The Ethics of Earnings Management: The Case of Income Smoothing
James Gaa University of Alberta May 2007

Information Asymmetry
In Most Situations, People Do Not Have the Same Information Management Inevitably Has Information that Would be Useful to Investors – and other Stakeholders In Financial Reporting: Information Asymmetry Follows Immediately from the Separation of Ownership and Management

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Corporate Transparency (OECD)
“The Corporate Governance Framework Should Ensure that Timely and Accurate Disclosure is made on All Material Matters regarding the Corporation, Including the Financial Situation, Performance, Ownership, and Governance of the Company.”
OECD, ”Corporate Governance Principles: 2004”
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Corporate Secrecy (OECD)
“Disclosure Requirements are Not Expected to Place Unreasonable Administrative or Cost Burdens on Enterprises. Nor are Companies Expected to Disclose Information that May Endanger their Competitive Position Unless Disclosure is Necessary to Fully Inform the Investment Decision and to Avoid Misleading the Investor”
OECD, ”Corporate Governance Principles: 2004”
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Corporate Secrecy
Corporations Have Secrets Some are Legitimate Corporations Should be Able to Keep them secret Trade Secrets Other Proprietary Information Some are Not Legitimate Corporations Should Not be Able to keep them secret Secrets about Harmful Products or Substances in the Workplace
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Secrets
“To keep a Secret from Someone … is to Block Information about it or Evidence of it from Reaching that Person, and to do so Intentionally: to Prevent Him from Learning it, and thus from Possessing it, Making Use of it, or Revealing it. The word ‘Secrecy’ Refers to the Resulting Concealment.”
(Bok, Secrecy 1983, pg. 5)
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Secrecy and Information Asymmetry
There are Two Cases: Decreasing Information Asymmetry Truthful Disclosures Reduce Asymmetry Maintaining or Increasing Information Asymmetry Secrecy Maintains Asymmetry In the Setting of Publicly Accountable Entities, Transparency – Disclosure of All Material Information – is the Standard Case In this Setting, Secrecy Needs to be Justified
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The Basic Ethical Problem
Every Company Needs to Make Disclosures Keep Secrets So, Every Company Needs a Strategy for Disclosing Information about Itself Often: to Maximize Secrecy / Minimize Disclosure May Include Earnings Management Is Earnings Management a Legitimate Part of a Company’s Disclosure Strategy?
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The Problem of Earnings Management
Earnings Management The Alteration of Financial Reports In Order to Affect the Behaviour of Others For Me: the Biggest Issue in Financial Accounting and Reporting Why: It Strikes at the Core of the Traditional Ideal of Accounting: The Preparation of Neutral – Unbiased – Information
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Empirical Evidence
Earnings Management is Common Strategies are Often Complex and Multi­period It is Done for a Variety of Motivations: Often for the Benefit of Management, Not (Solely) to Benefit Stakeholders Managers are Willing to Incur Real Economic Costs in Order to Alter Financial Reports
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Earnings Management
The Alteration of Financial Information to Produce a Predetermined Result by Intervening or Interfering in the Neutral Operation of the External Financial Reporting Process Involving the Use of Judgment in Financial Reporting, or in Creating or Structuring Transactions in Ways that have No Business Purpose Other than to Alter Financial Reports to Alter the Distribution of Information, for the Purpose of either Affecting Some Stakeholders’ Evaluation of the Underlying Economic Performance of the Company or Influencing Contractual Outcomes that Depend on Reported Accounting Numbers.
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Earnings Management: What
The Alteration of Financial Information to Produce a Predetermined Result by Intervening or Interfering in the Neutral Operation of the External Financial Reporting Process

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Neutrality – FASB
100. … It is, above all, the Predetermination of a Desired Result, and the Consequential Selection of Information to Induce that Result, that is the Negation of Neutrality in Accounting. To be Neutral, Accounting Information Must Report Economic Activity as Faithfully as Possible, Without Coloring the Image it Communicates for the Purpose of Influencing Behavior in Some Particular Direction.
(FASB, SFAC No. 2, 1980)
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Neutrality – IASB
36 To Be Reliable, the Information Contained in Financial Statements Must be Neutral, that is, Free from Bias. Financial Statements are Not Neutral If, by the Selection or Presentation of Information, they Influence the Making of a Decision or Judgement in order to Achieve a Predetermined Result or Outcome.

IASB, Framework of IAS Financial Statements, 1989
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Earnings Management: How
… Involving the Use of Judgment in Financial Reporting, or in Creating or Structuring Transactions in Ways that have No Business Purpose Other Than to Alter Financial Reports …

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Use of Judgment in Financial Reporting Accrual­Based Earnings Management Choice of Accounting Principles Discretionary Accruals in Creating or Structuring Transactions in Ways that have No Business Purpose … Real Earnings Management Transactions are Altered or Created for this Purpose in order to Alter Financial Reports
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Earnings Management: Why
… to Alter the Distribution of Information, for the Purpose of Either Affecting Some Stakeholders’ Evaluation of the Underlying Economic Performance of the Company ­­ Adverse Selection or Influencing Contractual Outcomes that Depend on Reported Accounting Numbers. ­­ Moral Hazard
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Earnings Management: Transparency and Secrecy
The Intentional Alteration of Financial Reports in order to Affect People’s Behaviour Can Be Done in the Interest of Transparency – Reducing Information Asymmetry Secrecy – Maintaining or Increasing Information Asymmetry

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Information Asymmetry, Contract Timing and Motivation
Adverse Selection (pre­contract) Decrease Information Asymmetry
(Transparency) To Provide Useful Information to Stakeholders

Moral Hazard (post­contract)

Increase Information Asymmetry
(Secrecy)

To Issue Financing To Engage in Insider Trading To Influence Legal/Political Issues

To Maximize Executive Compensation To Avoid Debt Covenant Violations To Influence Legal/Political Issues
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Motivation to Decrease Information Asymmetry
Stakeholders are Interested in Transparency They Want Information in Order to Evaluate the Underlying Economic Performance of the Company Stakeholders Want to Evaluate Its Ability to Earn Income Over the Long Run Over the Short Run Plus: Variability over Time
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The Focus of this Paper
The Alteration: Income Smoothing The Motivation: to Affect Stakeholders’ Evaluations By Reducing Information Asymmetry about Long­term profitability Assume: Earnings Managers Have no Other Motivation Is Earnings Management with this Intention Ethically Justifiable?
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Why This Specific Case?
It’s been Practiced for a Long Time Many People Accept Income Smoothing as a Justifiable Activity Common Claim: Smoothed Income Presents Management’s Best Estimate (within the Financial Reporting System) of the Company’s Long­Term Profitability
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Why This Specific Case?
This is the Most Favourable Case for Justifying Earnings Management Why: Management Intends to Benefit Recipients of Financial Reports, by Improving their Ability to Make Informed and Rational Judgments relating to Economic Performance Management May Benefit, But Benefiting is Incidental, Not Part of Motivation
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Why This Specific Case?
Conversely: If Earnings Management is Not Justifiable in this Most Favourable Case The Justifiability of Other Types of Earnings Management in which the Purpose of Earnings Management is to Maintain or Increase Information Asymmetry Is Doubtful But Beyond the Scope of this Paper

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Summary of Analysis
1. Is Income Smoothing Lying?
My answer: Not Necessarily

2. Is Income Smoothing Deception in Some Other Form?
My answer: Not Necessarily

3. If Income Smoothing is Not Deceptive,
There is No Ethical Problem

If It is Deceptive in Some Way, is it Ethically Justifiable?
My answer: No
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Deception and Lying
Deception: “When We Undertake to Deceive Others, We Communicate Messages Meant to Mislead Them, Meant to Make Them Believe What We Ourselves Do Not Believe.” Lying: “A Lie is simply a Message in the Form of a Statement which is Intended to Deceive Others.”
(Bok, 1999, pg. 13)

So, Lying is a Particular Form of Deception
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Deception and Secrecy
Information can be Concealed by: Lying: Assertions Intended to Mislead Silence: Not Disclosing Information / Preserving Secrecy Silence Can be Deceptive

Note: NZICA Code of Ethics Recognizes Both Forms of Deception – Discussed Later
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1. Is Income Smoothing Lying?
The Altered Income Statement is an Assertion It is Not Neutral But: It is Not Lying Why: If Conducted Purely with the Intention of Reducing Information Asymmetry regarding Long­term Profitability the Motivation is to Inform, Not to Mislead, with respect to the Company’s Long­run Profitability
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Is Income Smoothing Lying?
Smoothed Income Could be a Lie If the Motivation is Mixed, and Includes Increasing Information Asymmetry about Long­run Profitability, or Some Other Aspect of Economic Performance So, Income Smoothing is Not Necessarily Lying Whether it is Depends on Management’s Intentions
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Current Income Smoothing Practice
Income Smoothing is Done in Secrecy: Management is Silent or Lies about its Earnings Management Strategy the Methods Used the Magnitude of Departures from Neutrality

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2. Is Income Smoothing Deceptive? Current Practice
Assuming that Management is Attempting to Reduce Information Asymmetry the Ethical Problem is not Lying about Income Lying is Not Taking Place The Ethical Problem is Secrecy about the Process Via Lying or Silence Is Secret Income Smoothing Deceptive?
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The Current Practice is Deceptive
Management is Intentionally Keeping Secret Neutral Information about Current Income Variability of Income over Time So, Stakeholders Lack the Information Needed to Undo the Alteration and Obtain the Original Neutral Information They are Prevented from Acting as They Would Have, If They Had Had the Unaltered Income Statement
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3. Is Income Smoothing Justified?
Three Simple Ethical Principles The Perspective of the Deceived The Principle of Veracity The Principle of Publicity

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The Perspective of the Deceived
“Those who Learn that They have been Lied to in an Important Matter … See that They were Manipulated, that the Deceit Made Them Unable to Make Choices for Themselves according to the Most Adequate Information Available, Unable to Act as They Would Have Wanted to Act had They Known All Along.”
(Bok, 1999, pg. 20)
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The Principle of Veracity
There is an Initial Imbalance in the Evaluation of Truth­ telling and Lying. Lying Requires a Reason, while Truth­telling Does Not. It Must Be Excused; Reasons Must be Produced. …”
(Bok, 1999, pg. 22)

It Places the Burden of Proof Squarely on Those who Assume the Liar’s Perspective.”
(Bok, 1999, pg. 30)
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The Principle of Veracity
“…Truthful Statements are Preferable to Lies in the Absence of Special Considerations. … So, “…in Any Situation where a Lie is a Possible Choice, One Must First Seek Truthful Alternatives.”

(Bok, 1999, pg. 30, 31)
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The Principle of Veracity
Discussions of Earnings Management Often Suggest that it is Either Always Justifiable or Never Justifiable In General, Deception is Sometimes Justified Potential Areas of Justifiable Lies White Lies Lies to Protect Self or Others Lies to Protect National Security So, Is Income Smoothing Justified?
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The Principle of Publicity
An Ethical Principle Must be Publicly Justifiable to Reasonable Persons So, Justification of Income Smoothing is Based on Consent of Reasonable Persons Not Based on Abstract Theory But Also Not Based on Doing a Survey Is Does Not Imply Ought
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Justifying Income Smoothing
Can Income Smoothing for the Purpose of Reducing Information Asymmetry with respect to Long­term Profitability be Justified Publicly to Reasonable Persons? Who are these Reasonable People? Knowledgeable and Sophisticated Take the Perspective of the Deceived Otherwise, Disinterested
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Reasonable People Analysts, Investors, Legislators/Regulators?
As the Receivers of Information, they Naturally Take the Perspective of the Deceived Would these External Stakeholders Consent to Income Smoothing to Reduce Information Asymmetry?

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CFA Institute
Smoothing and Normalization are a Function of Analysis, Not of Financial Reporting Management Should Not Manage Earnings Not Even to Reduce Information Asymmetry Smoothing Hides the Variability of Income over Time CFAs Want Disclosure / Transparency
AIMR (CFA Institute), Financial Accounting and Policy Committee, 1998
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Financial Reporting Act 1993
11. Content of Financial Statements of Reporting Entities (1) The Financial Statements of a Reporting Entity Must Comply with Generally Accepted Accounting Practice. (2) If, in Complying with Generally Accepted Accounting Practice, the Financial Statements do Not Give a True and Fair View of the Matters to which They Relate, the Directors of the Reporting Entity Must Add such Information and Explanations as Will Give a True and Fair View of Those Matters.

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Securities and Exchange Commission
Legislative Mandate: To Promote Fair and Efficient Markets To Protect Investors The SEC is Mandated to Adopt the Perspective of the Deceived Policy and Enforcement Actions are Clearly Against Earnings Management – of all Kinds, for any Reason
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Reasonable People: Accountants and Management?
As Preparers, they are Knowledgeable and Sophisticated But They Naturally take the Perspective of the Deceiver Accountants Tend to Talk to Each Other People are Prone to Self­deception about their Own Actions e.g., Misestimating the Harms and Benefits to Others People are Prone to Paternalism Knowing What is Good for Others
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International Federation of Accountants
“Managing the Business and its Operations to Achieve a Desired Outcome or Hit a Target is Entirely Appropriate, (the Emphasis here is Placed on Managing the Business); Managing Earnings as We All Agree, is Not an Acceptable Practice to Hit Earnings Targets.”

(IFAC, Financial and Management Accounting Committee, 2003)
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NZICA Code of Ethics, 2006
Rule 2: False or Misleading Statements 21 A Member Must Not Make, Prepare or Certify, or Permit or Direct Another Person to Make, Prepare or Certify, Any Statement which the Member Knows, Believes or Ought to Know, to be False, Incorrect or Misleading, or Open to Misconstruction, by Reason of the Misstatement, Omission or Suppression of a Material Fact or Otherwise.
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NZICA Code of Ethics, 2006
53 Any Report for which Members in Employment are Responsible … Must be Prepared with Integrity and Objectivity. This Means, for example, that while a Report Prepared by a Member in Employment May Properly Present One Side of a Case and May Present that Case to its Best Advantage, the Report Should be Accurate, Truthful and, Within its Scope, both Complete and Balanced. It Should Not Rely on Ambiguities or Half truths but Should Be Objectively Justifiable and Should Be Based on Reasonable Assumptions.
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IFAC Assurance Standards
“8. Fraudulent Financial Reporting Involves Intentional Misstatements Including Omissions of Amounts or Disclosures in Financial Statements to Deceive Financial Statement Users. … 10. Fraudulent Financial Reporting Can Be Caused by the Efforts of Management to Manage Earnings in order to Deceive Financial Statement Users by Influencing Their Perceptions as to the Entity’s Performance and Profitability. …”
ISA 240: Auditor’s Responsibility To Consider Fraud …
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NZICA Assurance Standards AS­206: Responsibility to Consider Fraud
There are Only Two Kinds of Misstatement: “8. Misstatements in the Financial Reports Can Arise from Fraud or Error. The Distinguishing Factor between Fraud and Error is Whether the Underlying Action that Results in the Misstatement of the Financial Reports is Intentional or Unintentional.”

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Error and Fraud AS­206
“9. The Term “Error” Refers to an Unintentional Misstatement in Financial Reports, Including the Omission of an Amount or a Disclosure … 10. The Term “Fraud” Refers to an Intentional Act by One or More Individuals … Involving the Use of Deception to Obtain an Unjust or Illegal Advantage. …”

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Fraud, Deception and Earnings Management: AS­206
“12. Fraudulent Financial Reporting Involves Intentional Misstatements, Including Omissions of Amounts or Disclosures in Financial Reports, to Deceive Financial Report Users. … 14. Fraudulent Financial Reporting Can Be Caused by the Efforts of Management to Manage Earnings In Order To Deceive Financial Report Users by Influencing Their Perceptions as to the Entity’s Performance and Profitability. …”
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Secret Income Smoothing is Not Justifiable
These Major Groups are “Reasonable Persons” Some Would be Expected to Take the Perspective of the Deceived They are all Opposed to Earnings Management Why: Income Smoothing is a Form of Earnings Management Earnings Management is Deceptive. Therefore, Income Smoothing is Deceptive Deception is Not Justifiable Therefore, Income Smoothing is not Justifiable.
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Is Transparent Income Smoothing Justifiable?
Income Smoothing is Deceptive IF it is Done Secretly There is a Truthful Alternative to Secret Income Smoothing: Income Smoothing with Full Disclosure: that Income Smoothing is Occurring of the Methods Used of the Magnitudes of the Deviation from Neutrality The Truthful Alternative Allows the “Deceived” to Undo the Alterations and Obtain the Neutral (Unbiased) Information
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So, Income Smoothing May be Justifiable if:
Management’s Intention is to Reduce Information Asymmetry about Long­term Profitability So, Financial Reports are Altered, But are Not Lies and The Process of Smoothing Income is Disclosed Why: This is a Truthful Alternative to Deceptive Secrecy Disclose All Material Information about the Management of Earnings
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Is Transparent Income Smoothing Justified?
CFAs Might Agree – They Would Have both the Smoothed Numbers and the Ability to Undo the Alterations NZICA Might Agree – Transparent Income Smoothing Might Not be a Misstatement Securities Regulators – They Might Insist that All Financial Reports be Neutral Be Unwilling to Rely on Management’s Stated Intention to Reduce Information Asymmetry
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Summary
Income Smoothing is Ethically Justifiable If the Altered Financial Reports are Non­deceptive as Intended (e.g., to Help Evaluate Long­term Profitability), the Intention for Smoothing Income is to Decrease Information Asymmetry, and the Details of the Process are Disclosed So that the Income Smoothing Can be Undone
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Why Non­Deceptive Income Smoothing is Justifiable
The Complete Reports are Transparent: The Total information Set is Neutral Because the Alterations Can Be Reversed Can Be Used to Evaluate Profitability Long Term Short Term Variability

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Why Smooth Income Secretly?
Since Transparent Income Smoothing is a Truthful Alternative to Secret Income Smoothing Secrecy involves Intentional Concealment of the Income Smoothing Process It Appears that Secrecy about the Details of the Process is Essential to Success in Achieving Management’s Motivation

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Why Smooth Income Secretly?
Success Must Involve Other Motivations in addition to or Different from Reducing Information Asymmetry Secrecy May be a Sign that Reducing Information Asymmetry is Not Management’s Only Motivation or Not Management’s Motivation at all

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Burden of Proof
Deception is Not Ethically Neutral It Needs to be Justified Secret Income Smoothing is Deceptive Secret Income Smoothing is Not Justified by my Analysis Advocates of Secret Income Smoothing Need to Provide a Justification

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Information Asymmetry, Contract Timing and Motivation
Adverse Selection (pre­contract) Decrease Information Asymmetry
(Transparency) To Provide Useful Information to Stakeholders

Moral Hazard (post­contract)

Increase Information Asymmetry
(Secrecy)

To Issue Financing To Engage in Insider Trading To Influence Legal/Political Issues
The Ethics of Earnings Management

To Maximize Executive Compensation To Avoid Debt Covenant Violations To Influence Legal/Political Issues
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Further Research: Other Types of Earnings Management
Earnings Management for the Purpose of Maintaining or Increasing Information Asymmetry I.e., Maintaining or Increasing Secrecy Not Increasing Transparency Is This Justifiable? Why Would External Stakeholders Agree to Increased Disadvantage?
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Future Research: Privacy
Theory of Privacy in the Corporate Domain Privacy is About the Control over Information Personal Privacy Corporate Privacy Need: A Theory of Rights and Duties re. Disclosure and Secrecy

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Future Research: Information Strategies
Transparency vs. Secrecy Earnings Management Expectations Management Disclosure Management

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Earnings Management vs. Disclosure Management
Disclosure Management is Explicitly about A Company’s Policy and Practices relating to transparency and secrecy What sorts of information are legitimately secret? Recall the OECD Statement and the NZX Listing Rule

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Future Research: Secrecy
Focus on Secrecy (as opposed to Disclosure) They’re Closely Linked, But Rather than Focus on Mandated and Voluntary Disclosure Assume that Company’s Disclosure Strategy is to Maximize Secrecy Can we Gain Understanding by Starting from Secrecy?
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Future Research: Neutrality
Neutrality and Bias Their Relationship to Truth and Truthfulness Earnings Quality Reliability and Relevance esp. Representational Faithfulness True and Fair View

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Future Research: Neutrality
Giving up Neutrality as an Ideal Implications: The Effects on the Integrity of an important social institution Trustworthiness in Financial Information Trustworthiness of Financial Markets The Role of Auditors The Reaction of Regulators Anything Goes, Unless Altered Reports are Fraudulent?
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Future Research: Conflicting Interests of Stakeholders
This Analysis Needs Only One External Stakeholder Group: the Deceived In Fact, Stakeholder Groups Have Conflicting Interests E.g.: Investors vs. Creditors How to Balance or Rank these Interests Major Problem Area: the Justifiability of earnings management to prevent violations of debt covenants
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Future Research: Stakeholder Views
Recall: The Basis for Justification is the Public Justification to Reasonable Persons, from the Perspective of the Deceived So, the justifiability of earnings management is in Some Sense an empirical question What Do External Stakeholder Groups Really Think About Earnings Management? But!
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Justifiability is not Just an Empirical Question
The “Empirical” Determination of the Justifiability of Earnings Management is Not Value­Free We Need to Carefully Consider About Reasonable Persons They Take the Perspective of the Deceived Are Sufficiently Knowledgeable, Sophisticated Are not Subject to Bias or Self­Deception Recognize that the Burden of Proof is on Managers of Earnings to Justify their Practice
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Future Research: Types of Earnings Management
Are There Morally Relevant Differences Among Methods Accrual­based vs. Real Intentions Adverse Selection vs. Moral Hazard Level of Judgment Individual Acts vs. General Practices
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Individual Actions vs. General Practices
Professional Associations and Regulators: Earnings Management is Not Justifiable as a General Practice And Yet, Individual Accountants and Managers do it on a Regular Basis An Example of a Common Phenomenon: We Know Collectively that a Practice Should Not Exist – No One Should Do it But Many Individuals Decide to Do it Anyway
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Acts vs. Practices
This is a Very Old Problem in the Field of Ethics: Should We Require People to Do What They “Ought” to Do Even If No One Else Will Do it? The Person Not Doing it May Be Harmed “My Company Should Not Engage in Earnings Management Because it Harms the Integrity of the Securities Market” “But My Company Has a Strong Reason to Do it Anyway – To Prevent Harm to It”
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