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Consequences of Earnings Management: The Need for Ethical Leadership in Accounting

Chapter 07

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Learning Objectives

L O 7-1: Describe the characteristics of financial statement restatements.

L O 7-2: Explain how errors in accounting and reporting can trigger restatements.

L O 7-3: Explain how restatements due to operational issues occur.

L O 7-4: Explain how corporate governance systems influence earnings management.

L O 7-5: Describe the characteristics of ethical leadership.

L O 7-6: Discuss how various leader types influence earnings management.

L O 7-7: Explain how ethical leadership in accounting might positively influence whether earnings management occurs.

Questions for Consideration

What is the difference between reissuance restatements and revision restatements of the financial statements?

How can earnings management lead to regulatory actions and why?

How can corporate governance reduce or even eliminate earnings management?

What is the role of ethical leadership and ethical leaders in keeping earnings management in check?

Ethical Reflection

Earnings management reduces the usefulness of reported results and has consequences for the company, top management, and the shareholders whose interests they are supposed to protect.

Audit Analytics describes the differences when financial statements are restated because of improper financial reporting by revising or reissuing the financial statements effected.

The S E C reported a total of 484 restatements in 2019 the lowest in 19 years analyzed.

However, the percentage of revision restatements is high: 79% of the total.

Revision restatements do not appear to the public to be as severe as reissuance restatements where the public is told not to rely on the original financial statements.

Earnings management is oftentimes the motivation for fraudulent financial reporting and has implications for the internal controls.

Earnings management often leads to S E C investigations for violations of regulatory requirements.

Earnings management has implications for ethical leadership that is often missing causing gaps in corporate governance and an environment that condones, it not directs, earnings management.

Characteristics of Financial Statement Restatements

Revision of financial statements that was previously publicly reported may be one of two types.

Reissuance restatements are the more serious, as past or previous financial statements cannot be relied upon.

Revision restatements do not undermine reliance on past financials.

“Stealth Restatements”

A restatement disclosed only in periodic reports and not in the 8-K, or amended periodic report such as a 10-K/A or 10-Q/A.

The S E C requires companies to disclose within four business days that past financial statements should no longer be relied on.

The 8-K form is designed to be an early warning system so that the public knows immediately about the financial statement restatements and does not have to wait until the statements are filed with the S E C.

Hertz Accounting Restatements

Hertz Global Holdings, Inc., filed its 2014 Form 10-K with restated results for 2012 and 2013 as well as selected unaudited restated financial information for 2011.

Hertz addresses the issue of non-G A A P financial measures including EBITDA, Corporate EBITDA, and how these amounts were calculated.

By comparing the validity of these amounts to pretax G A A P income, Hertz mislead readers into thinking that non-G A A P measures of earnings may be as reliable as G A A P amounts.

Restatements Due to Errors in Accounting and Reporting

Exhibit 7.3 Accounting Errors that Trigger Financial Statement Restatements

Category	Cause of Restatements
Revenue recognition	Improper revenue recognition, including questionable items and misreported revenue
Expense recognition	Improper expense recognition, including period of recognition, incorrect amounts; includes improper lease accounting
Misclassification	Improper classification on income statement, balance sheet, or cash flow statement; includes non-operating revenue in the operating category; cash outflow from operating activities in investment activities
Equity	Improper accounting for E P S; stock-based compensation plans, options, warrants, and convertibles
Other comprehensive income (O C I)	Improper accounting for O C I transactions, including unrealized gains and losses on investments in debt and equity securities, derivatives, and pension-liability adjustments
Capital assets	Improper accounting for asset impairments; asset-placed-in-service dates and depreciation
Inventory	Improper accounting for valuation of inventory, including market adjustments and obsolescence
Reserves/allowances	Improper accounting for bad debt reserves on accounts receivable, reserves for inventory, and provision for loan losses
Liabilities/contingencies	Improper estimation of liability claims, loss contingencies, litigation matters, commitments, and certain accruals

Cubic Corporation

Cubic Corporation restated financial statements due to errors in calculating revenues on certain long-term development contracts and on long-term service contracts with non-U.S. Government customers.

Cubic historically recognized sales and profits for development contracts using the cost-to-cost percentage-of-completion method of accounting, modified by a formulary adjustment which had the effect of deferring a portion of revenue and profits until later in the contract performance period.

Cubic also used the cost-to-cost percentage-of completion to revenues for its service contracts, which is only acceptable for U.S. Government contracts.

Restatements Due to Operational Issues

On May 6, 2019, Kraft Heinz Co. disclosed that it would restate its financial statements due to faulty procurement practices. This is an example where the timing of expense recognition triggered the restatement rather than error corrections in the accounting and reporting.

In a regulatory filing, Kraft said the investigation showed “several employees in the procurement area engaged in misconduct” that qualitatively affected its financial reporting for 2016, 2017, and the first three quarters of 2018.

According to Kraft, the misstatements “principally relate to the incorrect timing of when certain cost and rebate elements associated with complex supplier contracts and arrangements were initially recognized, and once corrected for, the company expects to recognize corresponding decreases to costs of products sold in future financial periods”

The adjustments to financial statements totaled about $208 million, of which approximately $27 million was recorded in the fourth quarter 2018 cost of products sold, leaving a cumulative net misstatement of $181 million.

Kraft said that “The findings from the investigation did not identify any misconduct by any member of the senior management team.” However, the facts indicate otherwise.

MagnaChip Semiconductor, Ltd

MagnaChip managed earnings using revenue techniques such channel stuffing and delaying write-offs of inventory.

Employees engaged in a “pull-in” sales practice whereby they offered distributors undisclosed concessions via side agreements to incentivize them to order products earlier than wanted or needed so that MagnaChip would hit revenue targets.

MagnaChip also improperly recognized revenue on “sales” of non-existent or unfinished products in order to meet revenue targets.

The company also recognized revenue on unfinished production of products.

MagnaChip violated G A A P because it recognized revenue on purported sales of products that had not yet completed manufacturing and therefore had not yet shipped or been delivered, and the risk of loss had not transferred to the purchaser.

S E C Clawback for Accounting Violations

Firms with clawback provisions are over 2.5 times more likely to report material misstatements as revisions compared with firms without clawback provisions (70.1 percent and 26.8 percent respectively)

Managers are more likely to use discretion afforded by the materiality rules to correct misstatements through revisions instead of restatements.

It was "an unintended consequence of clawbacks, namely that clawback provisions deter the filing of restatements upon a misstatement discovery"

Corporate Governance and Earnings Management

Companies that engage in earnings management raise questions about the role of corporate governance and consequences of earnings management.

How is it that managers, the board of directors, and audit committee failed to identify and stop earnings management?

What was management’s role in choosing to use various financial shenanigan techniques to make the company look better than it really is?

What role did the internal controls over financial reporting play in keeping earnings management at bay?

These are a few of the questions to be asked when evaluating the consequences of earnings management.

What is Ethical Leadership?

The Ethical Leader:

Understands that positive relationships are built on respect, openness, and trust.

Portrays the underlying principles of integrity, honesty, fairness, justice, responsibility, accountability, and empathy.

Aligns external actions with one’s internal values.

Strives to honor and respect others in the organizations.

Seeks to empower others to achieve success by focusing on right action.

Leads by example.

Has a vision of the future that entails some notion of the good.

Values-Driven Leadership

A leader needs to connect with organizational values.

Leaders must ask what they stand for and why.

Leaders must consider why others would want to follow them. The goal is to get in touch with what motivates one’s actions and how best to motivate those in the organization who look to the leader for direction.

Kouzes and Posner suggest that “Clearly articulating and, more importantly, demonstrating one’s values, forms the basis of a leader’s credibility—and credibility in leadership is character-based”.

Ethical Leadership Competence

Refers to the ability to handle all kinds of moral problems that may arise in an organization.

Requires developing the competency to reason through ethical conflicts in a systematic way, judgment and reflection on what the right thing to do is.

Thornton identifies five levels of ethical competence.

Personal and Professional – accounting professionals should internalize the values of the profession, including objectivity, integrity, diligence, and duty to society.

Interpersonal – working in teams requires respect of others and fair-mindedness.

Organizational and Societal – auditors should follow the ethics codes and expectations of their organization, but they should never compromise their professional identify.

Authentic Leaders & Followers

Authentic leaders are,

Focused on building long-term shareholder value, not in just beating quarterly estimates.

Individuals who are deeply aware of how they think and behave and are perceived by others as being aware of their own and others’ values/moral perspectives, knowledge, and strengths; aware of the context in which they operate; and confident, optimistic, resilient, courageous, and of high moral character.

Acknowledging the ethical responsibilities of their roles, authentic leaders can recognize and evaluate ethical issues and take moral actions that are thoroughly grounded in their beliefs and values.

Followers are,

Likely to emulate the example of authentic leaders who set a high ethical standard.

Empowered to make ethical choices on their own without the input of the leader.

Becoming moral agents of the organization.

Transformational Leadership

Transformational leadership is defined as a leadership approach that causes change in individuals and social systems.

It creates valuable and positive change in followers with the end goal of developing followers into leaders.

It enhances the motivation, morale, and performance of followers through a variety of mechanisms and includes:

Connecting the follower’s sense of identity and self to the mission and the collective identity of the organization.

Being a role model for followers that inspires them.

Challenging followers to take greater ownership for their work.

Understanding the strengths and weaknesses of followers.

Transformational leadership is more effective than transactional leadership, where the appeal is to more selfish concerns.

Transformational leaders raise the bar by appealing to higher ideals and values of followers.

Followership & Leadership

The flip side of leadership is followership.

Introduced by Hollander and Webb, the term followership is characterized as an independent relationship in which the leader’s perceived legitimacy can affect the degree to which followers allow themselves to be influenced.

Followership, servant leaders (next slide), and authenticity all share one common characteristic: Leader ethicality.

De Cremer and Tenbrunsel define leader ethicality as the intention to demonstrate normatively appropriate conduct and to create an environment within which others will be encouraged to act ethically and discouraged from acting unethically.

The social perception of a leader’s legitimacy may play an important role in determining how the leader’s morally relevant actions are interpreted and the influence leaders have on followers.

Leadership and followership are reciprocal relationships with one influencing the other.

Servant Leadership

Servant leadership advocates a perspective that leaders have a responsibility to serve their followers by helping them achieve and improve by modeling leaders’ ethical values, attitudes, and behaviors that influence organization outcomes through the fulfillment of followers’ needs.

Leaders should put the needs of the followers before their own needs.

Servant leaders use collaboration and persuasion to influence followers rather than coercion and control; they understand their stewardship role and are accountable for their actions.

Social Learning Theory

Social learning theory holds that individuals look to role models in the work context, and model or imitate their behavior.

Modeling is acknowledged to be one of the most powerful means for transmitting values, attitudes, and behaviors.

Leaders who engage in unethical behaviors create a context supporting what Kemper calls “parallel deviance,” meaning that employees observe and are likely to imitate the inappropriate conduct, especially if leaders are rewarded for the unethical conduct.

The social learning approach argues that because of leaders’ authority role and the power to reward and punish, employees will pay attention and mimic leaders’ behavior, and they will do what is rewarded and avoid doing what is punished in the organization.

Ethical Skills of Leaders in Accounting Firms

Defined as the capacity to rigorously apply rules and procedures.

Independence – keeping a professional distance from the client.

Confidentiality – keeping confidential information confidential.

Having integrity, perseverance, humility, objectivity and acting on your values.

Ethical Leadership and Audit Firms

The promotion of responsible leadership is seen within audit firms as a way to improve audit quality.

Responsible leadership is a critical component of setting the proper tone and encouraging members of the organization to ask probing questions when management’s representations are unclear or unsubstantiated.

Authentic partner leaders gain the confidence of audit staff and managers and create a foundation for ethical decision making.

Ponemon found that leaders of accounting firms set the tone of their organizations, promoting those whose personal attributes more closely reflected the leaders’ perceptions and moral reasoning development.

Ponemon hypothesized a correlation between the organizational culture created by leaders of the accounting firms and the subordinates’ personal characteristics and decision-making styles.

Ethical Leadership and the Internal Audit Function

Chambers identifies attributes of internal audit leadership behavior including honesty, courageousness, accountability, empathy, trustworthiness, respect, and proactiveness.

Internal auditors can sometimes be bullied by C F Os which makes it more difficult for them to carry out their ethical obligations.

Auditors may take their cue from executive management’s behavior, especially if such behavior is the social norm and has been rewarded in the past.

A high quality internal audit function can reinforce the tone at the top and provide guidance for decision makers by monitoring internal control and management’s actions.

Culture and Ethical Leadership in Accounting

Accountants and auditors are less likely to report financial wrongdoing if they perceive that past attempts by others in the organization to blow the whistle internally lead to retaliation.

Having an ethics hotline enhances reportability and ethical leaders should support such efforts.

Brennan and Kelly studied the propensity or willingness to blow the whistle among trainee auditors.

The factors studied included audit firm organizational structures, personal characteristics of whistleblowers, and situational variables.

The authors found that formal structures for whistleblowing and internal (versus external) reporting channels increase the likelihood of the subjects’ reporting of an ethical violation by an audit partner.

Aaron Beam & HealthSouth

The $2.8 billion HealthSouth fraud involved recording fake revenues on the company’s books from 1996 through 2012 and correspondingly adjusting the balance sheets and paper trails.

Aaron Beam, a former C F O, allowed the C E O, Richard Scrushy, to bully him into manipulating financial reports to reflect the numbers Scrushy promised investors.

“I should have had the courage to stand up and say, ‘No, we can’t cross this line,’” Beam said.

Health South

Beam was not alone to fall prey to Scrushy.

Four other C F Os all failed in their duties.

Once in, they could not get out – Scrushy even stated to one C F O, if you quit you will be the fall guy.

Their head of internal audit did not even try to do their job appropriately.

None of them displayed the courage needed to be an effective leader in the accounting profession.

When Are Auditors More Likely to Report Wrongdoing?

The following points highlight when auditors are more likely to report wrongdoing:

superiors and top management do not place obstacles in their way;

the reporter has a high commitment to the organization and/or colleagues;

the issue has high moral intensity;

ethical dissonance is not present; and,

the reporter perceives the organization provides reliable outlets (i.e., hotline) to report wrongdoing and retaliation will not occur.

Concluding Thoughts

Financial Statement Restatements occur because of the use of aggressive accounting techniques (i.e., financial shenanigans)

These techniques are used to manage earnings and make the company look better from quarter to quarter and year to year.

In order to avoid S E C lawsuits for improper financial reporting, companies must tighten their corporate governance system and build ethical leaders.

Ethical leaders can set the tone for subordinates who then become followers in the organization. To build ethical leaders, the organization must commit to doing the right thing at every turn.

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