Effects of Materiality, Risk,
and Ethical Perceptions on
Fraudulent Reporting by
Financial Executives
ABSTRACT. This paper examines fraudulent finan-
cial reporting within the context of Jones’ (1991)
ethical decision making model. It was hypothesized
that quantitative materiality would influence judg-
ments of the ethical acceptability of fraud, and that
both materiality and financial risk would affect the
likelihood of committing fraud. The results, based on
a study of CPAs employed as senior executives,
provide partial support for the hypotheses. Contrary
to expectations, quantitative materiality did not
influence ethical judgments. ANCOVA results based
on participants’ estimates of the likelihood that a
“typical CPA” would manipulate reported results
indicated that both materiality and risk significantly
influenced the likelihood of fraud, but that the per-
ceived morality of the action did not. In contrast,
results based on participants’ self-reported behavior
indicated that materiality and the perceived morality
of the action would influence the likelihood of fraud,
but that financial risk would not. Regardless of the
measure used for the likelihood of fraud, the results
indicate that financial executives continue to be
influenced by quantitative materiality when misstate-
ments are clearly material on qualitative grounds.
William E. Shafer is professor of accounting at the
Graziadio School of Business and Management,
Pepperdine University. His primary research interest is
ethics and professionalism in accounting. His research has
appeared in a variety of academic and professional
journals, including AUDITING: A Journal of
Practice & Theory, Accounting Horizons,
Accounting Auditing & Accountability Journal,
Journal of Business Ethics, Journal of
Accountancy, and The CPA Journal.
Journal of Business Ethics 38: 243–262, 2002.
© 2002 Kluwer Academic Publishers. Printed in the Netherlands.
William E. Shafer
Introduction
The integrity of the financial reporting process
in the U.S. has recently come under intense crit-
icism. On several occasions, former Securities
and Exchange Commission (SEC) Chairman
Arthur Levitt asserted that registrants’ reported
financial results are often intentionally manipu-
lated to meet market expectations (e.g., Levitt,
1998, 2000). Levitt’s accusations were the latest
in a long line of charges of wrongdoing on the
part of accountants and their independent
auditors (e.g., Public Oversight Board, 1993,
1994; Schuetze, 1994). However, the frequency
and intensity of the recent allegations has
prompted writers in the financial press to openly
question the reliability of the entire financial
reporting process (e.g., Bartlett, 1998; Loomis,
1998).
One “earnings management” technique that
has provoked the ire of the SEC is the rational-
ization of intentional financial statement mis-
statements on the grounds that they do not
exceed traditional materiality thresholds.1 The
perception that such “abuses of materiality” are
commonplace led to the recent issuance of SEC
Staff Accounting Bulletin 99 (SEC, 1999). This
statement emphasized that exclusive reliance on
quantitative measures of materiality is inappro-
priate, and that intentional misstatements of
financial results may violate federal securities
laws, even if the amounts fall below traditional
materiality thresholds. The statement also
expressed the view that it is not reasonable to
record misstatements or not to correct known
misstatements, even if quantitatively immaterial,
244 William E. Shafer
as part of an ongoing effort of the company’s
senior management to manipulate or manage
reported earnings.
Staff Accounting Bulletin 99 contained no
new concepts or rules regarding materiality. Its
purpose was to remind registrants and their
auditors of the meaning and proper use of the
materiality concept (SEC, 1999). Obviously, the
concept was never intended as a vehicle for the
intentional manipulation of financial statements.
Many accounting issues arise for which the
“correct” answer is not known at the time of
financial statement preparation, e.g., estimates of
the realizable value of inventories or collectibility
of receivables. The concept of materiality allows
the use of reasonable estimates in such cases as a
matter of practicality; otherwise, timely finan-
cial reporting could not occur. The SEC appar-
ently felt that use of the concept in practice had
degenerated into game-playing, although the
only evidence offered to support this view was
anecdotal in nature (see Levitt, 1998, 2000).
Many studies in the accounting literature have
addressed the issue of earnings manipulation or
“earnings management”, but most of these
studies have relied on archived financial data and
focused exclusively on economic incentives,
rather than addressing this issue from an ethical
decision making perspective. The few studies that
have adopted an ethical perspective have focused
primarily on managers’ or shareholders’ percep-
tions of the moral acceptability of earnings
manipulations, and have failed to offer a theo-
retical explanation of why such manipulations
seem to be prevalent in practice. These studies
have also not focused specifically on the effects
of materiality on earnings manipulation.
Several recent studies in the auditing litera-
ture have examined the effects of quantitative
materiality on financial reporting judgments.
However, these studies have been limited to the
effects of materiality on the disposition of errors
that were either based on subjective accounting
estimates or “honest mistakes” on the part of
management, rather than cases of financial state-
ment fraud. These studies have also been
restricted to the study of independent auditors
rather than company managers or executives.
Financial executives often make accounting and
reporting decisions, and in the case of intentional
earnings manipulations, the acceptability of these
decisions may never be independently evaluated
unless the misstatements are detected by the
company’s auditors.2
In light of the recent SEC allegations, a better
understanding of financial executives’ propensity
to rationalize earnings manipulations on the
grounds of immateriality is clearly needed. The
current study contributes to extant knowledge of
this phenomenon in several ways. It introduces
Jones’ (1991) theory of moral intensity to the
literature on earnings manipulation, and argues
that this theory may help explain the prevalence
of earnings management in practice. It is also the
first study to examine the effects of quantitative
materiality on financial executives’ propensity to
engage in intentional manipulations of earnings.
Finally, it extends recent research on materiality
to the context of financial statement fraud, and
demonstrates that even fraudulent financial
reporting schemes may often be rationalized on
the grounds of immateriality. The findings of this
study support the SEC’s recent charges regarding
abuses of materiality, but also call into question
the feasibility of regulating this type of behavior.
Literature review and hypothesis
development
A long tradition of research on the issue of
intentional earnings manipulations or “earnings
management” exists in the accounting literature.
Healy and Wahlen (1999, p. 368) recently
defined earnings management as managers using
“judgment in financial reporting and in struc-
turing transactions to alter financial reports to
either mislead some stakeholders about the
underlying economic performance of the
company or to influence contractual outcomes
that depend on reported accounting numbers.”
Most previous studies of earnings management
have focused on economic incentives for this
type of behavior, such as the presence of man-
agement bonuses that are tied to reported
income, and have relied on archival studies of
published financial statements.3 Only a limited
number of studies have considered earnings
 Effects on Materiality, Risk, and Ethical Perceptions
management from an ethical decision making
perspective, and most of these studies have been
limited to assessing the perceived morality or
ethical acceptability of the behavior.
Studies of ethical perceptions usually make a
distinction between two basic types of earnings
management: (1) operating decisions, which
involve the use of discretion in establishing the
structure or timing of financial transactions; (2)
accounting decisions, which involve judgment in
the selection among alternative accounting
methods or revisions of accounting assumptions
or estimates. In related studies, Merchant and his
colleagues found that managers generally
consider it ethical to intentionally manipulate
earnings through operating decisions such as
deferring expenditures and engaging in year-end
sales promotions (Bruns and Merchant, 1990;
Merchant and Rockness, 1994). In contrast,
respondents tended to view the intentional
manipulation of accounting methods as uneth-
ical, although there was a great deal of variation
in their attitudes. Both Fischer and Rosenzweig
(1995) and Kaplan (2001) also found that
earnings management through operating deci-
sions was viewed as significantly more ethical
than accounting manipulations.
The reason for these differences in perceptions
is not difficult to understand. Analysis of the cases
used in these studies reveals that the operating
earnings management schemes involved initiatives
such as running year-end sales promotions to
boost revenue, deferring expenses such as main-
tenance and advertising until future years, and
selling off excess assets in order to realize a
profit.4 Although these types of management
decisions may be motivated by the desire to
manipulate earnings, they cannot be construed as
fraudulent, and the reported accounting numbers
in these cases will accurately reflect the under-
lying economic events. In contrast, the
accounting manipulations involved schemes such
as arbitrarily writing inventory values up or
down, prepaying future years’ expenses and
recording them as expenses in the current year,
and making arrangements with an outside con-
sulting firm to delay invoicing the company for
services rendered until the next year in order to
delay recognition of the expense. While some of
245
these manipulations (e.g., writing inventory
values down) can be rationalized on the basis of
professional judgment, others (e.g., arranging for
delayed invoicing for services already received)
constitute financial statement fraud, and there is
a clear disconnect between the reported
accounting numbers and the underlying
economic events. Thus, the findings of these
studies suggest that intentional or fraudulent
earnings management through accounting
manipulations are generally viewed as unaccept-
able.
Studies of ethical attitudes toward earnings
management have generally neglected the issue
of materiality. However, in one of the Bruns and
Merchant (1990) scenarios the dollar amount of
the misstatement was manipulated on a within-
subjects basis. Although the effect of this manip-
ulation was statistically significant (Merchant and
Rockness, 1994), the difference in respondents’
ethical judgments for the large and small manip-
ulations was actually quite small. In light of the
demand effects associated with within-subjects
manipulations, it appears that the effects of the
dollar amount of intentional earnings manipula-
tions on judgments of their ethical acceptability
remains an open question.
Several recent studies have investigated the
effects of materiality on auditors’ willingness to
allow aggressive financial reporting.5 Shafer et al.
(1999) and Ketchand et al. (1999) studied the
effects of the dollar amount of financial statement
errors, as well as certain qualitative variables such
as the perceived likelihood of harm to financial
statement users, on the financial reporting
judgments of practicing auditors. Both studies
found that the dollar amount of misstatements
had a significant influence on auditors’ judgments
of the ethical acceptability of acquiescing in
clients’ aggressive reporting schemes. Libby and
Kinney (2000) examined the effects of analysts’
consensus earnings forecasts and proposed
changes to professional auditing standards on
audit managers’ willingness to allow a quantita-
tively immaterial misstatement to go uncorrected.
This study found that auditors were less likely
to require correction of immaterial errors if those
errors would cause the company’s earnings to fall
below the analyst-forecasted targets. The results
246 William E. Shafer
also indicated that recent changes in professional
auditing standards that mandate communications
regarding uncorrected errors to a company’s audit
committee did not increase the likelihood of
error correction if such correction would cause
the company to miss its earnings targets.
These findings all suggest that auditors are
quite likely to allow immaterial errors to go
uncorrected, as charged by the SEC. However,
these studies used cases involving errors that were
based on subjective judgments or honest over-
sights by company management, rather than
financial statement fraud. It is hardly surprising
that auditors can be persuaded to acquiesce in
immaterial earnings management schemes
involving accounting issues that are in the “gray
area” or that involve subjectively determined
accounting estimates. After all, in these cases
legitimate differences of opinion often exist, and
any potential error should have a minimal impact
on financial statement users. Fraudulent reporting
is a much more egregious offense, because it
involves clear intent on the part of management
to deceive financial statement users. Libby and
Kinney (2000) suggested that future studies of the
effects of materiality on financial reporting
should examine cases involving management
intent to manipulate earnings, since the effects of
materiality under these circumstances may be
different. Accordingly, the current study sought
to extend research on abuses of materiality to the
context of financial statement fraud.
The materiality of a potential financial state-
ment misstatement is a situational, or issue-con-
tingent variable. To examine the effects of this
type of variable on ethical decision-making
processes, a model is needed that explicitly
focuses on the characteristics of moral issues,
rather than other potential variables such as char-
acteristics of the decision makers. Jones’ (1991)
theory of moral intensity provides such a focus,
and also appears to have particular relevance for
the study of abuses of materiality. Accordingly,
this model was adopted as a theoretical frame-
work for the current paper.
Jones’ theory of ethical decision making
According to Jones (1991), all phases of the
ethical decision making process will be influ-
enced by the extent of issue-related moral imper-
ative present in a given situation. Jones’ theory,
which is presented in Figure 1, adopts the classic
four-component model of ethical decision
making proposed by Rest (1986). This model,
which has been widely adopted in the accounting
literature (e.g., Wright et al., 1998; Ketchand et
al., 1999; Shafter et al., 1999), decomposes the
process into four logical components: (1) recog-
nition of an issue, (2) making a moral or ethical
judgment, (3) establishing behavioral intentions,
and (4) engaging in actual behavior.
The first component of the model involves
recognizing the moral implications of an issue,
identifying the alternative courses of action that
are available, and assessing the consequences of
those actions (Rest, 1986). Once the moral
implications of an issue have been properly
recognized, an ethical judgment will be made,
which identifies the morally correct course of
action. After identifying one course of action as
the morally correct one, a person must weigh
their moral values in relation to other values in
order to establish behavioral intentions. For
example, if a person values advancement in their
career more than they value ethical behavior,
Figure 1. Jones’ ethical decision making model.
 Effects on Materiality, Risk, and Ethical Perceptions
they may compromise their moral principles.
Even if a person resolves to do what is judged as
morally correct, they may not possess the perse-
verance or resolve to follow through on their
intentions. Thus, the model makes an explicit
distinction between moral intentions and actual
behavior.
As indicated in the figure, the moral intensity
of an issue is hypothesized to affect all compo-
nents of the ethical decision making process.
Jones (1991) recognized six components of the
moral intensity construct: (1) magnitude of con-
sequences, (2) probability of effect, (3) temporal
immediacy, (4) social consensus, (5) proximity,
and (6) concentration of effect. Magnitude of con-
sequences refers to the sum of the harms or
benefits resulting from a given action. A higher
magnitude of consequences results in greater
moral intensity. Probability of effect refers to the
likelihood of the consequences actually occur-
ring. When the probability of actual harm is
relatively low, the moral intensity of the scenario
will also be low. The temporal immediacy of a
moral action refers to the length of time between
the action and the onset of its consequences.
According to Jones (1991), people discount the
effects of future consequences; thus, for a given
magnitude of consequences, events that will
occur in the future will be less morally intense
than events that are imminent. Social consensus
refers to the extent of agreement that an action
is ethical or unethical. Greater consensus leads to
greater moral intensity.Proximity refers to the
degree of affinity between the decision maker
and the victims or beneficiaries of the act in
question. Greater affinity with either the victims
or beneficiaries of the act should increase the
likelihood that the moral agent will act on these
parties’ behalf. The final component of the moral
intensity construct, concentration of effect, is an
inverse function of the number of people affected
by an action of a given magnitude. Higher con-
centration of effect leads to greater moral inten-
sity.
Moral intensity has been offered as a poten-
tial explanation of attitudes and behaviors relating
to a wide variety of ethical issues in business,
including software piracy (Logsdon et al., 1994),
environmental pollution (Morris and McDonald,
247
1995), sexual harassment (Bowes-Sperry and
Powell, 1999), and whistle-blowing (Singer et al.,
1998). Empirical studies have also found support
for the influence of moral intensity on ethical
decision making processes, although the specific
components of moral intensity that influence
decisions have varied among studies.
Morris and MacDonald (1995) concluded
based on early empirical studies that two dimen-
sions of moral intensity, magnitude of conse-
quences and social consensus, tend to be more
significant than the others. Their results, based
on student responses to three ethical dilemmas,
generally supported this contention. Singer
(1996) and Singer et al. (1998) also found that
magnitude of consequences and social consensus
had the most significant effects on observers’
judgments of actions with ethical implications.
Davis et al. (1998) tested the effects of three
components of moral intensity (magnitude of
consequences, social consensus, and proximity)
in a cross-cultural study of judgments relating to
questionable human resource management prac-
tices. The results indicated that social consensus
had the strongest effect on judgments. Mixed
results were reported for the effects of proximity,
while the effects for magnitude of consequences
were not significant. In a study that manipulated
all six components of moral intensity on a
within-subjects basis. Frey (2000) found that
magnitude of consequences, social consensus, and
probability of effect had the most significant
effects on business executives’ decisions relating
to two ethical scenarios. On the other hand,
Singhapakdi et al. (1996) found that all six com-
ponents of moral intensity had a significant
influence on the ethical perceptions of marketing
professionals.
Overall, these findings seem to indicate sub-
stantial support for the influence of the magni-
tude of consequences and social consensus on
ethical decision making, but less support for the
effects of the other components of moral inten-
sity. Obviously, not all the components of moral
intensity will be relevant to all ethical decision
making scenarios ( Jones, 1991); thus, variations
among studies that examine different decision
contexts would be expected. Consequently,
application of the moral intensity concept to
248 William E. Shafer
particular decision contexts should be based on
careful consideration of its relevance for that
context. In the case of intentional earnings
manipulations that fall below traditional materi-
ality thresholds, there appears to be strong con-
ceptual support for the relevance of the moral
intensity concept.
The magnitude of consequences appears to
have particular relevance in this scenario, because
by definition the magnitude of consequences for
immaterial manipulations will be small or negli-
gible. Since materiality is defined as the
minimum amount that would make a difference
in financial statement users’ decision processes,
it seems likely that managers and accountants will
rationalize misstatements that fall below normal
materiality thresholds on the grounds that they
will not have a significant adverse impact on
users. The perceived prevalence of this line of
reasoning recently prompted former SEC
Chairman Arthur Levitt to counter-argue that, if
“immaterial” earnings manipulations are in fact
inconsequential, managers would not go to such
great lengths to perpetrate them (Levitt, 1998).
There are also reasons to believe there may be
a low degree of social consensus regarding the
immorality of small misstatements. If, as former
SEC Chairman Levitt has suggested, a financial
reporting culture has developed in the U.S. in
which recording small intentional misstatements
is commonplace, accountants may feel there is a
consensus that such behavior is an acceptable
business practice. Theories of ethical decision
making commonly recognize the influence of
cultural or social norms on judgments (e.g.,
Ferrell and Gresham, 1985; Hunt and Vitell,
1991, 1986). If accountants feel that small
earnings manipulations are commonplace and
culturally acceptable (low consensus of
immorality), they should be more likely to view
them as ethical.
Accounting scholars have even openly ques-
tioned the validity of the SEC’s condemnation of
immaterial manipulations. Both DeChow and
Skinner (2000) and Libby and Kinney (2000)
argued that immaterial earnings misstatements
appear to be within the guidelines of Generally
Accepted Accounting Principles, thus ques-
tioning the SEC’s position on this issue. Even tra-
ditional definitions of fraud usually incorporate
a materiality test. For example, the National
Association of Certified Fraud Examiners defines
fraud as “the intentional, deliberate, misstate-
ments or omission of material facts, or accounting
data, which is misleading and, when considered
with all the information made available, would
cause the reader to change or alter his or her
judgment or decision” (NACFE, 1993, p. 12,
emphasis added). According to this definition,
fraudulent financial reporting ceases to be fraud
when the amounts involved fall below users’
materiality thresholds. The SEC attempted to
counter this notion by asserting in Staff
Accounting Bulletin 99 that intentional or fraud-
ulent earnings manipulations may violate federal
securities laws even if they are immaterial.
However, this argument has also met with con-
siderable resistance. For instance, Fang and Jacobs
(2000) asserted that the SEC’s “invention of
immaterial fraud” will allow the circumvention
of plain statutory language and years of case law
requiring that fraud be material. This discussion
illustrates that the SEC has encountered consid-
erable difficulty in its attempts to enlist support
for the condemnation of abuses of materiality.
This further implies a relatively low degree of
consensus that such behavior is inappropriate.
Other components of the moral intensity
construct also appear relevant to the study of
earnings manipulation. In the context of earnings
management, the probability of effect may be
viewed as the joint probability of users relying
on the financial statements, and harm occurring
as a result of that reliance. A number of factors
may serve to reduce the perceived probability of
effect, such as the availability of alternative
sources of information about the company.6 Also,
as the dollar amount of an intentional misstate-
ment decreases, the probability that users will
make harmful decision (e.g., to buy or sell shares)
as a result of the misstatement should also
decrease, resulting in a relatively low estimated
probability of harm for quantitatively immate-
rial misstatements.
The lack of proximity between accountants
and those harmed by earnings manipulations also
portends a low level of moral intensity.
Particularly in the case of public companies, the
 Effects on Materiality, Risk, and Ethical Perceptions
potential harm will often be inflicted on a large
group of anonymous stakeholders, which makes
it easier to dismiss the moral implications of the
action. In the case of quantitatively immaterial
misstatements, the fact that the potential harm
will be widely distributed suggests that the
amount of harm to most individuals will be
minimal. This low concentration of effect will
also reduce the perceived moral intensity of
earnings management.
Hypothesis development
Jones’ (1991) theory suggests that the moral
imperative associated with quantitatively imma-
terial misstatements will be relatively low. By
definition, the potential magnitude of conse-
quences for such misstatements should be small
or negligible. Since materially thresholds repre-
sent the minimum misstatements necessary to
influence users’ judgments, the perceived likeli-
hood of harm (probability of effect) resulting
from misstatements below such thresholds should
also be low. If accountants feel that small earnings
manipulations are commonplace in the current
financial reporting culture, as suggested in recent
SEC communications, they are also likely to feel
that there is at least some degree of social con-
sensus that such misstatements are less than
egregious. The lack of close proximity between
auditors and anonymous stakeholders of public
companies, as well as the widely diffused nature
of any potential consequences, should also serve
to reduce the moral intensity of immaterial
misstatements. Consequently, materiality should
influence the perceived ethical acceptability of
earnings manipulations, even if they are inten-
tional or fraudulent in nature. This reasoning is
reflected in the following hypothesis:
Hypothesis 1: Financial executives will judge
financial statement fraud as more (less)
ethical when the dollar amounts involved
are quantitatively immaterial (material).
Economic factors such as materiality should
have a more pronounced effect on ethical
intentions and actual behavior than on ethical
249
judgments. The explicit separation of ethical
judgments and behavior in the Rest (1986) and
Jones (1991) models is based on recognition of
the fact that practical considerations may lead to
behaviors that are inconsistent with a person’s
conception of what is morally right and wrong.
For example, the model presented in Figure 1
explicitly acknowledges the potential influence
of organizational factors on ethical intentions and
behavior. Jones (1991) recognized that factors
such as group dynamics, organizational authority,
and socialization processes may influence moral
intentions and behavior. Theories of ethical
decision making in organizations also commonly
recognize the influence of other practical con-
straints on ethical intentions and behavior. For
instance, the Hunt-Vitell model recognizes that
factors such as the probability and desirability of
consequences, and the importance of the stake-
holders involved will affect ethical intentions and
behavior (Hunt and Vitell, 1991, 1986). When
practical considerations are taken into account, it
appears that the likelihood of small intentional
misstatements may be rather high.
As previously argued, the perceived moral
intensity of immaterial manipulations should be
low, and a low level of moral intensity portends
a high likelihood of engaging in questionable
behaviors. For example, when the potential
misstatements are quantitatively immaterial, the
perceived magnitude of consequences and prob-
ability of harm may be negligible. In such cases,
the impact of practical considerations such as
organizational pressures will be considerable. The
perceived probability of detection and punish-
ment for immaterial misstatements should also be
rather small. Thus, when an accountant or finan-
cial executive is placed under organizational
pressure to manipulate financial results by
amounts that are quantitatively immaterial,
he/she will often be in a position of weighing
direct and immediate personal benefits (e.g.,
cessation of pressure, job retention, higher raises
or bonuses) against a low probability of harm to
a large group of relatively anonymous financial
statement users. Couple this with a low proba-
bility of detection and punishment, and it is easy
to understand why “abuses of materiality” may
be common in practice. The Shafer et al. (1999)
250 William E. Shafer
and Ketchand et al. (1999) studies also found
that the dollar amount of a financial statement
misstatement had a strong impact on professional
auditors’ estimates of the likelihood that they
would allow aggressive reporting by a client.
SEC officials have recently suggested that the
manipulation of financial results has become
commonplace among publicly traded companies,
particularly when the amounts fall below
traditional materiality thresholds (e.g., Levitt,
1998, 2000). However, neither the validity of this
assertion nor the extent to which materiality
affects the likelihood of fraud by financial exec-
utives has been documented. A demonstration
that quantitative materiality influences the like-
lihood of fraudulent reporting would suggest that
financial executives are not appropriately con-
sidering qualitative factors when making judg-
ments about earnings manipulations. Accordingly,
the following hypothesis is proposed:
Hypothesis 2: Financial executives will be
more (less) likely to commit financial state-
ment fraud when the dollar amounts
involved are quantitatively immaterial
(material).
Another factor that should influence the per-
ceived moral intensity of financial statement fraud
is the degree of risk associated with the company.
Companies with higher financial risk face a
higher likelihood of bankruptcy and consequent
losses to shareholders; accordingly, the perceived
probability of effect should be higher. A higher
likelihood of imminent bankruptcy should also
increase the temporal immediacy of the poten-
tial losses to stakeholders, further increasing the
perceived moral intensity of the action. These
arguments are supported by the results of the
Ketchand et al. (1999) study, in which the
intended use of financial statements was manip-
ulated on a between-subjects basis. In one
version of the case, the statements were to be
distributed to a bank for routine credit mainte-
nance purposes, while in another version they
were to be used to establish the value of the
company pursuant to a pending buyout.
Ketchand et al. argued that in the case of
imminent transactions that pose a high risk of
loss to the stakeholders involved, higher levels
of moral intensity should decrease the perceived
morality of aggressive reporting, as well as the
likelihood of such reporting occurring. The
findings strongly supported this contention.
Potential bankruptcy poses a similar threat to
stakeholders, by increasing both the likelihood
and imminence of potential losses.
Additional support also exists for the influence
of risk on aggressive financial reporting judg-
ments. Theories of ethical decision making in
organizations recognize the intuitive proposition
that the higher the probability of punishment for
unethical behavior, the lower the likelihood that
managers will compromise moral principles (e.g.,
Ferrell and Gresham, 1985; Trevino, 1986; Hunt
and Vitell, 1986). SEC investigations are often
triggered by company bankruptcy or other
financial difficulties (Beasley et al., 1999).
Consequently, the likelihood that intentional
earnings manipulations will be detected and sanc-
tions administered should be higher for com-
panies with greater financial risk.
Theories of auditor independence have also
recognized the potential influence of risks asso-
ciated with litigation and other sanctions on
auditors’ reporting judgments (e.g., Shockley,
1982). In fact, several studies have assumed that
auditors’ willingness to acquiesce in aggressive
reporting schemes essentially involves a trade-off
between the risk of client loss on the one hand,
and the risk of litigation or other adverse con-
sequences on the other (e.g., Farmer et al., 1987;
Trompeter, 1994; Hackenbrack and Nelson,
1996). Shafer et al. (1999) explicitly modeled
auditors’ ethical intentions as a function of the
perceived likelihood of various sanctions being
imposed, such as negative peer review effects,
professional disciplinary actions, and adverse lit-
igation judgments. Their findings indicated that
the perceived risk of punishment affected the
likelihood that auditors would allow aggressive
reporting. Thus, higher levels of risk should
increase both the moral intensity of fraudulent
reporting and the perceived likelihood of pun-
ishment for such actions. Both of these effects
should decrease the likelihood of fraud, as
reflected in the following hypothesis.7
 Effects on Materiality, Risk, and Ethical Perceptions
Hypothesis 3: Financial executives will be
significantly more (less) likely to commit
financial statement fraud when the finan-
cial risk associated with the company is
lower (higher).
Methodology
The data for this study were obtained by mailing
instruments to a sample of practicing CPAs
employed in industry. This section describes the
research instrument and participants.
Instrument
The research instrument included (1) a cover
letter, (2) a financial reporting case, and (3) a sup-
plemental data sheet. The case, which is illus-
trated in Appendix 1, was based on the financial
statements of an actual company that was sanc-
tioned by the SEC for fraudulent financial
reporting and subsequently declared bankruptcy.
Risk and materiality were manipulated on a
between-subjects basis, resulting in a 2 × 2 exper-
imental design.
In the High Risk condition, the reported
financial position and results of operations of the
company were similar to those reported by the
actual company prior to the discovery of the
fraud scheme by the SEC. In the Low Risk
condition, the financial statements were adjusted
to reflect a significantly stronger financial position
and results of operations. Both the High and Low
Risk versions indicated that since its incorpora-
tion, the company had been primarily engaged
in process and product technology development,
and had developed a unique proprietary process
that it believed to be a technological break-
through. In the High Risk condition, the case
further indicated that since the implementation
of this process two years before, the company had
failed to capture a significant market share, and
most of its sales had been to two principal cus-
tomers. The High Risk version also indicated
that the company had suffered recurring oper-
ating losses and that their audit report for the past
two years had been modified to indicate sub-
stantial doubt about their ability to continue as
251
a going concern. In contrast, the Low Risk case
indicated that, since the implementation of its
proprietary technology, the company had
captured a significant share of the market. The
Low Risk version stipulated that the company
had experienced a strong upward trend in
revenue and earnings for the past three years, and
expected increases in market share and prof-
itability in the future. This version made no
mention of a going concern modification in the
company’s audit report.
In the High (Low) Materiality condition, the
fraud scheme involved the acceleration of the
recognition of $2 000 000 ($200 000) of revenue,
which would have overstated revenue by approx-
imately 25 (2.5) percent, and overstated the
pretax earnings or understated the pretax loss
(depending upon the risk condition) by approx-
imately 38 (3.8) percent. Thus, the amounts
involved in the Low Materiality condition were
below traditional materiality thresholds, while in
the High Materiality condition they clearly
exceeded such thresholds. The case was designed
in this manner to test whether participants would
be willing to rationalize the acceptability of an
earnings manipulation on the basis of quantita-
tive immateriality.
The cases were reviewed by three CPAs who
were employed as Chief Financial Officers
(CFOs) of publicly held companies, who all
indicated that the case seemed to address an
important current issue, and that the case was
realistic, given practical constraints on the length
of the survey instrument. The case was also
pretested on 27 members of an MBA night class,
which resulted in minor changes being made to
clarify certain issues.
To assess the likelihood of fraudulent finan-
cial reporting, participants were asked to provide
their best estimate of the probability that (1) a
typical CPA employed in a similar position, and
(2) they personally would acquiesce in the
proposed premature revenue recognition scheme.
Responses were provided on eleven-point Likert
scales anchored on “0 percent” and “100
percent.” Previous studies in accounting have
assumed that responses regarding an “average” or
“typical” CPA provide a more accurate estimate
of what participants would do personally, due to
252 William E. Shafer

social desirability effects (e.g., Cohen et al., their company. The gender composition of the
1995). Although it’s true that responses regarding sample is not surprising, in light of the fact that
other CAPs are probably more likely to be honest a strong majority of CPAs occupying higher-level
than responses regarding participants’ own positions in the U.S. are male (Doucet and
behavior, the current study does not assume that Hooks, 1999). The majority of participants had
responses regarding the “typical CPA” necessarily not earned a graduate degree, and had no pro-
reveal subjects’ personal propensity to commit fessional certifications other than the CPA
fraud. Rather, the two measures are treated as credential. The average respondent was 46 years
separate dependent variables for purposes of old and had approximately 22 years of profes-
analysis, and it is recognized that both estimates sional accounting experience.
probably understate subjects’ honest assessment
of the likelihood of fraud.
To test the effectiveness of the manipulation TABLE I
of risk, respondents were asked to (1) rate the Demographic profile of participants
degree of financial risk associated with the
Number Percent
hypothetical company; and (2) estimate the like-
lihood that the company would not continue as Sample size 138
a going concern. The financial risk estimates a
Gender:
were provided on an eleven-point scale anchored
Male 120 88.2%
on “low risk” and “high risk”, while the going Female 16 11.8
concern estimates were provided on an eleven-
point scale anchored on “0 percent” and “100 Position:
Financialb 103 76.3
percent.” To check the materiality manipulation,
Operationsc 32 23.7
participants rated the materiality of the misstate-
ments resulting from the proposed premature Company type:
revenue recognition scheme on an eleven-point Public 85 62.5
Nonpublic 51 37.5
scale anchored on “immaterial” and “highly
material.” Respondents also provided ethical Highest degree:
judgments of the hypothetical CPA’s actions on Bachelors 91 66.9
an eleven-point scale anchored on “clearly Masters or aboved 45 33.1
ethical” and “clearly unethical.” Certifications:
CPA only 126 92.6
CPA plus Otherse 10 7.4
Participants Age:
Mean 46
Instruments were mailed to a random sample of Standard deviation 8.0
500 AICPA members whose membership infor- Professional experience (years):
mation indicated that they were employed as Mean 22
senior executives in commerce or industry. After Standard deviation 7.9
a follow up mailing, a total of 138 usable a
responses were obtained, providing a response In all cases in which numbers do not sum to 138,
rate of approximately 28 percent. A comparison it is due to missing values.
b
Includes job titles Chief Financial Officer,
of the responses to the audit case and demo-
Controller, and Vice-President of Finance.
graphic data for the early and late respondents c
Includes job titles Chief Executive Officer,
indicated no significant differences. A demo- President, and Chief Operating Officer.
graphic profile of participants is provided in d
Includes two subjects with a J.D. and one subject
Table I. As the data indicate, approximately 88 with a Ph.D.
percent of the respondents were male, and 76 e
Includes CMA, CIA, CFE, and other miscellaneous
percent served as the chief financial executive of certifications.
 Effects on Materiality, Risk, and Ethical Perceptions 253

Approximately 62 percent of the participants TABLE II

worked for public companies, while the Responses to case: Estimated likelihood of
remaining 38 percent worked for private com- committing fraud
panies or other types of organizations.8 Since the
case dealt with an SEC registrant, preferably Risk
respondents should have had public company
Low High Pooled
experience. However, of the 51 participants who
worked for nonpublic companies, 31 (60 percent) Panel A – Typical CPA:
reported that they had prior experience either
Materiality:
working for or auditing public companies. Thus,
only 20 respondents had no previous public Lowa, b 63% 42% 53%
company experience.9 There were no statistically (70) (24) (53)
significantly differences between the mean n = 35 n = 35 n = 70
responses of subjects employed by public and High 32% 23% 28%
nonpublic companies; consequently, all subjects (19) (12) (17)
were pooled for purposes of analysis. n = 36 n = 32 n = 68
Pooled 47% 33% 40%
(53) (22) (41)
Results n = 71 n = 67 n = 138
Panel B – Participants:
Responses to case and preliminary analyses
Materiality:
A summary of respondents’ estimates of the like- Low 16% 10% 13%
lihood of committing fraud is provided in (22) (6) (16)
Table II. The data generally indicate clear dif- n = 35 n = 35 n = 70
ferences between both the Low and High Risk High 6% 7% 6%
and the Low and High Materiality conditions. (5) (4) (4)
The data also reflect a large disparity between n = 36 n = 32 n = 68
participants’ likelihood assessments for the typical Pooled 11% 8% 10%
CPA and for themselves. For example, in the (16) (6) (12)
Low Risk, Low Materiality condition, respon- n = 71 n = 67 n = 138
dents felt there was a 63 percent chance that the
typical CPA would commit fraud in the face of Notes:
a
Reported numbers are mean responses. Numbers
organizational demands, but only admitted to a
in parentheses represent standard deviations.
16 percent chance that they personally would b
All responses were provided on an eleven-point
succumb to such pressure. The large disparities scale where 0 = “0 percent” and 10 = “100 percent”,
between responses to these two questions suggest and converted to percentages.
that subjects’ responses regarding their own cor-
ruptibility were affected by a social desirability
bias, which is not surprising given the sensitive bility even when the amounts were highly sig-
nature of this issue. nificant. The existence of such pessimistic atti-
Participants’ estimates of the likelihood of the tudes toward CPA integrity suggests that earnings
typical CPA committing fraud provide cause for manipulation may indeed be a relatively common
concern. Across both risk conditions, respon- phenomenon.
dents felt there was a 53 percent probability that Responses to the manipulation checks are
their peers would succumb to organizational summarized in Table III. Estimates of the finan-
pressures to fraudulently manipulate reported cial risk associated with the hypothetical
financial results when the amounts involved were company show marked differences between the
relatively small, and almost a 30 percent proba- Low and High Risk conditions. A one-way
254 William E. Shafer

TABLE III
Other case responses

Materiality

Low High

Low Risk High Risk Low Risk High Risk

Manipulation checks:
Financial riska, b 5.07 8.40 5.53 8.19
(1.67) (0.99) (2.50) (1.61)
Going concern riskc 3.34 5.76 4.24 5.64
(2.10) (2.63) (2.35) (2.53)
Materialityd 5.63 6.89 9.07 9.03
(2.58) (2.85) (0.59) (0.79)
Ethical judgmentse 9.03 9.16 9.39 9.38
(0.98) (0.69) (0.54) (0.44)

Notes:
a
Reported numbers are mean responses. Numbers in parentheses represent standard deviations.
b
Responses were provided on an eleven-point scale where 0 = “low risk” and 10 = “high risk”.
c
Responses were provided on an eleven-point scale where 0 = “0 percent” and 10 = “100 percent”.
d
Responses were provided on an eleven-point scale where 0 = “immaterial” and 10 = “highly material”.
e
Responses were provided on an eleven-point scale where 0 = “clearly ethical” and 10 = “clearly unethical”.

ANOVA with perceived financial risk as the
dependent variable and manipulated risk as the
independent variable indicated that the effects
of the manipulation were significant at the
0.0001 level. Although the differences are not as
large, a one-way ANOVA also indicated that the
effect of the risk manipulation on the estimated
likelihood that the company would not continue
as a going concern was significant at the 0.01
level. These results indicate that the manipula-
tion of risk was effective.
A one-way ANOVA indicated that the effect
of the materiality manipulation on perceived
materiality was also significant at the 0.0001 level.
Because the materiality ratings appeared to reflect
an interaction between materiality and risk, a
two-way ANOVA with perceived materiality as
the dependent variable and manipulated risk and
materiality as the factors was also ran. This model
indicated that the main effect for materiality
remained significant at the 0.0001 level, while
the risk/materiality interaction was also signifi-
cant at the 0.05 level. This result reflects the fact
that, in the Low Materiality condition, subjects
who received the High Risk case felt that the
misstatement was more material. This result is
not surprising, since materiality judgments
should reflect qualitative considerations such as
the likelihood of harm to financial statement
users. However, in the High Materiality condi-
tion, risk had no appreciable effect, as subjects
almost uniformly agreed that the misstatement
was highly material.
Judgments in the Low Materiality condition
reflected less consensus among participants, as
indicated by the relatively high standard devia-
tions of the responses. From a normative stand-
point, it could be argued that any intentional
misstatement of financial statements is highly
material, regardless of the dollar amount (SEC,
1999). According to this logic, the misstatement
in the Low Materiality condition should also
have been rated as highly material by the survey
participants. The fact that the ratings in the Low
Materiality condition were above the midpoint
of the scale indicates that, overall, subjects did
feel that the misstatement was material on
qualitative grounds, even though the effects on
 Effects on Materiality, Risk, and Ethical Perceptions 255

the financial statements were below conventional that a typical CPA employed in a similar position
materiality thresholds. However, the lack of would have committed the fraud described in the
consensus in the Low Materiality condition case. In the second model, the dependent
reflects the fact that many subjects failed to variable was the estimated likelihood that par-
acknowledge the qualitative significance of the ticipants themselves would have committed the
intentional earnings manipulation, and fraud. The results of both models are presented
approached the materiality decision primarily in Table IV. Both models included risk and mate-
from a quantitative standpoint. riality as between-subjects variables. Because the
Univariate ANOVA and regression models Jones (1991) model of ethical decision making
were used to test for possible effects of various recognizes the influence of moral judgments on
demographic factors on participants’ responses to ethical decision making, both models also
the case. Univariate ANOVA models indicated included ethical judgments as a covariate. Due to
that neither gender, job title (financial vs. oper- the significant interactive effect of risk and
ating position), nor education level (bachelors vs. materiality on participants’ materiality judgments
masters) had a significant effect on responses. discussed in the preceding section, the interac-
Linear regression models also revealed that tion of risk and materiality was also included in
neither age nor years of experience affected the ANCOVA models.
participants’ responses. Based on the lack of sig- The results in Panel A of the table indicate that
nificant influence of demographic factors, these both risk and materiality had a significant effect
variables were excluded from subsequent analyses. on the estimated likelihood of a typical CPA
committing fraud, which provides support for
Hypotheses 2 and 3. Ethical judgments did not
Hypothesis tests
TABLE IV
Table III also presents participants’ mean ethical ANCOVA results
judgments regarding the hypothetical CPA’s
actions. The high means and low standard devi- F-value Significance
ations of these responses indicate that most levela
subjects viewed the action as clearly unethical.
There was also very little variation in responses Panel A – Typical CPA:
across the four experimental conditions, which Between-subjects effects:
suggests that neither materiality nor risk had a Risk 4.7 0.033
significant effect on ethical judgments. To Materiality 11.30 0.001
formally address Hypothesis 1, an ANOVA Risk ∗ Materiality 0.7 0.410
model was ran with ethical judgments as the Covariates:
dependent variable and materiality as the inde- Ethical judgments 1.8 0.183
pendent variable. The effects of materiality on Model R2 00.14
ethical judgments did not approach significance, Panel B – Participants:
suggesting that financial executives view even
Between-subjects effects:
small intentional earnings manipulations as Risk 1.7 0.191
unethical. Of course, these results should be Materiality 5.3 0.022
interpreted with caution, since self-reported Risk ∗ Materiality 2.5 0.117
ethical judgments regarding a currently sensitive
Covariates:
issue may be subject to a significant social desir- Ethical judgments 28.80 0.000
ability bias. Model R2 00.26
Hypotheses 2 and 3 were tested using analysis
of covariance (ANCOVA) models. Two separate Notes:
models were estimated. In the first model, the a
Reported significance levels are based on one-tailed
dependent variable was the estimated probability tests.
256 William E. Shafer
have a significant impact on participants’ esti-
mates of the likelihood that their peers would
commit fraud. Panel B presents the results for
participants’ self-reported behavior. The effects
of materiality were again significant, although the
risk factor was not. Thus, the results of the study
provide consistent support for the effects of
quantitative materiality on the propensity to
commit fraud, but mixed results for the effects of
financial risk. In contrast to the results reported
in Panel A, the effects of the perceived morality
of the action had a highly significant effect on
the self-reported likelihood of fraud.
The interaction of risk and materiality was not
significant in either of the models tested.
Although no interaction effects were explicitly
hypothesized, they were included in the
ANCOVA models due to the fact that the risk
and materiality manipulations had a significant
interactive effect on participants’ materiality
judgments. Specifically, higher levels of risk
increased perceived materiality in the low mate-
riality condition, but not in the high materiality
condition. This result implies that under condi-
tions of low materiality, the effects of risk on
ethical intentions should have been greater. This
is consistent with the pattern of responses
reported in Table II for self-reported intentions,
but not for estimates of peer intentions. The
interactive effect of manipulated risk and mate-
riality on materiality judgments was only mar-
ginally significant (0.05 level); therefore, the
effect may have simply been too subtle to sig-
nificantly affect behavioral intentions.
Discussion and suggestions for future
research
Contrary to expectations, the results of the
current study indicate that financial executives
view intentional earnings manipulations as highly
unethical, even when the amounts involved fall
below traditional materiality thresholds. Across
both materiality conditions, there was a high
degree of consensus among the study participants
that the premature recognition of revenue was
morally unacceptable. However, despite these
moral reservations, participants felt there was a
significant probability that company executives
will succumb to organizational pressures to fraud-
ulently misstate reported financial results, partic-
ularly when the amounts are quantitatively
immaterial.
Participants felt that the likelihood of a typical
executive perpetrating a financial statement fraud
would be strongly influenced by the dollar
amount of the misstatement and the financial risk
associated with the company. Participants’ esti-
mates of the likelihood that they would person-
ally commit fraud were much lower than their
estimates for a representative CPA, but were also
clearly influenced by the dollar amount of the
misstatement. Interestingly, although the per-
ceived risk associated with the company signifi-
cantly influenced estimates of peer behavior, the
effects of risk on participants’ self-reported like-
lihood of fraud were not significant. It is also
interesting to note that judgments of the ethical
acceptability of fraudulent reporting significantly
influenced the self-reported likelihood of fraud
as would be predicted by the Rest (1986) and
Jones (1991) models, but did not influence the
estimated likelihood of fraud by participants’
peers.
This pattern of results is consistent with the
presence of a social desirability response bias;
thus, the self-reported results should be inter-
preted with caution. When answering regarding
their own intentions, participants may have
deemphasized the rational consideration of risk
effects, and simply provided what was perceived
as the socially desirable response. This explana-
tion is generally consistent with the observed
results, which indicate low self-reported proba-
bilities of fraud, and a highly significant influence
of ethical judgments on personal intentions.
Participants’ responses regarding their own
behavior generally reflect the position that
because fraud is highly unethical they would be
unlikely to consider it under any condition, par-
ticularly if the effects were material. In contrast,
responses regarding peer behavior seem to reflect
the view that a typical financial executive would
essentially ignore ethical considerations but
would consider the risk involved, and that there
is a significant likelihood that he/she would
commit fraud even if the amounts were material.
 Effects on Materiality, Risk, and Ethical Perceptions
The fact that materiality was significant in both
models attests to the robustness of materiality
effects on fraudulent financial reporting, i.e., even
when participants answered in a socially desirable
fashion, they acknowledged the influence of
materiality on their judgments. Future research
in this area should attempt to more effectively
address the issue of social desirability response
bias, e.g., by explicitly measuring and controlling
for subjects’ proclivity to respond in a socially
desirable fashion.
The findings of this research have several
implications. First, the results raise general
concerns regarding the likelihood of executives
yielding to organizational pressures for the
manipulation of financial results. Across all risk
and materiality conditions, the estimated likeli-
hood that participants’ peers would commit fraud
was approximately 40 percent. Theories of ethical
decision making recognize that one of the key
predictors of unethical behavior is an employee’s
perceptions of what their peers or other organi-
zational members would do (Ferrell and
Gresham, 1985; Hunt and Vitell, 1986, 1991;
Trevino, 1986). If peer perceptions have a similar
influence on financial executives’ behavior, the
results of the current study suggest that the like-
lihood of their acquiescence in earnings manip-
ulation schemes may be significant. This
observation appears to be consistent with the
spate of recent criticisms by regulators, and
suggests that there may be systemic weaknesses
in the current financial reporting system.
The results also suggest that risk and materi-
ality continue to influence judgments in a situ-
ation in which, according to accounting
regulators, they should have no influence. The
SEC has recently asserted that conventional
concepts of materiality do not apply in situations
involving intentional manipulations of earnings
(Levitt, 1998; SEC, 1999). However, it appears
that economic considerations such as materiality
still have a strong impact on the likelihood that
financial executives will commit fraud. Whether
the probability of fraud was measured by subjects’
estimates that a typical CPA or they personally
would manipulate earnings, the likelihood was
significantly higher when the dollar amounts
could be rationalized as immaterial.
257
Thus, despite intense efforts on the part of the
SEC to discourage “abuses of materiality”, the
findings of the current study indicate that such
behavior may still be prevalent in practice. Even
in a clear case of financial statement fraud, par-
ticipants felt there was a greater than 50 percent
chance (across both risk conditions) that a typical
CPA employed as a financial executive would
succumb to organizational pressure for earnings
manipulation when the amounts fell below
traditional materiality thresholds. The likelihood
of earnings management through less egregious
means, such as the manipulation of accounting
estimates, is probably significantly greater than in
the case of fraud.
These findings raise questions regarding the
ability of regulatory authorities such as the SEC
to control immaterial manipulations of reported
financial results, and add to previously expressed
doubts regarding the wisdom of the SEC’s recent
emphasis on this issue. Fang and Jacobs (2000)
argued that the SEC’s attempt to “micromanage”
financial disclosures by prohibiting immaterial
misstatements is economically unsound, because
increased vigilance in detecting and correcting
small errors will increase accounting and auditing
costs in exchange for questionable benefits. Fang
and Jacobs (2000) also argued that, because legal
definitions of fraudulent financial reporting
incorporate materiality tests, it is doubtful that
prohibitions of immaterial financial statement
manipulations will be legally enforceable. If these
assertions are correct, it is not likely that the
SEC’s condemnation of small manipulations will
be effective, since it will not carry the threat of
legal liability.
Additional insights into the effectiveness of
attempts to regulate earnings manipulations could
be obtained through the study of the perceived
certainty and severity of disciplinary actions or
sanctions resulting from such behavior. Research
in law and sociology has investigated the effects
of both formal (e.g., litigation, fines, license sus-
pension) and informal (negative publicity, loss of
respect of peers) sanctions on the likelihood of
committing a variety of crimes, including cor-
porate and white collar crimes (e.g., Braithwaite
and Makkai, 1991; Makkai and Braithwaite,
1994; Elis and Simpson, 1995). Recent studies
258 William E. Shafer

in the auditing literature have also addressed the
effectiveness of sanctions as deterrents to aggres-
sive financial reporting. For example, Shafer et
al. (1999) investigated the effectiveness of several
formal sanctions, such as peer review and legal
liability, in controlling aggressive reporting
among professional auditors. Similar studies of
financial executives could provide useful input for
policy decisions. For instance, if future studies
reveal that the perceived threat of sanctions for
immaterial misstatements is negligible, the SEC
will be faced with a choice of either intensifying
its disciplinary efforts or abandoning costly
attempts to regulate such behavior, as suggested
by Fang and Jacobs (2000).

Appendix 1: Experimental cases

High risk, high materiality condition:

Bob Jenkins is a licensed CPA and has been employed as the CFO of Photek, Inc. for the past year and a half.
Photek develops, manufactures, and markets high-performance film-coated glass used in such products as
computer screens, photocopiers, and projection televisions. The company was incorporated in 1994, and from
its inception through 1997 was primarily engaged in the development of process and product technology, with
limited commercial production. The company has successfully developed a unique, proprietary process for
applying thin film coatings to glass and other products that it believes represents a fundamental technological
breakthrough. However, since the implementation of this technology in early 1998 they have not captured a
significant share of the market for this type of process, and the majority of their sales have been to two prin-
cipal customers.
Photek’s common stock was initially registered with the SEC in May 2000, and is quoted on the NASDAQ.
It is now January, 2001, and the company is preparing for an audit of their annual financial statements for the
year ended December 31, 2000, which will be included in their Form 10K filed with the SEC. Summarized
financial information for Photek as of and for the three years ended December 31, 2000 follows:

(Unaudited)
1998 1999 2000

Balance Sheet:
Current assets $1,569,010 $8,374,559 $6,068,392
Property and equipment 5,779,044 8,394,457 23,235,573
Other assets 31,782 262,170
$7,379,836 $17,031,186 $29,303,965

Current liabilities $2,936,994 $12,234,619 $6,081,206

Long term liabilities 633,691 915,340 793,376
Common stock 7,993,400 8,005,460 29,191,905
Retained earnings (deficit) (4,184,249) (4,124,233) (6,762,522)
$7,379,835 $17,031,186 $29,303,965

Income Statement:
Revenue $1,097,683 $4,035,382 $8,063,848
Cost of sales 1,219,954 2,458,226 6,232,346
Gross (loss) profit (122,271) 1,577,156 1,831,502
Operating expenses 1,489,084 1,173,424 4,375,750
Interest expense 74,688 343,716 94,041
Net (loss) income $(1,686,043) $60,016 $(2,638,289)
 Effects on Materiality, Risk, and Ethical Perceptions 259

As indicated above, the company has suffered operating losses and has a large accumulated deficit as of the end
of the current year, and a net loss for the year. The company incurred substantial charges for process and
product development during the year ended December 31, 2000 (reported as Operating expenses), in an effort
to develop other technologies that may prove profitable in the future. The company’s audit report has also been
modified for the past two years to indicate substantial doubt regarding their ability to continue as a going concern.
After seeing the unaudited results presented above for the year ended December 31, 2000, the company’s founder
and CEO, Jim Munitz, became very concerned about the company’s poor operating results and the failure to
meet market analysts’ forecasts. Consequently, he proposed a plan to improve reported performance. The plan
would involve backdating sales invoices and shipping documents for a large number of sales made during the
first quarter of 2001, so that the sales could be recognized in the year 2000. One of the company’s freight carriers
has agreed to backdate their bills of lading to correspond with the company’s shipping documents. Munitz
directed Jenkins to accelerate the recognition of approximately $2,000,000 in revenue for the year ended
December 31, 2000. This plan would increase gross profit and reduce the reported net loss by approximately
$1,000,000. Jenkins agreed to implement the plan, because he was concerned about losing his job if he refused
to comply with the CEO’s request.

Low risk, low materiality condition:

Bob Jenkins is a licensed CPA and has been employed as the CFO of Photek, Inc. for the past year and a half.
Photek develops, manufactures, and markets high-performance film-coated glass used in such products as
computer screens, photocopiers, and projection televisions. The company was incorporated in 1994, and from
its inception through 1997 was primarily engaged in the development of process and product technology, with
limited commercial production. The company has successfully developed a unique, proprietary process for
applying thin film coatings to glass and other products that it believes represents a fundamental technological
breakthrough. Since the implementation of this technology in early 1998, they have captured a significant share
of the market for this type of process.
Photek’s common stock was initially registered with the SEC in May 2000, and is quoted on the NASDAQ.
It is now January, 2001, and the company is preparing for an audit of their annual financial statements for the
year ended December 31, 2000, which will be included in their Form 10K filed with the SEC. Summarized
financial information for Photek as of and for the three years ended December 31, 2000 follows:

(Unaudited)
1998 1999 2000

Balance Sheet:
Current assets $2,569,010 $8,374,559 $6,068,392
Property and equipment 4,779,044 8,394,457 23,235,573
Other assets 31,782 262,170
$7,379,836 $17,031,186 $29,303,965

Current liabilities $2,936,994 $11,046,680 $6,081,206

Long term liabilities 633,691 915,340 793,376
Common stock 4,993,399 4,993,399 19,715,327
Retained earnings (deficit) (1,184,249) 75,767 2,714,056
$7,379,835 $17,031,186 $29,303,965
260 William E. Shafer

Income Statement:
Revenue $2,097,683 $5,035,382 $8,063,848
Cost of sales 1,129,954 2,458,226 4,232,346
Gross (loss) profit 967,729 2,577,156 3,831,502
Operating expenses 789,084 973,424 1,099,172
Interest expense 74,688 343,716 94,041
Net (loss) income $103,957 $1,260,016 $2,638,289

As indicated above, the company has experienced a strong upward trend in revenue and earnings over the past
three years, and is expected to increase its market share and profitability in the future. Nevertheless, after seeing
the unaudited results presented above for the year ended December 31, 2000, the company’s founder and CEO,
Jim Munitz, was concerned about the company’s failure to meet market analysts’ forecasts. Consequently, he
proposed a plan to improve the reported performance.
The plan would involve backdating sales invoices and shipping documents for a large number of sales made
during the first quarter of 2001, so that the sales could be recognized in the year 2000. One of the company’s
freight carriers has agreed to backdate their bills of lading to correspond with the company’s shipping
documents. Munitz directed Jerkins to accelerate the recognition of approximately $200,000 in revenue for the
year ended December 31, 2000. This plan would increase gross profit and pretax income by approximately
$100,000. Jenkins agreed to implement the plan, because he was concerned about losing his job if he refused
to comply with the CEO’s request.

Notes and Messier (1982). For more recent perspectives see,

1
Materiality is usually defined as the magnitude of
error in a company’s financial statements that would
influence the judgment of informed users of those
statements (SEC, 1999).
2
The significant role played by company executives
in the financial reporting process is evident when one
considers that the majority of SEC Accounting and
Auditing Enforcement Releases (AAERs) name either
the Chief Financial Officer or Chief Executive Officer
as a participant in fraudulent reporting schemes. For
example, in the sample of AAERs examined in the
recent COSO study, CFOs or CEOs were named in
83 percent of the cases (Beasley et al., 1999).
3
See Healy and Wahlen (1999) for a recent review
of this literature.
4
Bruns and Merchant (1990), Merchant and
Rockness (1994), and Fischer and Rosenzweig (1995)
all used the same set of earnings manipulation
scenarios, which were originally developed by Bruns
and Merchant (1990). Kaplan (2001) also used similar
scenarios.
5
Previous studies have investigated the effects of
many variables on auditors’ materiality judgments, but
few studies have investigated the effects of materi-
ality on aggressive financial reporting. For a review of
early empirical studies on materiality, see Holstrum
e.g., Carpenter and Dirsmith (1992) and Carpenter
et al. (1994).
6
If accountants or auditors subscribe to the efficient
markets hypothesis, they should assume that the prob-
ability of effect approaches zero, i.e., earnings manip-
ulations should be transparent and ineffectual in an
efficient market.
7
We acknowledge that in practice, higher levels of
financial risk may also have the opposing effect of
making management more “desperate” to improve
reported results, which may lead to added pressure on
financial executives for aggressive reporting. However,
holding the level of pressure constant, risk should
decrease the propensity for fraudulent reporting.
8
Two participants were employed by nonprofit
organizations.
9
It appears that a disproportionate number of
respondents had current or previous experience
working for publicly-traded companies. This is
probably attributable to the fact that the case dealt
with a public company, and the cover letter described
the project as a study of issues recently raised by the
SEC. However, any possible bias in favor of public
company respondents was not considered a cause for
concern, since these individuals should have been
more qualified to respond to the case.
 Effects on Materiality, Risk, and Ethical Perceptions
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