managers with a hypothetical ethics scenario. The researchers wanted to discover whether “The ends of positive consequences justify the means of earnings management?” in current managers. To test the idea, managers were given a hypothetical scenario of measuring the scale of severity that upper managers would reprimand lower level managers who were found to be managing earnings reports to increase  salary bonuses. Fleischman wrote “Our findings suggest that the current generation of managers have a tendency to behave as if the end justifies the means, which raises the issue of rationalization of unethical conduct.”

Earnings management is defined by the Journal of Accountancy as “the discretionary distortion of revenue, expense and depreciation schedules to optimize short term goals such as executive performance bonuses, budget objectives or the manipulation of stock prices.”   Earnings management typically involves optimizing of income and expense schedules to achieve short term benefits resulting in salary bonuses and positive evaluations, often resulting in negative consequences for the firm. Biasing earnings reports to achieve short range goals can disrupt market feedback, product development, production, and customer relations in the supply chain.

The study was broken into four separate hypothetical scenarios which found that the managers surveyed agreed that the practice was unethical; however, the positive or negative impact on the firm’s profits was factored into how severely they would reprimand the subordinate manager. The study found that managers overall viewed unethical management practices less negatively if the behavior resulted in a positive short term benefit to the firm. The study suggests that the foundation is detected for the ethical dilemma of “incrementalism” where an acceptance of minor unethical practices gradually lead to large scale corruption and loss of investor confidence.

The researchers surveyed 264 participants who were currently employed in business management positions while enrolled in working adult MBA programs at a variety of universities. The hypothetical situation each manager assessed involved one of the four following basic situations which resulted in either positive or negative repercussions for the firm.

The initial hypothetical situation below presents the subordinate as the originator of the unethical behavior:

“Terry Patton, an automobile dealer manager that you supervise, is anxious to maximize his incentive compensation that is based on budgeted net income for the dealership. Terry receives a higher bonus if he achieves 120 percent of this target, and a lower bonus if he achieves only 80 percent of this target. The sliding scale between these two performance extremes is not linear and encourages achievement of net income in excess of the budget (100 percent). Terry calculates that if he accelerates or delays revenues and expenses to increase the variability of his dealership’s net income over time he will, on average, receive higher bonus income than if he does not manage revenues and expenses.”

The study then presents one of the following two consequences to Terry’s strategy:

1. Positive Outcome – “Terry tells his friends at dealerships for another company about his compensation strategy and is able to convince these very able managers to join Terry’s company because the compensation is so much more attractive. This causes Terry’s company as a whole to become better managed and 18% more profitable this year.”
2. Negative Outcome – “Terry tells his friends at other dealerships within the same company of his plan and they also engage in the managing of revenues and expenses, which cause the company as a whole to experience an 18 percent decline in profitability for the year, which is discovered could be solely attributed to Terry’s strategy.”

The alternated basic scenario involves the subordinate Terry being the whistleblower of the bonus manipulation plan described above of other dealer managers: “Terry Patton, an automobile dealer manager that you supervise, has overheard other dealer managers at other locations within Terry’s company discuss their incentive compensation maximizing strategy.” Following this basic story line the participant is presented then offers one of the two following outcomes:

1. Terry brought up the practice at a dealer managers meeting and discouraged this manipulation. He obtained support from some managers but criticism from others. Over the next twelve months the company as a whole was 18 percent more profitable because those managers that stopped manipulating their dealer net income based on Terry’s recommendation.
2. Terry brought up this practice at a dealer managers’ meeting and discouraged this manipulation. He obtained support from some managers but criticism from others. Some talented managers were so upset by Terry’s comments that they left the company, which suppressed overall company profitability by 18 percent this year.

The study found that either case, being the supervisor of the conspirator or of the whistleblower that the managers surveyed would have reprimanded the hypothetical subordinate “Terry” more harshly in situations which resulted in losses to the annual profits than in identical dilemmas resulting in improved annual profits. These findings support their hypothesis that in terms of ethics, the management participants surveyed would lean toward “the end justifies the means” attitude to management in ethical dilemmas.

Researcher Eric Johnson concluded: “Our findings suggested that, overall, the ethical nature of an act had the greatest influence on manager judgment of the act and the intention to intervene, however positive organizational consequences significantly reduced the reprimand. This finding answers the question: the end did justify the means. In addition to advancing literature on the ethics of earnings management, these results also provides empirical support for understanding how managers actually respond to such ethical dilemmas, rather than stating what they should do.”