Earnings Management and Discretionary Accruals

Chief Financial Officers (CFOs) decisions have great impact to financial reporting and dividends declared. There is a major concern from companies’ stakeholders on limiting aggressive financial reporting and earnings management. CFOs are influenced by incentives and perception of ethicalness that lead to financial misreporting thereby risking a company’s financial performance in the future as a result of decisions made based on the financial reports (Beaudoin, Cianci, and Tsakumis, 2015). The CFOs make decisions on accruals and presence or absence of an incentive influences their decision when preparing financial reports. The CFOs therefore need to uphold high Management Ethics when reporting financial information of a company. The following report discusses the impact of CTO’s incentive earnings, management ethics on their financial reporting, the mediating role of moral disengagement and the relationship between equity incentive and misreporting. The report also outlines the role of risk-taking incentive in financial reporting.  

Earnings are the most single important item in financial reporting. They indicate a company’s ability to convert capital employed to profits or engage in value-added activities. The predetermined earnings of a company are used determine present value of a company stock. This means that increasing earnings presentation is increased company value and vice versa. Earnings management is a technique used in accounting to prepare financial reports that present positive view on financial position of a company (Sun, Kent, and Wang, 2017). The CFO are tasked by many accounting principles and rules to make decisions in order to achieve correct reporting of a company’s financial performance and position. Earnings management techniques take advantage of accounting rules and their application to manipulate expenses and revenues to achieve a desired or favourable financial reporting outcome.

The CFO’s decision can either be discrete or non-discrete. A set financial target for a company and reward for achieving the targets influence CFO’s application and interpretation of accounting principles and concepts (Beaudoin, Cianci, and Tsakumis, 2015). The CFO’s then manipulates financial statements to reflect a desired figure that earns them bonus (incentives). Presence of CFO’s incentives motivates them to apply earnings management techniques that impact representation in financial reports. One way that CFO’s manipulate expenses or revenues is by making income decreasing or income- increasing discretionary accruals. The CFO’s discretionary accruals to income-decreasing tend to high when they got incentives to defer earnings and tend to be income-increasing when there are incentives aimed to accelerate earnings (Caglio, Dossi, and Van der Stede, 2018). For instance, a CFO can underestimate cost of a company’s operations to maximize its earning in the current financial period or overestimates costs of a company operations when its exceed financial targets or is profitable. These decisions and actions by CFOs are undertaken in situations when they want to avoid failing to achieve earnings targets or improving stock prices hence falling short of their bonuses (incentives).  

Management Ethics and Earnings Management

Management ethics influence CFOs’ perception and attitude when undertaking their professional practice in financial reporting. The CFOs’ earnings management behaviour is therefore determined by their willingness to adhere to management ethics when preparing financial reports. The management ethics and earnings management in presence of CFO’s incentives lead to conflicting interests when reporting a company’s financial performance. According to Beaudoin, Cianci, and Tsakumis, (2015), earning management practices by CFOs’ are unethical and result to negative consequences as they obscures a firm’s true value and erodes shareholders and companies trust. On contrary, Cotlet et al (2012) stated that earning management by CFOs’ is necessary and logical as it allows them to make choices among many permissible options under accounting set standards. This suggests that earning management ethicalness is dependent on perceptions that underlie its purposes. Managing earnings for CFOs’ self interests can be said to be less ethical as compared to managing earnings for benefits of the firm. The presence of CFOs’ incentives can lead to earnings manipulation to achieve bonus. Feng, Ge, Luo, and Shevlin, (2011) found that financial managers  are likely to use accounting discretion for earnings managements for them to maximize cash bonuses and equity compensations.

Therefore, CFO’s incentive and management ethics influence financial reporting decisions. The CFOs’ incentives have an influence to manipulating company’s earnings to achieve company’s financial targets to earn self bonus. The perception to management ethics on managing earnings governs a CFO’s purposes to apply earning management techniques. Therefore, it can be said that the perception of ethicalness and presence of CFOs’ incentives have influence on financial reporting decisions.

Moral disengagements refers to a process of an individual convincing self that certain ethical standards don’t apply in a particular situation (Johnson and Connelly, 2016). This enables an individual to disable the mechanism of self-condemnation after making a certain decision or undertaking an action. In financial reporting context, moral disengagement refers to mechanism through which there is activation between the interaction of management ethics and incentives that influence earning management behaviour (Davidson, Dey, and Smith, 2015).  A financial manager with high moral disengagement propensity is more likely to have exacerbated earning management behaviour. Moral disengagement occurs to CFOs’ through eight interrelated cognitive mechanisms that allows them to disengage self-sanctions that guide their behaviour when preparing financial reports. According to Gosh, (2010), individuals adopt moral standards that when activated help serve as self-reactive deterrent for a particular unethical behaviour. This leads to people using strategies that justify, downplay, or rationalize their unethical decisions. They therefore disengage their conduct with moral standards thereby protecting self image, reducing cognitive distress and enabling them to act unethically. Jiang, Petroni and Wang, 2010), stated that CFOs’ management ethics significantly influence tendencies for moral disengagement when given incentives. A CFO’s expense accruals are then dependent on absence or presence of an incentive conflict. The mediating role of moral disengagement therefore allow CFOs’ to manipulate financial statements for earning managements even when they know it inappropriate or has adverse consequences to the company (Christian and Ellis,2014).

Moral Disengagement

Equity incentives are reward to employees for long time performance and job retention. The shareholders reward the company’s employees to motivate them to achieve consistent and predetermined financial targets. The employees attain stake interest in the company and are earn dividends as shareholders of the company. According to Powers, Robinson and Stomberg (2016), financial managers who are sensitive to changes in stock prices have greater incentive for financial reporting. Equity incentives influence financial managers accounting decisions to achieve financial targets that increase their wealth. Financial misreporting affects equity values and increase equity risks (Kim, Li, and Zhang, 2011).  This means that a financial manager decision on reporting is significantly influenced by the incentive to report. That is, a CFOs’ who need to increase wealth by attaining more equity in the company is likely to misreport to earn it and a manager with shares in a company avoids misreporting to avoid increased equity value and equity risk for the company’s stock. Therefore, equity incentives can lead to financial misreporting through manipulation of CFOs’ accounting decisions.

Risk-taking incentives govern the management of a company to making decisions that minimizes a company risk. According to Chen et al. (2015), the higher the investment returns the higher the risks. A company management under incentives to achieve a set financial target is under pressure to invest in high return investments that can expose the company to greater risks. The risk-taking incentive reward management for reporting financial information that show application of risk policies.  This makes financial manager to be risk averse and strike a balance between high returns and risks that a company is likely to face. Therefore, risk-taking incentives are play a role in financial reporting by influencing financial decisions on different items to earn bonuses.

Conclusion

From the report, financial information reporting is dependent to CFOs’ accounting decisions. The accounting decisions are significantly influenced by CFOs’ incentives and management ethics. CFOs’ incentives such as equity incentive lead to misreporting as a result of conflicting interest between personal managers interests and shareholders’ interests. The managers manipulate earnings to show that a company achieved a set financial target in order to be rewarded with bonuses (incentives). Moral disengagement makes CFOs’ to justify their conduct when manipulating earning to attain their incentives. The report has found that there is a relationship between equity incentives and misreporting. Risk-taking incentives have an important role in minimizing financial misreporting. It solves the agency problem that exists in equity incentives hence enabling CFOs’ to focus on corporate financial performance instead of personal bonus of financial performance. The report recommends that companies should train financial manager on moral disagreement to avoid manipulation of earnings and adopt risk-taking incentives to minimize financial misreporting.   

References

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Jiang, J.X., Petroni, K.R. and Wang, I.Y., 2010. CFOs and CEOs: Who have the most influence on earnings management?. Journal of Financial Economics, 96(3), pp.513-526.

Johnson, J.F. and Connelly, S., 2016. Moral disengagement and ethical decision-making. Journal of Personnel Psychology.

Kim, J.B., Li, Y. and Zhang, L., 2011. CFOs versus CEOs: Equity incentives and crashes. Journal of Financial Economics, 101(3), pp.713-730.

Powers, K., Robinson, J.R. and Stomberg, B., 2016. How do CEO incentives affect corporate tax planning and financial reporting of income taxes?. Review of Accounting Studies, 21(2), pp.672-710.

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