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Justification of Earnings Management:

 Jooste (2011) states that not all earnings management practices are illegal, and many are
within the managers prerogatives. However, this raises questions from an ethical
perspective.
 There are obviously ethical issues which arise when earnings management is concerned,
with scandals such the Enron scandal in 2001 where earnings where misrepresents and
manipulated which ultimately led to the company’s bankruptcy.
 Stakeholders rely on the financial statements and assume that the reported earnings are
indicative of the long-term profitability of the company. For example, shareholders and
potential investors use the information in their investment decisions. Banks use them for
loan decisions, suppliers use them in deciding whether to do business etc…
 These stakeholders may then use the information to make decisions they would not have
made, had the information not been distorted.
 Numerous studies have been undertaken to discover people’s perceptions of the morality
surrounding earnings management
 Bruns & Merchant 1990 conducted a survey with 13 earnings management situations.
o Although all situations were legal, some were in violation with GAAP.
o The study showed a large dispersion of what managers viewed as eithical or
unethical. None of the situations were viewed as unanimously ethical or unethical.
o However, it was discovered that it was viewed to be less acceptable if the method of
earnings management increased earnings as well as situations such as the timing,
i.e. during the year or at the year end.
o It was found that if the practice was not illegal and there was only a slight deviation
from the GAAP, it was generally viewed as an ethical practice regardless of who was
affected by it
 Rosenzweig & Fischer State (1994) state that because earnings management has the
potential to distort reported earnings and mislead reported earnings and mislead users of
financial information, earnings management is a significant ethical problem.
 Some studies have also found earnings management to be beneficial to stakeholders, for
example earnings management may be used to convey private information that would not
have been available otherwise
 Arya et al (2003) argues that the notion of earnings management reducing transparency is a
simplistic one. In a large decentralised organisation information is dispersed across many
people, and therefore a well-managed earnings stream can convey more information than if
it was unmanaged.

Solutions to earnings management

 The responsibility of educators


 More rigorous accounting standards
 Increased corporate governance and monitoring
 Improved audit quality to detect earnings management.