Isn't it the Time to Terminate the Debate Around Earnings Management?

In recent years, much attention has been devoted to ethical conduct of accountants. Critics have alleged that ethics have deteriorated and that the interests of users of financial statements and financial reports have been subordinated to the desires of prepares of such reports to present a favorable picture of financial status of reporting entity. Perhaps such critics have received their increasing power, by far, from the earnings management literature – as an extension for Book Cooking – which has been the subject of much accounting research over the past three decades. In that literature, there is documented ample evidence that firms intentionally "manage" or "dampen" fluctuations around some predetermine earnings target, and earnings management has been described as distorting the application of generally accepted principles accordingly. Within this vein, on the other hand, the recent scandals at Enron and WorldCom have generated a public perception that earnings management behavior is utilized opportunistically by firm managers for their own self-interest rather than for the interest of the shareholders. Together, these facts rise the par of pressure over the financial and investment communities, mainly the SEC, and pushed them toward tightening accounting standards [for "example" Sarbanes-Oxley Act – 2002, a development of an extensive inspection program by Public Company Accounting Oversight Board (PCAOB), addition requirements made by NYSE and NASDAQ for member firms, and the International Accounting Standards Board (IASB 2003) improvements project which eliminated accounting options in several standards]. Finally, in short words, earnings manipulation's practices have been as "immoral", "cheating" and "unethical in the eye of most practitioners, theorists, and regulators in the accounting field where, such consensus had been inherent in the early studies (1960s) about these financial phenomena and found its official way as a part of standards on the hand of institute of management accountants IMA by issuing the "standards of ethical conduct for practitioners of management accounting and financial management" in 1983 followed by an issuing from financial executive institute FEI called " code of ethics" in 1985, and then by American institute of certified public accountants AICPA which issued the revised "code of professional ethics". Thenceforward, FASB, GASB, and auditing standard board have adhered to these rules and standards in ethics.

Surely, the story of earnings management could not be fully told in few lines especially, when a long line of literature in this vein is considered. However, it is worth to remember that neither additional standards nor putting ethics in form of cods and standards have conduced to one beneficial result concerning reducing these practices, except that practices have become something of a religion for firms' executives. So, in regards to the ethical aspect of this story, is it true that earnings management practices are unethical? If it is, who must charge the responsibility? And, for more than 40 years of extensive works in this area (i.e. earnings manipulations in general), the exploration of a pragmatic solution has not been reached even alluded, and there is no signal it will be so in the foreseeable future, simply why?! Such questions have no typical and specific direct answers among the literature genres and regulators' speeches. Properly, the answers, for the most part, are considered not scientific to be mentioned!!, or perhaps For a "TRUE" problem, there is no solution. Whatever the reason was however, these questions are the ultimate aims of this article which attempts to draw, as possible, scientific answers but bounded by the business and economics sciences framework.

As it was mentioned before, most genres of earnings management literature and financial communities' speeches have convicted these practices as immoral and unethical as well as they distorting the application of GAAP. However, this line of arguments seriously ignore too many facts, mainly these that can be found in the accounting theory--the mother. On the one hand, one of the approaches for accounting theory is the ethical approach which emphasis on concepts of justice, fairness and truth. Each one of these concepts has found its way into the conceptual framework created by FASB in forms such, reliability, relevancy and natural, nonetheless the theory itself had revealed high confusion regarding ethics as in the question of "What is the term Truth mean? And it has confessed that ethics are something of judgment in the mind of practitioners of accounting. This confusion also has transmitted into an ongoing confliction between reliability and relevancy within the qualitative characteristic of accounting information. On the other hand, the economic approach for the accounting theory calls for employing accounting (through the financial reports) in macroeconomic policies, that is, by considering the objective of reporting stable earnings across the years legitimizes the use of reserves and flexible depreciation polices. Isn’t that what being known as income smoothing (a special form of earnings management)? And, wasn’t it originally made in accounting theory? In addition, this is Paul Rosenfield – who was the director of the AICPA accounting standards division for 14 years – in an article titled "What Drives Earnings Management?" explains deeply how U.S. GAAP as currently designed fails pervasively to provide the meaning of transparency in financial reporting.

According to the common belief, the central question for standard setters and regulators is to decide how much judgment to allow management to exercise in financial reporting. Where, it is believed that standard setters are likely to be interested in evidence on how management uses or misuses judgment permitted under accounting standards. Conceivably, after the empirical evidence had been well documented around the GAAP flexibility as a main source of the increasing earnings management practices, and after the total incurred costs of earnings management had been considered huge (as in his 1998 “Numbers Game” speech, former SEC Chairman, Arthur Levitt charged that widely publicized accounting problems, which earnings management is one of them, at a considerable number of firms ware in danger of undermining U.S. capital markets), it was supposed that standard setters will make fundamental amendments in the wide options in standards rather than rise the power of inspection on auditing firms. Furthermore, many of the revised statements of FASB that have been issued in past few years allow additional flexibility and contains more options for managers, herby places substantial burden on auditors to detect such practices. However, auditors may never be able to detect real earnings manipulations in which managers left the options and move toward managing short-run real economic activities.

After all, to date this area has witnessed much of the accounting researches that have the ultimate goal of providing a bas for standard setters so that these "unethical" practices can be reduced efficiently… May it is well known that advertising is defined sometimes as "legal lie", at the same time, ads are rights for any firms. Such line of reasoning can be applied to earnings management by which executives legally attempt to draw a favorable picture for their firms' performance. One last item, pragmatically, Arthur Levitt statement (1998), “While the problem of earnings management is not new, it has swelled in a market that is unforgiving of companies that miss their estimates”, carried more than a sense of sympathy, it is much closed to concede that earnings management is factual behavior.