Mitigation: How would you, as CEO/CFO of a publicly traded manufacturing firm, mitigate the potential for serious corporate damage due to ethical and/or legal issues? Explain.
Process: What kind of process would you build into operations, culture, policy, and procedures to make sure your firm will not experience any ethical or legal issues?
Introduction Earnings management involves the manipulation of revenues and/or expenses to obtain a desired financial reporting outcome (e.g., Ball 2006; Healy and Whalen 1999; Schipper 1989). This practice has played a role in the downfall of some major corporations (e.g., Enron and Sunbeam) and led to a push by the accounting profession and standard setters for regulatory changes (Elias 2002; Lawton 2007; SEC 2008). For example, in his 2002 testimony before the UK Parliament Select Committee on Treasury, International Accounting Standards Board (IASB) Chair Sir David Tweedie decried the widespread use of aggressive earnings management (Tweedie 2002). Similarly in 1998, then Chair of the US Securities and Exchange Commission (SEC), Arthur Levitt, warned that earnings management erodes investor confidence and undermines credibility of the financial markets (Levitt 1998), a view that is also reflected more recently by the SEC (SEC 2008). However, despite regulatory efforts to Electronic supplementary material The online version of this article (doi:10.1007/s10551-014-2107-x) contains supplementary material, which is available to authorized users. C. A. Beaudoin Accounting Faculty, School of Business Administration, University of Vermont, Burlington, VT 05405, USA e-mail: [email protected] A. M. Cianci (&) Accounting Faculty, School of Business, Wake Forest University, Winston Salem, NC 27109, USA e-mail: [email protected] G. T. Tsakumis Department of Accounting & MIS, Alfred Lerner College of Business and Economics, University of Delaware, Newark, DE 19716, USA e-mail: [email protected] 123 J Bus Ethics (2015) 128:505–518 DOI 10.1007/s10551-014-2107-x combat aggressive financial reporting (e.g., Sarbanes–Oxley Act of 2002), earnings management persists and is exacerbated by managers’ incentives (e.g., Cohen et al. 2008; McVay 2006). Thus, it is important to understand earnings management and investigate ways to minimize its potentially dysfunctional effects (SEC 2008). To investigate these issues, we conduct an experiment to examine the joint effect of incentive conflict (i.e., the presence or absence of a personal financial incentive that conflicts with a corporate financial incentive) and chief financial officers’ (hereafter ‘‘CFOs’’) assessments of the ethicalness of key earnings management motivations (hereafter ‘‘EM-Ethics,’’ dichotomized as high or low) on earnings management behavior. In our setting, a personal financial incentive is an incentive to increase current period expenses to maximize bonus potential over a two-year period and a corporate financial incentive is an incentive to minimize expenses to achieve corporate targets. We manipulate incentive conflict, because prior research has found that incentives play an important role in earnings management behavior (Bergstresser and Philippon 2006; Burns and Kedia 2006; Ibrahim and Lloyd 2011).1 Our measure of EM-Ethics, developed specifically for this study, is a fourteen-item construct based on executives’ motivations for managing earnings identified in the seminal survey conducted by Graham et al. (2005). We focus on EM-Ethics, a dispositional measure, because, as suggested by Al-Khatib et al. (2004), the individual is the correct unit of analysis when investigating ethics since it is the individual’s ‘‘personal’’ code of ethics that ultimately influences his/her behavior. This notion is especially relevant to the current context given the varying perspectives on earnings management, with some viewing it as an unethical practice resulting in negative consequences (e.g., Johnson et al. 2012; Kaplan 2001; Vinciguerra and O’Reilly-Allen 2004), while others suggesting that it is an inherent result of the financial reporting process that does not eliminate the usefulness of accounting earnings (e.g., Graham et al. 2005; Lin et al. 2012; Parfet 2000). Further, we examine CFOs’ assessment of EM-Ethics in particular because the CFO is the company’s financial reporting gatekeeper, responsible for approving actions that may lead to earnings management (Levitt 2003) and contributing, along with other executives, to creating a ‘tone at the top’ that shapes the ethical culture and climate within the organization (e.g., Sweeney et al. 2010; Arel et al. 2012). Prior research finds that CFOs make accrual decisions consistent with maximizing their personal incentives (e.g., Cohen et al. 2008; Fields et al. 2001). Our results only provide directional (not statistically significant) support for the expectation that in the presence (absence) of a personal financial incentive that conflicts with a corporate financial incentive, CFOs tend to engage in more (less) self-interested earnings management. However, consistent with our hypotheses, we find that CFOs’ EM-Ethics moderates their willingness to manage earnings under either incentive conflict condition. Specifically, we find that (a) in the presence of a personal financial incentive that conflicts with a corporate financial incentive, CFOs with low (high) EM-Ethics tend to give into (resist) the personal incentive by booking higher (lower) expense accruals; and (b) in the absence of a personal financial incentive that conflicts with a corporate financial incentive, CFOs with low (high) EMEthics tend to give into (resist) the corporate incentive by booking lower (higher) expense accruals. Also consistent with our hypotheses, we find support for a mediatedmoderation effect whereby CFOs’ EM-Ethics significantly influences their propensity to morally disengage morality from their actions and give into incentives. That is, the propensity to morally disengage differentially affects the level of CFOs’ expense accruals depending on their incentives. CFOs with high (low) EM-Ethics are less (more) likely to morally disengage and thus give into a personal financial incentive (i.e., book larger expense accruals) or a corporate financial incentive (i.e., book smaller expense accruals).