School of Accounting Seminar Series Semester 2, 2012

Earnings management decisions: The role of economics and ethics

Paul Coram The University of Melbourne

Date: Friday, 3rd August 2012 Time: 3.00pm – 4.30pm Venue: Tyree Energy Technologies Building LGO5

(Refer to campus map reference H6 here)

Australian School of Business School of Accounting

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Earnings Management Decisions: The Role of Economics and Ethics

Paul Coram

The University of Melbourne

James Frederickson

Melbourne Business School

Matt Pinnuck

The University of Melbourne

July 20, 2012

ABSTRACT: This study through a survey of 225 CFOs and CEOs of listed companies

attempts to better understand earnings management (EM) decisions. We extend Graham

et al. (2005) by providing participants with a case study scenario which asked them to

decide on whether to manage earnings when earnings were not expected to meet market

expectations. The survey then evaluates how they incorporate economic factors such as

costs and benefits to various stakeholders in their decision making, as well as evaluating

whether their perception of whether EM is ethical makes a difference. We find the most

significant economic factor affecting the EM decision is to avoid the costs to current

shareholders from not managing earnings to meet the market expectations. However, the

perception of whether EM is ethical and the related issue of whether EM is perceived as

lying are also significant factors that affect the decision to manage earnings. Finally, we

provide evidence that the choice by managers on the method of accrual compared to real

operational EM is primarily driven by ethical perceptions of these alternative actions.

[Draft – please do not quote without permission]

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I. INTRODUCTION

Earnings management (EM) is a pervasive aspect of corporate reporting which accounting

researchers attribute to contracting or market based incentives. However, despite the wealth

of archival literature on this topic there is relatively little research on the decision making

processes of managers who undertake these actions with the exception of Graham et al.

(2005). Motivated by the lack of understanding of the decision making processes by

managers we conduct a survey of 225 CFOs and CEOs of listed companies (hereafter

‗managers‘) in relation to EM to examine how they weigh up the various economics factors

in making their decisions. We also evaluate whether factors beyond economics such as

ethical considerations affect these decisions as recent economic research has questioned the

assumption of economic man (Benabou and Tirole 2011) and notes there is ample evidence

that people often behave ―morally‖.

EM refers to situations where managers apply accounting standards and/or structure

transactions to alter the company‘s financial statements with the intent of either misleading

some stakeholders about the company‘s true economic performance or influencing

contractual outcomes that are based on reported accounting numbers (Healy and Wahlen

1999). Prior archival research has documented that managers are more likely to manage

earnings in certain situations such as when unmanaged earnings are below an important

benchmark or when the firm is in danger of violating an accounting-based debt covenant and

commonly have used a version of the Jones (1991a) model to measure EM (see, e.g., Fields et

al. 2001, Dechow and Skinner 2000, or Healy and Wahlen 1999 for summaries). However,

documenting situations where managers are likely to manage earnings provides only a partial

picture of factors that influence managers. A complete picture requires that we understand the

specific factors that managers consider when deciding whether to manage earnings in a

particular situation. Through a variety of mechanisms that are based on accounting numbers

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(e.g., debt covenants, investment decisions, and so forth), EM redistributes wealth across a

range of stakeholders (e.g., the manager, current shareholders, current debtholders, future

shareholders). Presumably, the decision whether to manage earnings in a particular situation

is based on managers undertaking an expected cost-benefit analysis that incorporates the

effects on the various stakeholders potentially affected in that situation. Understanding which

stakeholders (and the expected costs and benefits to those stakeholders) managers consider

when deciding whether to manage earnings and how they trade off the expected costs and

benefits is critical for designing governance structures and compensation packages that will

curtail EM.

To better understand the EM decision, a prominent survey by Graham et al. (2005)

attempted to address a number of important questions from the prior literature such as which

benchmarks are most important to managers and what factors motivate managers to manage

earnings or make real operational adjustments. Their survey provided a rank ordering of

CFOs perceived importance of each motive to manage earnings and found managers were

most interested in meeting or beating earnings benchmarks to influence stock prices and their

own reputations. A surprising finding to emerge from their study is that managers prefer to

manage earnings via real operational methods rather than by accounting adjustments. In

considering this finding Graham et al. (2005) speculated that these responses may have been

affected by ethical considerations, which had been found in an earlier study by Bruns and

Merchant (1990). These findings as well as recent economics research that has questioned the

assumption of economic man (Benabou and Tirole 2011) raise the issue of whether

considerations beyond economics are factored into managers‘ decisions, which is part of

what we examine in this paper. This research project will disentangle the effects of the

various competing economic factors as well as ethical considerations that may affect

managers‘ decisions to engage in EM.

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Our approach to address these questions is by a survey that places managers in a

situation where there is pressure created by earnings being below market expectations and

then asking them to make a decision on whether they would manage earnings, and if so,

whether they would use real operational or accounting adjustments. The specific motives of

managers are then identified by asking questions on the magnitude of costs to various

stakeholders from the various available alternatives of: doing nothing; managing earnings

using accounting adjustments; or managing earnings using real operational adjustments.

Questions were also asked about managers‘ perceptions on whether undertaking EM is

ethical and also whether they think it is lying. This enabled us to model factors that influence

managers in deciding whether to manage earnings, and also factors that affect the approach

they would use to manage earnings (i.e., real versus accounting adjustments). We can

therefore more explicitly examine how managers consider the effects on various stakeholders

as well as the relative importance of economics and ethics in their decision making on EM.

This study is the first to try and more comprehensively understand managers‘ decision

making in this area. It provides several important new insights. First, we document the

evaluation of economic costs and benefits to stakeholders by managers in deciding on

whether to undertake EM. Second, we show managers‘ perceptions of the ethics of EM

actions and the related concept of whether they perceive EM as lying both provide significant

explanatory power in the decision to manage earnings. Finally, we examine the factors that

affect the choice between real operational and accounting EM or alternatively, why some

firms decide to do nothing. Again, economics is important but ethical considerations also

affect this choice. In summary, for both the decision to manage earnings and the method of

managing earnings we find that economics and ethical factors are important.

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II. LITERATURE REVIEW

Earnings Management

The question of why and when managers manage earnings has been the subject of

significant research over many years. It is an important topic that is of interest both to the

accounting profession and regulators as high profile cases of ‗earnings management‘ have

resulted in significant negative publicity for the accounting profession. The main motivations

for undertaking EM documented in the prior literature has come from either contracting or

capital markets based incentives. From a contracting perspective, studies on the effect of

being close to breaching a lending covenant have generally found little evidence of EM

(Healy and Palepu 1990; DeAngelo et al. 1994). The effect of management compensation

contracts on EM has however found evidence consistent with expectations from contracting

theory (Healy 1985; Guidry et al. 1999). DeChow and Sloan (1991) also observed real

operational EM by observing CEOs in their final years reducing R&D spending to increase

reported earnings.

More recently, the EM research has focused more on capital market incentives. Evidence

shows that managers overstate earnings prior to initial public offering of stock (Teoh, Welch

and Wong 1998). There has also been research that has observed EM to meet the expectations

of analysts (Kasznik, 1999). The focus on the importance of meeting these targets does

suggest that the decision to manage earnings is a more complex decision with a number of

possible costs to various stakeholders compared to if it is based solely on contracting factors

alone. Graham et al (2005) find that two of the most important benchmarks for managers are

meeting analysts‘ expectations and prior earnings.

The contracting and market based studies have identified situations where EM is

expected to occur and then observed whether it does. It has examined a number of separate

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and different factors that are associated with EM. However the situations provides no

understanding of the underlying economic motivations of the corporate manager. Positive

accounting research (Watts and Zimmerman 1986; Christie and Zimmerman 1994), under

which research on EM is typically classified, assumes that when deciding what decision to

make, managers maximize an objective function. Given that the manager‘s objective function

is unknown, the only way to fully understand the EM decision in an unbiased manner is to

specify and test an objective function that meets two conditions. The first is that the

objective function includes all key stakeholders likely to be affected by the EM decision.

Without including these stakeholders, it is impossible to identify and understand how

managers trade-off different stakeholders when deciding whether to manage earnings. Further,

if the net expected costs or benefits from EM are correlated across two or more stakeholder

groups, including all potentially relevant stakeholders is necessary to avoid a correlated

omitted variable problem. From a broad stakeholder theory perspective (Jensen 2001),

managers‘ objective functions could potentially reflect the expected costs and benefits to the

following stakeholders: the manager, current shareholders, current debtholders, other current

stakeholders (e.g., suppliers, employees, customers), and future stakeholders.

The second necessary condition is that the empirical test must reflect both the expected

costs and benefits to each stakeholder group if earnings are managed versus if they are not.

For example, assume that the benefit to the manager from managing earnings is a bonus

while the costs are job and reputation loss if the EM is detected. If the empirical test includes

only the expected benefits or only the expected costs, as is common in the existing research,

the net expected cost/benefit is measured asymmetrically, which in turn will yield

significantly biased inferences about the relative importance of each stakeholder.

Graham et al. (2005) attempted to answer some of these questions about the EM decision

through a survey. However, in doing so they raised more questions, particularly relating to

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other considerations such the role of ethics in these decisions and the use of real operational

EM both of which are addressed in this present study.

Ethics

Defining ethics is difficult, although it relates to a basic question of ―What ought one to

do?‖1 In examining the effect of ethics on EM, Merchant and Rockness (1994) noted that

most EM acts were legal, however the ethical perspective raised the question of whether they

were the ―right things to do‖ (p.81). The difficulty in determining what one ought to do or the

right thing to do comes from the fact that people bring morality and values to their ethical

decision making, which comes from traditions or theories – which will vary between

individuals. Further complexity in evaluating an ethical dilemma can be due to important

values held by individuals may conflict. For example, two important values that many

cultures and traditions agree upon as morally right would be to tell the truth and to not cause

others harm. What happens when these two values conflict? The answer to this might then

depend on the ethical theory that an individual ascribes to. A teleological approach assesses

the rightness or wrongness of something by the consequences, therefore they would choose

lying over harming others. A deontological approach relates to universal laws, therefore if

they think that lying is always wrong, they would tell the truth under all circumstances. A

recent experimental paper by Johnson et al. (2012) provides some evidence that for many

managers, the ends may justify the means in relation to EM, thereby suggesting that

managers may adopt a teleological approach to this decision.

There is limited research that has examined ethical considerations on managers‘ decision

making relating to accounting. This may be partially due to the assumption underpinning

positive accounting theory that managers actions will only be in their own self interest (Watts

1 This question was raised by Socrates in the fifth century BC.

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and Zimmerman 1986). Erhard and Jensen (2012) have proposed a positive model of integrity

which relates to ―honoring ones word‖. They assert their definition of integrity has nothing to

do with morality and ethics, which are normative concepts. While it is true that they are

normative concepts, there has been significant interest in ethics in recent years due to the

perceived lack of ethics in some of the high profile corporate collapses in the early 2000s, as

well as in the current global financial crisis. In addition, some have recognized that in order

for economic settings to function smoothly, ethics and trust are necessary (e.g., Holmstrom

2005; Noreen 1988).

In discussing their finding that US CFOs prefer to manage earnings via real operational

methods, Graham et al. (2005) speculate—but do not test—that this effect could be due to

ethical considerations. In this discussion, Graham et al. make reference to the study by Bruns

and Merchant (1990) who found that managers perceive managing earnings via real

operational methods to be more ethical than using accounting methods. A number of studies

have examined the ethical dimension in decision making and Loe et al. (2000) provide a good

review of this literature. However, from this review, it is apparent that the majority of this

research has focused on the role of awareness, individual and organizational factors in ethical

decision making. An exception was Merchant and Rockness (1994) who examined the

morality of EM with a focus on the moral issue itself. They found some evidence that the

acceptability of various EM practices varied with the type, size, timing, and purpose of

actions. Their reasoning for applying an ethical perspective is because many types of EM

behaviors are not obviously acceptable or unacceptable. Therefore the concept of whether the

actions are the ‗right thing to do‘ can become important.

In the evaluation of an ethical decision, it is a determination of what is acceptable, or

therefore what is ‗right‘. Our study will be the first to evaluate whether the decision making

of managers goes beyond the traditional economic considerations to explain EM. It will

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address the question of how managers see these decisions. Are these purely economic

decisions in that the actions by managers are solely in their self interest? Due to contract

design, this self interest is also usually linked to the short term effect on the company.

Alternatively, does ethics in determining what is ‗right‘ beyond personal self interest come

into these decisions. Jones (1991b, p.367) defined an ethical decision as a ―decision that is

both legal and morally acceptable to the larger community‖, and a moral issue as being

present when ―a person‘s actions, when freely performed, may harm or benefit others‖ (from

Velasquez and Rostankowski, 1985). Jones developed the concept of moral intensity as a

framework to evaluate the moral issue itself itself over six dimensions, which are: magnitude

of consequences; social consensus; probability of effect; temporal immediacy; proximity; and

concentration of effect. Most of these are specific considerations on the effect of the decision

on others – although social consensus might include other aspects, e.g., whether the action is

perceived as lying or not. Our study takes into account some of these other considerations

(which we define as economic factors in the survey) to provide a comprehensive

understanding of the factors affecting managers decision making in relation to EM.

In determining what is ‗right‘ a deontological approach to ethical decision making would

expect that individuals should tell the truth under all circumstances whereas a teleological

approach would take the view that the consequences were most important.2 Both of these

approaches contrast with a purely economic perspective where it would be assumed that a lie

would be told whenever it benefits the liar and irrespective of the effect on any other party.3

Gneezy (2005) experimentally evaluated whether people do behave in this way or whether

the propensity to lie is affected by differing gains to the individual or consequences to others.

He found that people are sensitive to the amount of their gain when deciding to lie and are

2 Erhard and Jensen‘s (2012) concept of integrity would seem to be much more focused on the former rather

than the latter. 3 The economic approach is concerned with some consequences – that is, those related to the individuals self

interest.

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also sensitive to the level of harm to others from the lie. In relating this to EM, this would

suggest that whether the manager thinks that EM is lying will have a significant effect on his

or her behavior. We will test these findings of Gneezy (2005) in this study by evaluating

whether those who think that EM is lying will still undertake these actions based on

variations in the benefits and consequences to others.

Recent accounting studies have shown that managers‘ decisions on EM can be affected

by more than the traditional motivations as would be expected based on economic theory.

McGuire et al. (2012) found that greater levels of religiosity are associated with less EM.

Although not explicit in that paper, for many religious people ‗lying‘ is perceived to be

wrong in an absolute sense, which may the reason for this finding. A recent survey by

Abernathy et al. (2012) found an ethical work climate that focuses on ‗self‘ yields agents who

are more likely to manipulate accounting earnings. Hunton et al. (2011) found an association

between perceived tone at the top and accruals quality. Dikolli et al. (2012) found a positive

association between the managerial trait of integrity as defined by Jensen (2009) and accruals

quality. In summary, these studies provide some evidence to suggest exploring factors that

might explain decision making beyond economics can be important.

As well as consideration of the ethics of deciding to manage earnings or not, the choice

of EM method also appears to be one partly driven by ethical considerations and we consider

this issue in the next section.

Real Earnings Management

Real earnings management (REM) is when managers undertake actions that ―change the

timing or structuring of an operation, investment, and/or financial transaction in an effort to

influence the output of the accounting system‖ (Gunny, p.855, 2010). Studies have shown

that REM exists, such as Roychowdhury (2006) who developed empirical proxies for REM

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and found that managers avoid reporting losses by undertaking REM. There is also evidence

of an increase in REM in recent years as the method by which to undertake EM (Bartov and

Cohen 2009). This is consistent with the findings by Graham et al. (2005), who found 80

percent of their sample of CFOs said they would undertake REM to meet an earnings target.

Graham et al. expressed surprise at these findings as they reasonably assert that these

decisions are ones that sacrifice economic value. However, interestingly, recent archival

research seems to suggest that firms undertaking REM perform at least as well or better than

those who do not in the longer term (Gunny 2010). It should be noted that REM studies still

suffer from the measurement issues associated with studies on accrual EM (see Fields et al.

2001) and also the problem of determining whether the changes in actual decisions are

undertaken solely for financial reporting reasons. Archival studies are not able to evaluate

why the decision to make the real operational adjustments occurred.

Irrespective of some of the recent changes in preferences for managers to use real rather

than accrual EM, the key questions about the factors that affect their decisions of this nature

are largely unexplored. Some experiments have examined these questions relating to

motivations for REM, such as Bhojraj and Libby (2005) who showed evidence of managerial

myopia to meet earnings benchmarks. Further, Seybert (2010) found that allowing

capitalization of research and development would lead to REM through overinvestment in

continuing projects so managers could avoid reputation damage from asset impairment. As

noted earlier in this paper, the survey by Graham et al. (2005) found a preference by

managers to use REM. McGuire et al. (2012) found religiosity is negatively associated with

abnormal accruals, but positively associated with proxies for REM. For religious people

values that inform ethical decision making can be guided by prescribed moral rules (such as

lying is always wrong), this therefore provides some evidence consistent with prior research

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that suggests managers‘ perceive REM to be more ethical than accrual EM (Bruns and

Merchant 1990; Graham et al 2005).

III. RESEARCH QUESTIONS

Our study examines a decision by managers on whether to manage earnings and how

they will manage earnings when they are below market expectations. In evaluating the

economic considerations that affect manager‘s EM decisions the first order effect that we

examine is the economic considerations of the likelihood of success of the action and the

direct effect on the manager. We then explore whether the direct effect on the manager is due

to consideration of shareholders and other stakeholders and the relative importance of these

groups in the decision making process. This has not been done before and will provide insight

into some important questions on why managers make these decisions.

We also ask managers their perceptions on the ethics of EM to see whether it plays a part

in their decision making process. In discussing the fact that CFOs stated they were more

willing to report taking real decisions rather than accounting decisions, Graham et al (2005)

suggest that this effect could be due to ethical considerations. This present study will also

explore the effect of ethical considerations on managers‘ decision making process. Merchant

and Rockness (1994) examined the ethics of EM but took a very different approach to our

study.4 We will evaluate whether the harm to others affects decision making and whether

managers see this effect as an ethical consideration. Due to contracts, sometimes the harm to

others has a direct effect on the manager. We will evaluate whether some considerations of

4 Merchant and Rockness used a questionnaire that consisted of 13 potentially questionable earnings

management activities, these varied by: type of action; consistency with GAAP; the direction of the effect on

earnings; materiality; the period of effect; and the purpose in mind. They then asked participants the ethical

acceptability of each case presented and they found that ethical judgments were affected by the type of earnings

management and that using real compared to accounting methods to adjust earnings was much more ethically

acceptable.

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the harm to others takes on an ethical dimension, beyond managers‘ self interest. As there

have been very few studies to try to understand the decision making processes of managers

associated with EM, we will frame our study in terms of research questions.

The first research questions therefore relates to the question of why managers manage

earnings:

RQ 1: What economic factors are important in the decision to manage earnings?

RQ 2: What is the relative importance of economics and ethics on the decision to

manage earnings?

By determining whether ethics makes a difference beyond the potential harm to

stakeholders, we are moving towards exploring values that inform ethical decision making

that are not related to economics at all such as whether the action seems the ―right thing to do‖

or whether it involves lying or not. As noted by Gneezy (2005), extreme economic theory

would suggest that ―lies will be told whenever it is beneficial to the liar‖(p.384). This would

seem to be contrary to the positive notion of integrity which means to ―honor ones word‖ as

proposed by Erhard and Jensen (2012). By definition as per Healy and Wahlen (1999) earlier

in this paper, EM involves deception therefore technically it could be construed as lying. We

therefore raise the question that has not been previously considered in the literature: whether

managers (a) view EM actions as ‗lying‘, and if so (b) will they still do it?

RQ 3a: Is earnings management perceived as lying?

RQ 3b: Does perceiving earnings management as lying affect the decision to manage

earnings?

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Gneezy (2005), showed that inconsistent with an economic theory, individuals are

sensitive to the harm that lying may cause to others. The third research question therefore

examines whether this finding applies to the EM decision to see whether the decision to

manage earnings for those who think EM is ‗lying‘ is affected by the costs and benefits to

other parties. We address this as follows:

RQ 4: Where EM is viewed as lying, is the decision to undertake EM affected by the

costs and benefits to other parties?

The final issue that we examine is how managers decide whether to adjust earnings – by

real or accrual earnings adjustments? Graham et al. (2005) provided the interesting finding

that managers prefer real over accrual EM techniques. In evaluating their findings, they

thought that the response of managers to their survey question on this issue may have been

affected by whether they perceived the two approaches as ethically different. Studies in

recent years have examined REM and found some evidence of it being associated with future

firm value (Gunny, 2010). However, even if the decision is made for financial reporting

reasons, for many firms it is quite possible that reductions in expenditure for the purposes of

managing earnings (REM) might also be beneficial to the efficiency of the firm in the longer

term anyway. That is, the ‗requirement‘ to reduce real expenses to manage earnings may act

as an impetus to improve efficiencies in the longer term. This argument would support the

findings of Gunny (2010). We will be able to evaluate whether managers choosing to

undertake REM are doing it with consideration of future shareholders. Our study will be the

first to examine perceived costs and benefits to stakeholders and whether ethics are

considered by managers when actually making a choice of real versus accrual EM.

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We evaluate whether ethics affects this choice as follows:

RQ 5: What is the relative importance of economics and ethics on the choice of

method to manage earnings?

IV. RESEARCH DESIGN

A difficulty inherent in the archival studies of EM that examine specific incentives to

manage earnings is due to endogeneity and correlated omitted variables problems, as a result

this makes it difficult to draw strong causal influences to explain this behavior (e.g., Fields et

al. 2001). As pointed out by Libby and Seybert (2008) in a review of behavioral studies of

EM, the advantage of experiments and surveys is that they can address unanswered questions

from prior archival research. They further state that behavioral studies of EM are able to

isolate specific motives for EM and causally link them to EM attempts. How managers

actually consider these economic and ethical factors and make these tradeoffs are empirical

questions which will be examined by a survey in this research paper.

Participants

A survey was sent to all the CFOs and CEOs of approximately 1200 of the largest public

companies in Australia.5 This was done by obtaining a mailing list as well as significant hand

collection of data. For all of the CEOs we attempted to find the related CFO if we did not

have them already, similarly for all of the CFOs we attempted to find the related CEO. This

process ultimately resulted in a list of 1044 CFOs and 1180 CEOs who were sent the surveys.

5 Australia has a similar corporate governance framework and institutional environment to the United States (see

Leuz et al. (2003)). Prior research has also shown that earnings benchmark beating is important in the Australian

environment (Carey and Simnett 2006). Although SOX was obviously not introduced in Australia, there were

significant regulatory changes imposed at about the same time through CLERP 9. There is no evidence to

suggest that they CFOs and CEOs would respond in any differently from an equivalent group in the US to a

survey of this type.

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The first survey was mailed out in December 2009. To encourage responses a donation

would be made on their behalf on completion of the survey. The number of responses

(response rate) from the first mail out was 82 CFOs (7.9%) and 59 CEOs (5.0%). A second

request was sent in April 2010, this resulted in the sample increasing to 146 CFOs (14%) and

90 CEOs (7.6%) to give a total sample size of 236. The final number analyzed in this paper

was 225 as we excluded any respondents who did not answer the majority of questions. For

this type of participant group the response rate is reasonable, for example, Graham et al.

(2005) achieved an overall average of 10.4% in their survey of financial executives.

Of the respondents, 62% were CFOs and 38% were CEOs. As would be expected they

were very experienced with an average of 23 years of professional work experience,

including an average of 4.8 years in their current positions. A significant number (65%) had

professional accounting qualifications, with 20% CPAs and 45% Chartered Accountants.

Ninety-two percent of respondents were male.

Survey Task

The participants were provided with information about a hypothetical company facing a

situation where the earnings per share is not going to meet the markets‘ expectations by 4%.6

Some extracts from the survey are presented in the Appendix. They were then told there were

two possible actions that were available under these circumstances. First, take no special

action, or second, try to improve reported performance by either accounting or operational

adjustments. They were then asked in Question 1 the likelihood that their firm would improve

reported performance using accounting or operational adjustments on a scale of 0 (certain not

to happen) to 100% (certain to happen). This was then followed by a direct question (Qu. 2)

6 Considerable feedback from practitioners and academics was incorporated in determining this amount. Four

percent was decided on because: (a) it was a significant amount; (b) achievable to be adjusted by real or

accounting means in the time frame outlined in the case study materials; and (c) it was less than 5%, which is an

important materiality benchmark for auditors. The responses to the survey would suggest that the percentage

chosen was reasonable.

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on the decision their firm would actually make in this situation to either take no special

actions or try to improve reported performance. If they selected the latter, they were further

asked whether they would rely solely on accounting adjustments (0%) or operational

adjustments (100%). In the final part of this section in Question 3 they were asked their

perceived likelihood that their firm could increase reported earnings by each of the possible

options of: only accounting adjustments; only operational adjustments; or a combination of

both.

The next part of the task was to evaluate the magnitude and likelihood of costs for each of

the stakeholder groups that might be affected by each of the three possible alternatives

(Questions 4, 5 & 6). The stakeholder groups comprised: CFO and CEO; company in the

short term; company in the long term; company‘s current shareholders; company‘s future

shareholders; company‘s debtholders; and other stakeholders (e.g., employees, customers, or

general public).7

To assess the ‗ethics‘ associated with the options available, we asked how ethically

questionable the participant assessed each course of action (Qu. 13), which was to get an

overall sense of the participant‘s perceived ‗rightness‘ or ‗wrongness‘ of the action. Second,

we asked whether the participant thought that manipulating earnings through accounting or

operational adjustments was ‗lying‘ (Other Questions 2 & 3), which is an important value

many people bring to their ethical decision making.

Extensive time was spent on developing the survey with reference to the prior literature

on EM. An important criteria in this development was that the participants had to make a

‗decision‘ so that modeling of the factors that were associated with that decision could occur.

The draft survey was circulated to a number of experts for comment before it was finalized.

7 Other questions were asked about corporate governance. However, these responses are not included in this

paper.

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The experts who perused the materials and provided us with comments, included: three

academics, two regulators, two business professional association members, one technical

audit partner, and one retired CFO of a top 100 Australian company. The feedback from the

experts was considered by the research team and incorporated where appropriate into the case

materials.

V. RESULTS

Descriptive Statistics

Table 1 reports descriptive statistics relating the various questions from our survey about

EM. Question 1 asked managers the likelihood that they would manage earnings and the

mean response of 54% indicates it is more likely on average that managers would choose to

manage earnings. In Question 2 they were asked to actually make a decision and 68% said

that they would manage earnings. For those who would manage earnings, the clear preference

was to use operational adjustments with an overall average of 74%. Question 3 asked

perceptions on the likelihood of success of each of the methods to manage earnings and using

a combination of accounting and operational adjustments is most likely to be successful

(62%), followed by operational (51%), and then accounting adjustments (38%).

INSERT TABLE 1 ABOUT HERE

Questions 4, 5 and 6 asked about the costs to various stakeholders of the options

available on a scale of 0 = absolutely no costs to 100 = very large costs. Question 4 related to

the costs of taking no special action rather than managing earnings. This question by

addressing the costs of taking no action provides a measure on the benefits of EM. The three

questions where the costs are perceived as most significant (>40) are on the CFO and CEO,

company in the short term, and the company‘s current shareholders. Question 5 asked about

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the costs of accounting adjustment. Costs to the company in the long term are highest with a

mean of 41, which is consistent with accrual reversal of these types of adjustments in the

longer term. The effect on the CFO and CEO were also high with a mean of 38, which is

consistent with the potential consequences of these types of actions if they are detected.

Question 6 asked about costs of operational adjustments and generally the perceived costs are

lower than those for accounting adjustments. The highest cost is for the company in the long

term, with a mean of 34. This is consistent with the proposition that real operational EM

sacrifices economic value.

Table 2 presents correlations between the some of the variables reported in Table 1.

There is a high level of correlation between the various costs associated with doing nothing

(Qu 4). There is also a correlation between perceptions of EM actions as unethical (Q13_2)

and perceptions of whether they are lying for both accounting adjustments (OQ2, 0.33) and

operational adjustments (OQ3, 0.77). Another correlation of note is that if participants

thought that operational earnings adjustments were unethical or lying they were less likely to

adjust earnings and also much less likely to use it as a method of managing earnings.

INSERT TABLE 2 ABOUT HERE

Why Do Corporate Managers Manage Earnings?

A conceptual model of the EM decision was developed that included all economic and

ethical reasons for the decision. OLS regressions were then estimated that included all of the

economic and ethical responses of participants as independent variables. We estimated two

regressions with: (i) the decision to manage earnings as the dependent variable; and (ii) the

decision on the method of managing earnings as dependent variable. The estimated

regressions are as follows:

20

(a) EM (Q1) = (Economic Consequences, Ethics and Lying)

(b) EM (Q2-2) = (Economic Consequences, Ethics and Lying)

To evaluate the first and second research questions five regressions were run with the

decision to manage earnings as the dependent variable and they are reported in Table 3 below.

These regressions are to try and explain the tradeoffs between stakeholders and other

considerations by managers in their decisions on whether to manage earnings.

INSERT TABLE 3 ABOUT HERE

The first regression (a) in Table 3, includes the likelihood of success of the various EM

actions (Q3) as well as the benefits and costs of taking the actions on the CEO/CFO (Q4A_1,

Q5A_1, Q6A_1). The overall R2 for this first regression is 0.24. The likelihood of success

through accounting adjustments (Q3_1, p=0.077), operational adjustments (Q3_2, p=0.001),

or and a combination of operational and accounting adjustments (Q3_3, p=0.002) are all

significantly associated with the decision to manage earnings. If managers perceive there is a

cost to themselves to doing nothing they are more likely to manage earnings (Q4A_1,

p=0.002). However, they also are more likely to manage earnings if they think there is a low

cost to themselves from accounting adjustments (Q5A_1, p=0.10). The second regression (b)

incorporates the benefits and costs to shareholders and other stakeholders from the decision

to manage earnings and the R2 increases to 0.31. The interesting finding from this regression

is that once these other factors are included, the significant effect for self interest to

CEO/CFOs goes away. The most significant benefit of EM to emerge from the second

regression is the avoidance of costs to current shareholders by managing earnings (Q4A_4,

p<0.001). This suggests that current shareholders are the mediating factor in manager‘s

consideration of the effect on themselves. The other costs to emerge as significant are if there

are perceived low costs to future shareholders (Q5A_5, p=0.102) or debt-holders (Q5A_6,

21

p=0.046) from accounting adjustments, then managers will be more likely to undertake EM.

Therefore in addressing Research Question 1, the high R2 does confirm economic factors are

important, further this analysis shows the overriding economic factor of importance in

deciding on whether to undertake EM is through consideration of the effect on current

shareholders from doing nothing when earnings are not going to meet market expectations.

The next two regressions address Research Question 2, which evaluates whether ethical

factors also affect managers‘ decisions to undertake EM. The third regression (c) in Table 3,

shows the first regression (a) plus inclusion of the perceived ethics of the various EM options

(Q13). As can be seen the R2 increased from 0.24 to 0.41. When ethics are included, the

affect of benefits and costs to CEO/CFOs themselves becomes insignificant. If managers

think that taking no special action is ethically questionable, they are more likely to manage

earnings (Q13_1, p<0.001). If they think that operational adjustments are ethically

questionable, they are less likely to manage earnings (Q13_3, p<0.001), which could be

driven in part by the fact that the majority who choose to manage earnings do so by

operational methods. The fourth (d) regression, shows the first regression (a) with the

inclusion of whether managers perceive the EM methods as lying or not (OQ2&3). Again,

this provides an increase in explanatory power over the first regression (R2 increased from

0.24 to 0.33), although it is not as much of an increase as from inclusion of the ethics

questions. If managers think that accounting (OQ2, p<0.001) or operational adjustments

(OQ3, p=0.015) are lying they are less likely to manage earnings. In this regression, unlike

the third one, if the managers perceive a cost to themselves to doing nothing, it is still a

significant factor in their decision to manage earnings (Q4A_1, p=0.042), indicating that this

consideration has an ethical component but does not relate to lying.

The fifth regression (e) includes all questions from the previous four regressions. The

overall R2 increases to 0.49. This shows that there is incremental explanatory power from all

22

of the various components measured by this survey to understand the EM decision. In this

overall model, the effect on current shareholders from doing nothing remains an important

consideration in deciding whether to undertake EM or not (Q4A_4, p<0.001). If there are low

costs to future shareholders and debt-holders from accounting adjustments, managers are

more likely to undertake EM. A significant effect comes through only in the complete model

for the effect on current shareholders from operational adjustments. That is, if there are low

costs perceived to current shareholders from operational adjustments, managers are more

likely to manage earnings (Q6A_4, p=0.057).

In relation to the ethical factors in the complete regression (e), the perceived ethics of

taking no action or operational adjustments continues to be a significant factor relating to the

EM decision. However, the ethical perception of accounting adjustments was not significant

in the third regression (c) and becomes even more insignificant in the complete regression (e).

Whether accounting adjustments are perceived as lying remains very significant (OQ2,

p=0.003), however whether operational adjustments are perceived as lying becomes

insignificant with inclusion of all questions in the complete regression (OQ3, p=0.302).

A regression was also run (not reported) that only examined the effect of ethics on the

EM decision. This provided an R2 of 0.35, however, 0.25 of that explanatory power was

correlated with economic factors, indicating that an important part of managers‘ ethical

evaluation is the harm to others. However, there was still 0.10 of ‗pure ethics‘ beyond any

economic considerations, which helps explain the significant effect from perceptions of lying

on the EM decision found in this study.

Is EM Lying and Does Perceiving EM as Lying Affect the Decision to Manage Earnings?

Research Question 3a addresses whether EM is perceived as lying, which has not been

examined in the literature before. In Table 1, the descriptive responses to these questions is

23

presented. Other Question (OQ) 2 shows a mean of 60% who think accounting adjustments

are lying compared to OQ 3 with a mean of 27% who think that operational adjustments are

lying. Question 13 relates to perceived ethics of the available options, as can be seen, taking

no action is the most ethical with a mean of 24 (scale of 0 = not (ethically) questionable at all

to 100 = Extremely (ethically) questionable), followed by operational adjustments (34), then

accounting adjustments (67) as least ethical. From the correlations in Table 2, it is shown that

a major reason accounting adjustments are seen as unethical is because they are seen as lying

(0.33). In relation to RQ3b, which relates to whether if perceiving EM as lying affects the

decision to manage earnings, results presented on Table 3 showed that perceiving accounting

adjustments as lying (OQ2) means that managers will be less likely to manage earnings

(p=0.003).

Research Question 4 is an evaluation of whether for those who think EM is lying, the

economic costs and benefits of the EM makes a difference to their decision on whether to

manage earnings. Table 4 provides an analysis by splitting the sample into whether they think

that accounting EM is lying or not.8 Table 4, Panel A provides details of the economic

benefits of EM (through avoidance of the costs of doing nothing on stakeholders – Question

Set 4). As can be seen the R2 is relatively low for those that think accounting EM is lying (R

2

= 0.05), however it increases significantly for those who do not think accounting EM is lying

in Panel B (R2 = 0.16) indicating economic benefits are more important for the group who do

not think that accounting EM is lying. For this group the significant individual factor is the

effect on current shareholders as a reason for undertaking EM (Q4A_4, p=0.038). The second

regression in Table 4, Panel A, incorporates the economic benefits and costs (costs to

stakeholders of accounting adjustments - Question Set 5) of accounting adjustments. For

those who think accounting EM is lying, the inclusion of consequences increases the R2 to

8 The focus is only on accounting EM because for the majority of managers they do not perceive operational EM

as lying.

24

0.10. One of the specific consequences of accounting adjustments relating to the company in

the short term is marginally significant (Q5A_2, p = 0.08), which indicates this negative

consequence of accounting adjustments is associated with managers choosing to engage in

EM. This finding may come about because most managers who choose to engage in EM use

operational not accounting adjustments. For the group who think that accounting EM is not

lying, the explanatory power hardly changes with the inclusion of consequences in Panel B

(R2 from 0.16 to 0.18), and none of the individual consequences are significant.

Overall, our findings show that for those who think EM is lying, that economic factors

do not affect their propensity to undertake these EM actions, which is not consistent with

Gneezy (2005). However, it does also illustrate there are a significant group of managers

whose actions seem to be primarily determined by whether they think accounting EM is lying.

This does seem to indicate that the view by management on this issue is an important

management trait that has economic consequences, which is explored further in the next

research question.

INSERT TABLE 4 ABOUT HERE

Table 5 controls for ethics to evaluate the decision of the groups who think that

accounting is lying compared to those who do not. In Table 5, Panel A, for those who think

that accounting is lying, the ethical factors (Q15) have significant explanatory power in the

regression (R2 of 0.40). When economic considerations are introduced into this regression the

explanatory power barely changes (R2 of 0.41), which is consistent with findings in Table 4.

If accounting EM is perceived as lying, the ethics of taking no action or operational

adjustments makes a difference to the EM decision but nothing else does. Specifically, for

this group, if they think that taking no action is unethical, they are more likely to manage

25

earnings, and if they think that operational adjustments are unethical they are less likely to

manage earnings.

INSERT TABLE 5 ABOUT HERE

Table 5, Panel B shows the group who do not think that accounting is lying and also

controlling for ethics. In this case, ethics alone has a much lower explanatory power for those

who think that accounting is lying (R2 of 0.25). However, inclusion of economics has a much

more significant effect on the decisions of this group (R2 of 0.37). In evaluating specific costs

and benefits that are considered in deciding to manage earnings, the benefits are to current

shareholders (by avoiding costs of doing nothing) from EM actions (Q4A_4, p=0.001) and

the potential costs are to the CEO or CFO (Q5A_1, p=0.076).

Therefore in addressing RQ 4, where EM is viewed as lying, the economic costs and

benefits to other parties do not matter. However, if it is not viewed as lying economic costs

and benefits do affect managers‘ decisions.

Choice of Earnings Management Technique

Research Question 5 evaluates the relative importance of economics and ethical factors

in the choice of EM technique (i.e., for those who have decided to manage earnings). Three

regressions are run as shown in Table 6.

INSERT TABLE 6 ABOUT HERE

The first regression in Table 6 shows economic factors that affect this choice. The main

economic determinant on this choice is the likelihood of success of a particular EM technique.

If managers do not think that accounting EM can achieve the required increase in earnings

then they are more likely to use operational adjustments (Q3_1, p=0.002). Similarly, if

managers do not think that operational EM could achieve the required increase in earnings

26

then they are more likely to use accounting adjustments (Q3_2, p<0.001). The only other

economic variable of significance is perceptions of the cost of accounting adjustments to the

company in the long term. If managers think these costs are high, they are more likely to use

operational adjustments (Q5A_3, p=0.020). However, this consideration of the longer term

effect on the company appears to have an ethical component because it becomes insignificant

when ethics variables are added in the second regression.

The second regression in Table 6 adds the ethics questions and this significantly

increases the explanatory power of the model to an R2 = 0.48 (from R

2 = 0.29 for the model

with economics factors only). If managers think that accounting adjustments are ethically

questionable, they are more likely to use operational adjustments to manage earnings (Q13_2,

p<0.001). Similarly, if managers think that operational adjustments are ethically questionable,

they are more likely to use accounting adjustments to manage earnings (Q13_3, p=0.001).

The final regression includes the questions asked on whether the EM actions were perceived

as lying or not. If managers think that accounting adjustments are lying, they are more likely

to use operational adjustments to manage earnings (OQ2, p=0.058). However, whether

managers think operational adjustments are lying or not does not affect their choice between

the two types of EM techniques (OQ3, p=0.301). These findings suggest that managers do

not see operational adjustments as lying or deception but they are seen as by some as

unethical. This is consistent with the adjustments being ‗real‘ decisions which could therefore

more easily be justified to oneself as not lying. From this third regression it seems the

primary determinants on the choice of method relates to ethical perceptions of the actions,

and for accounting adjustments it also relates to whether managers perceive the actions as

lying. As reported earlier, many more managers think accounting adjustments are unethical

and lying. This therefore translates into the much higher use of operational EM methods as

has been shown in this survey and the survey of Graham et al. (2005).

27

VI. DISCUSSION AND CONCLUSIONS

This study examines economic factors and tradeoffs between stakeholders that affect the

decision to manage earnings and is the first to show in a comprehensive model of factors

associated with EM decisions that ethical considerations are important in the decision and the

choice of the method of EM.

The first research question evaluated what economic factors were important in the

decision to manage earnings. The most important factor affecting this decision is the

likelihood of success of the EM. The most significant perceived cost relates to the costs of

doing nothing, of which the most important aspect are the costs to the current shareholders

from taking no action. The second research question examined the relative importance of

economic and ethical factors for managers in deciding on whether to manage earnings. We

find that economic factors, ethics and lying all have a statistically significant effect on the

decision to undertake EM. The most important factors are economics and ethics, and they are

highly correlated, showing that ethical considerations do often relate to economic factors.

Which is consistent with a teleological approach to ethical decision making and the moral

intensity model proposed by Jones (1991b).

From the detailed analysis performed addressing the second research question, the

‗ethical acceptability‘ of taking no action or operational adjustments are both associated with

the decision to manage earnings. Those who viewed taking no action as ethically

questionable were more likely to manage earnings. We are not aware of not managing

earnings as being documented as ethically questionable in any previous study. It does also

illustrate the importance of benchmarks to managers, but suggests they think there are ethical

implications to these decisions rather than the traditional view of meeting these targets being

28

purely associated with short-term self-interest. This finding is consistent with the recent

experiment by Johnson et al. (2012), where they found that if the organizational

consequences were positive from undertaking EM, they perceived the EM actions as less

unethical. Those who viewed operational adjustments as unethical were less likely to manage

earnings. This is not surprising as we also find that operational adjustments were the most

‗popular‘ method of managing earnings by those who chose to do so, with 74% of our sample

preferring this method.

The next research questions explored a part of ethical decision making (not previously

explored in the accounting literature) on whether managers see EM as ‗lying‘ and if so,

whether this affects their decisions. From our descriptive data, the majority of managers

perceived undertaking accounting EM adjustments as lying, although this was not found for

operational EM. This flows through to the decision on EM, if accounting adjustments were

perceived as lying, managers were less likely to manage earnings. This does show that

perceptions of ‗lying‘ of these actions can make difference to behavior of managers. We also

tested the findings by Gneezy (2005) on whether the decision to lie is affected by costs and

benefits to other parties and we found that for those who think accounting EM is lying their

decisions are not affected by economic considerations.

The final research question related to the relative importance of economic and ethical

factors for managers in deciding on the method of managing earnings. In terms of economic

factors affecting the method chosen, the perceived likelihood of success of the particular

method is again the most important factor. However, ethical considerations are more

important from managers‘ perspective in making this choice as the ethical acceptability of

accounting compared to operational adjustments was associated with the choice of the

method of managing earnings. That is, if managers thought accounting adjustments were

more unethical they were more likely to use operational adjustments to manage, whereas

29

those who thought that operational adjustments were more unethical were more likely to use

accounting adjustments to manage. The other consideration of importance was whether they

thought making accounting adjustments is ‗lying‘, if they did, they were less likely to use

accounting adjustments to manage earnings.

This study shows that the decision to manage earnings and the method to manage

earnings are complex decisions. Some economic factors clearly affect managers‘ decisions on

EM such as the likelihood of success of particular methods of EM. The affect on current

shareholders is also an important consideration, which quite reasonably shows that managers

see their duty directly related to current shareholders, which not surprising as it is usually

aligned to their economic ‗self-interest‘. However, a significant new finding from this

research is that decisions on EM are not solely affected by direct economic self interest and

that there is a consideration of what is ‗right‘ or ‗ethical‘ in a determination of EM decisions.

Associated with this, whether they believe the actions to be lying or not also has an impact.

Further, ethical perceptions of both real operational and accounting EM and the perceptions

of whether accounting adjustments are lying significantly effects the choice between real

operational and accounting EM. Therefore this study provides evidence on the importance of

ethics in these decisions on EM as was alluded to by Graham et al. (2005), and is consistent

with recent economic research that has questioned the assumption of ‗economic man‘

(Benabou and Tirole 2011).

In summary, this study is the first to comprehensively evaluate the spectrum of factors

that has been shown to affect EM decisions from the prior literature and shows that beyond

the importance of these factors, ethical considerations make a difference. Therefore, a

broader perspective in evaluating EM that encompasses the ethical decision making

framework of managers is important to properly understand the decision to manage or to not

manage earnings.

30

APPENDIX

General Background Information

Assume ―the Company‖ is listed on the Australian Stock Exchange, and it has a large, diversified

shareholder base.

The Company has an independent Audit Committee, and a Corporate Code of Ethics for all directors,

officers, and employees.

Financial Background Information

The Company has always reported earnings per share (EPS) that has met or beaten the market‘s

expectations.

The Company has long-term borrowings with a debt covenant.

The Company‘s year-end is 30 June.

Assume that today is 15 May 2010

Based on the Company‘s reported EPS for the six months ended 31 December 2009, the Company was

on track (as of 31 December 2009) to generate EPS of $1.75 for the year ended 30 June 2010, which is

equal to the market‘s expectations.

Today (i.e., 15 May 2010), the Company re-assessed its financial results for 2009/10. The relevant

information is summarised below.

Due to a series of independent, minor, company-specific setbacks unrelated to economic

conditions, the Company is now certain (as of 15 May 2010) that actual EPS for 2009/10 will fall

in the range of $1.67 to $1.69, with $1.68 being the most likely outcome. Thus, the Company now

expects to underperform the market expectation of $1.75 by 4%.

Although the decrease in EPS will move the Company closer to the debt covenant‘s required

benchmarks, the Company‘s expected EPS will be sufficient to maintain a more than acceptable

margin to avoid violating the debt covenant.

Potential Courses of Action

The Company has two general options regarding its reported performance, as the figure below indicates.

Take no special actions to improve reported performance, and thus underperform market expectations by

4%.

Use accounting and/or operational adjustments to improve reported performance by 4% to meet market

expectations.

1. In this situation, where the Company will underperform market expectations by 4% if it does nothing, what

is the likelihood that your firm would try to improve reported performance using accounting adjustments

and/or operational adjustments?

Certain

not to

happen

Certain

to happen

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

31

2. What decision do you think your firm would actually make in this situation (please tick the one box that

corresponds to your answer)?

Take no special actions.

Try to improve reported performance, using

accounting and/or operational adjustments Indicate the proportions below.

Would rely

solely on

accounting

adjustments

Would rely

50% on

accounting

adjustments

and 50% on

operational

adjustments

Would rely

solely on

operational

adjustments

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

3. What is the likelihood that your firm would be able to increase reported earnings by 4% in this situation to meet

market expectations if it:

Certain

not to

happen

Certain

to

happen

0% 10

%

20

%

30

%

40

%

50

%

60

%

70

%

80

%

90

%

100%

• Used ONLY accounting adjustments

• Used ONLY operational adjustments

• Used a combination of accounting and

operational adjustments

32

4. Assume your firm takes no special action [Qu 5 using only accounting adjustments; Qu6 using only

operational adjustments] to improve reported performance and underperforms market expectations by 4%.

A. How large are the potential costs that taking no special action [Qu 5 accounting; Qu 6 operational] (and thus

underperforming market expectations by 4%) will impose on each of the following stakeholder groups?

Absolutely no costs

Very large costs

0 10 20 30 40 50 60 70 80 90 100

• CFO and CEO

• Company in the short term

• Company in the long term

• Company’s current shareholders

• Company’s future shareholders

• Company’s debtholders

• Other stakeholders (e.g., employees,

customers, or general public)

B. What is the likelihood that a particular stakeholder group will actually incur the potential costs you identified

above?

Certain

not to happen

Certain

to happen

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

• CFO and CEO

• Company in the short term

• Company in the long term

• Company’s current shareholders

• Company’s future shareholders

• Company’s debtholders

• Other stakeholders (e.g., employees,

customers, or general public)

33

Ethical Questions

11. Over what period of time do you expect any costs from each course of action to occur?

Immediately

< 6

months

6 months

to 1 year

1 to 2

years

2 to 3

years

3 to 4

years

4 to 5

years

> 5 years

• Take no special actions

• Use accounting adjustments

• Use operational adjustments

12. How many people do you think would be affected by the costs of each course of action?

None 1 2 to 10 10 to 50 50 to 1000 1000+

• Take no special actions

• Use accounting adjustments

• Use operational adjustments

13. How ethically questionable do you believe each course of action is? Not

questionable

at all

Extremely

questionable 0 10 20 30 40 50 60 70 80 90 100

• Take no special actions

• Use accounting adjustments

• Use operational adjustments

14. What percentage of people in your same senior management position do you believe would consider the course of

action to be ethically questionable?

None 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

• Take no special actions

• Use accounting adjustments

• Use operational adjustments

15. What percentage of people in your same senior management position do you think would select each of the following

actions when faced with underperforming market expectations by 4%? The percentages allocated across the actions

must add up to 100.

Take no special actions.

Rely solely on accounting adjustments to improve reported performance

Rely solely on operational adjustments to improve reported performance

Use some combination of accounting and operational adjustments to improve

reported performance

Total (sum of your responses must equal 100%) 100%

34

Other Questions

1. Indicate your belief about the degree to which

attempts to improve reported performance via

accounting and/or operational adjustments are

initiated by a company‘s CEO versus its CFO.

CEO CFO

Initiated Initiated

0 10 20 30 40 50 60 70 80 90 100

2. Indicate the degree to which you think that

improving reported performance by using

accounting adjustments is lying?

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

3. Indicate the degree to which you think that

improving reported performance by using

operational adjustments is lying?

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

35

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39

_STAT_ Q1 Q2_1 Q2_2 Q3_1acc Q3_2op Q3_3com Q4a_1ceocfo Q4a_2cost Q4a_3colt Q4a_4csh Q4a_5fst Q4a_6dh Q4a_7other

N 224 225 153 210 217 214 225 225 225 225 224 223 224

MIN 0 0 0.1 0 0 0 0 0 0 0 0 0 0

MAX 1 1 1 1 1 1 100 100 100 100 100 100 100

MEAN 0.54 0.68 0.74 0.38 0.51 0.62 43.20 46.09 23.02 43.47 20.09 17.27 20.40

MEDIAN 0.6 1 0.8 0.3 0.5 0.7 50 50 20 50 10 10 15

STD 0.34 0.468 0.202 0.335 0.28 0.326 28.229 27.071 22.712 26.364 22.31 21.957 20.03

Q5a_1ceocfo Q5a_2cost Q5a_3colt Q5a_4csh Q5a_5fsh Q5a_6dh Q5a_7other Q6a_1 Q6a_2 Q6a_3 Q6a_4 Q6a_5 Q6a_6 Q6a_7

N 224 225 225 225 225 224 225 225 225 225 225 225 224 225

MIN 0 0 0 0 0 0 0 0 0 0 0 0 0 0

MAX 100 100 100 100 100 100 100 100 100 100 100 100 70 100

MEAN 38.21 29.51 41.24 26.22 33.29 22.50 22.31 29.16 30.67 33.51 23.64 29.16 17.19 24.62

MEDIAN 30 20 40 20 20 10 20 20 20 30 20 20 10 20

STD 33.77 27.71 29.40 25.94 28.83 25.22 22.56 25.66 24.18 25.73 21.38 25.03 19.03 23.30

Q13_1noaction Q13_2acc Q13_3opr OQ2 OQ3

N 224 224 224 222 222

MIN 0 0 0 0 0

MAX 100 100 100 1 1

MEAN 24.78 67.01 33.53 0.60 0.27

MEDIAN 10 75 30 0.7 0.2

STD 32.90 28.98 28.72 0.33 0.27

TABLE 1 Descriptive Statistics

40

Q1 Q2_2 Q3_1ACC Q3_2OP Q3_3COM Q4A_1CEOCFOQ4A_2COSTQ4A_3COLTQ4A_4CSHQ4A_5FST Q4A_6DH Q4A_7OTHERQ13_1NOACTIONQ13_2ACCQ13_3OPROQ2 OQ3

Q1 1.00 0.17 -0.22 0.01 0.13 -0.07 0.05 0.09 0.02 -0.09 -0.05 -0.06 0.12 -0.01 -0.23 0.07 -0.25

Q2_2 1.00 -0.02 0.53 -0.06 -0.31 -0.18 -0.01 -0.03 -0.18 -0.21 -0.05 0.06 0.10 -0.53 0.10 -0.60

Q3_1ACC 1.00 0.13 0.65 0.16 0.21 -0.04 -0.04 0.18 0.04 0.13 -0.03 -0.21 0.20 -0.43 0.23

Q3_2OP 1.00 0.01 -0.25 -0.10 0.05 -0.08 -0.12 -0.06 -0.01 0.03 -0.03 -0.24 0.00 -0.19

Q3_3COM 1.00 0.31 0.36 0.01 0.07 0.14 -0.07 0.22 0.11 -0.10 0.23 -0.26 0.10

Q4A_1CEOCFO 1.00 0.83 0.60 0.59 0.46 0.54 0.63 0.37 0.07 0.17 0.00 0.06

Q4A_2COST 1.00 0.65 0.65 0.44 0.45 0.54 0.39 0.09 0.15 -0.19 0.05

Q4A_3COLT 1.00 0.55 0.53 0.60 0.59 0.53 0.01 0.06 0.04 0.03

Q4A_4CSH 1.00 0.18 0.18 0.47 0.20 0.07 0.13 0.02 -0.03

Q4A_5FST 1.00 0.64 0.48 0.41 -0.09 0.14 -0.16 0.14

Q4A_6DH 1.00 0.51 0.29 0.06 0.03 0.03 0.16

Q4A_7OTHER 1.00 0.13 -0.02 0.05 -0.07 0.05

Q13_1NOACTION 1.00 0.06 0.11 0.06 -0.11

Q13_2ACC 1.00 0.10 0.33 -0.20

Q13_3OPR 1.00 0.05 0.77

OQ2 1.00 -0.01

OQ3 1.00

TABLE 2

Correlation Matrix

41

Table 3

Regression of Q1 on Economics, Ethics and Lying

(a) (b) (c) (d) (e)

Variable Coefficient Prob. Coefficient Prob. Coefficient Prob. Coefficient Prob. Coefficient Prob.

C 0.2077 0.0003 0.1871 0.0017 0.4482 0 0.4432 0 0.4639 0

Q3_1ACC -0.1497 0.0766 -0.1083 0.1971 -0.1111 0.1435 -0.1627 0.044 -0.0874 0.2389

Q3_2OP 0.3100 0.0007 0.2588 0.0063 0.1840 0.0283 0.2833 0.0013 0.1802 0.0304

Q3_3COM 0.3174 0.0015 0.2609 0.0121 0.2499 0.0047 0.2887 0.0025 0.1871 0.0426

Q4A_1CEOCFO 0.0026 0.0022 0.0010 0.2697 0.0005 0.5631 0.0017 0.0416 -0.0009 0.3135

Q5A_1CEOCFO -0.0012 0.0999 -0.0003 0.7436 0.0000 0.9732 -0.0004 0.6043 0.0006 0.4534

Q6A_1 -0.0011 0.2794 -0.0018 0.1183 -0.0004 0.6215 -0.0006 0.5317 -0.0012 0.2097

Q4A_4CSH 0.0037 0.0004 0.0032 0.0006

Q4A_5FST 0.0006 0.6422 -0.0003 0.8059

Q4A_6DH 0.0011 0.4387 0.0001 0.9099

Q4A_7OTHER 0.0007 0.6226 -0.0002 0.9055

Q5A_4CSH 0.0012 0.2959 0.0010 0.3041

Q5A_5FSH -0.0018 0.102 -0.0016 0.0995

Q5A_6DH -0.0031 0.0463 -0.0026 0.0603

Q5A_7OTHER 0.0011 0.5064 0.0007 0.6448

Q6A_4 -0.0020 0.1578 -0.0024 0.0567

Q6A_5 -0.0001 0.9453 0.0011 0.3287

Q6A_6 0.0004 0.8041 0.0015 0.3615

Q6A_7 0.0011 0.3883 0.0014 0.212

Q13_1NOACTION 0.0029 0 0.0029 0

Q13_2ACC -0.0011 0.1365 0.0004 0.6368

Q13_3OPR -0.0034 0 -0.0043 0

OQ2 -0.2425 0.0005 -0.2333 0.0028

OQ3 -0.2186 0.015 0.1159 0.3021

Adjusted R-squared 0.2375 0.3063 0.4074 0.3280 0.4879

42

Variable Coeff t-Statistic Prob. Coeff t-Statistic Prob.

C 0.3095 4.68 0 0.3505 4.87 0

Q4A_1CEOCFO -0.0019 -0.96 0.3416 -0.0015 -0.76 0.4516

Q4A_2COST 0.0017 0.85 0.3995 0.0012 0.57 0.5677

Q4A_3COLT 0.0019 0.83 0.4075 0.0012 0.52 0.6048

Q4A_4CSH 0.0012 0.71 0.4819 0.0010 0.59 0.5573

Q4A_5FST 0.0020 0.97 0.3339 0.0020 0.92 0.3584

Q4A_6DH -0.0009 -0.44 0.6604 0.0002 0.09 0.9305

Q4A_7OTHER 0.0016 0.71 0.4765 0.0013 0.59 0.5597

Q5A_1CEOCFO -0.0015 -1.11 0.2683

Q5A_2COST 0.0029 1.79 0.0766

Q5A_3COLT 0.0005 0.26 0.7947

Q5A_4CSH 0.0014 0.84 0.4058

Q5A_5FSH 0.0000 0.02 0.9802

Q5A_6DH -0.0020 -1.02 0.3104

Q5A_7OTHER -0.0030 -1.32 0.1888

Adjusted R-squared 0.0498 0.0951

F-statistic 1.8166 1.8183

Prob(F-statistic) 0.0919 0.0467

1.7290 0.1114

Variable Coeff t-Statistic Prob. Coeff t-Statistic Prob.

C 0.3814 6.09 0 0.4061 6.42 0

Q4A_1CEOCFO 0.0012 0.80 0.4272 0.0013 0.83 0.4105

Q4A_2COST 0.0009 0.54 0.5872 0.0015 0.85 0.3962

Q4A_3COLT 0.0015 0.92 0.3576 0.0026 1.50 0.1377

Q4A_4CSH 0.0032 2.10 0.0379 0.0041 2.57 0.0116

Q4A_5FST -0.0020 -1.19 0.2355 -0.0035 -1.90 0.0607

Q4A_6DH -0.0015 -0.95 0.3467 -0.0014 -0.71 0.4812

Q4A_7OTHER 0.0015 0.86 0.3896 0.0024 1.24 0.2178

Q5A_1CEOCFO 0.0012 0.85 0.3949

Q5A_2COST -0.0006 -0.33 0.7425

Q5A_3COLT -0.0023 -1.13 0.2628

Q5A_4CSH 0.0003 0.13 0.8941

Q5A_5FSH -0.0027 -1.45 0.1498

Q5A_6DH -0.0004 -0.16 0.8759

Q5A_7OTHER 0.0006 0.28 0.7804

Adjusted R-squared 0.1648 0.1816

F-statistic 4.0721 2.7280

Prob(F-statistic) 0.0006 0.0020

1.3000 0.2588

Included observations: 110

Panel A OQ2 Accounting is Lying

Panel B OQ2 Accounting is not Lying

Wald Test: Q5 (F-stat)

Wald Test: Q5 (F-stat)

TABLE 4

Anlysis of Benefits and consequences Conditional on Lying or Not Lying

43

Robustness Measure to Lying based on a 50% cuttoff

Ethics Adjusted R-squared 0.412165

Ethics and Benefits/Consequences Adjusted R-squared 0.440128

F-statistic 1.560189 0.1025

Sample 128

Variable Coefficient t-Statistic Prob. Coefficient t-Statistic Prob.

C 0.4681 4.82 0 0.4548 3.99 0.0001

Q13_1NOACTION 0.0038 4.36 0 0.0032 2.91 0.0045

Q13_2ACC 0.0012 1.12 0.2646 0.0009 0.76 0.4477

Q13_3OPR -0.0053 -6.10 0 -0.0052 -5.78 0

Q4A_1CEOCFO -0.0036 -2.23 0.028

Q4A_2COST 0.0023 1.38 0.1714

Q4A_3COLT -0.0018 -0.88 0.3828

Q4A_4CSH 0.0015 1.07 0.2861

Q4A_5FST 0.0013 0.73 0.4689

Q4A_6DH 0.0002 0.11 0.9165

Q4A_7OTHER 0.0022 1.17 0.2441

Q5A_1CEOCFO -0.0006 -0.55 0.5813

Q5A_2COST 0.0019 1.43 0.1569

Q5A_3COLT 0.0012 0.72 0.4762

Q5A_4CSH 0.0003 0.19 0.8469

Q5A_5FSH -0.0005 -0.33 0.7405

Q5A_6DH -0.0015 -0.94 0.3522

Q5A_7OTHER -0.0016 -0.85 0.3996

Adjusted R-squared 0.3995 0.4067

F-statistic 25.6133 0.0000 5.3951 0.0000

1.1894 0.2968 Wald test F-statistic Q4 and Q5

TABLE 5

Analysis of Benefits/Consequences of Lying or Not Lying after Controlling for Ethics

Panel A OQ2 Accounting is Lying

44

Variable Coeff t-Statistic Prob. Coeff t-Statistic Prob.

C 0.6753 10.90 0 0.5321 7.36 0

Q13_1NOACTION 0.0029 3.78 0.0003 0.0025 3.17 0.0021

Q13_2ACC 0.0001 0.11 0.9128 -0.0006 -0.50 0.6217

Q13_3OPR -0.0043 -3.79 0.0003 -0.0039 -3.56 0.0006

Q4A_1CEOCFO -0.0004 -0.30 0.7617

Q4A_2COST 0.0018 1.18 0.2414

Q4A_3COLT 0.0014 0.91 0.3649

Q4A_4CSH 0.0048 3.37 0.0011

Q4A_5FST -0.0031 -1.86 0.0654

Q4A_6DH -0.0018 -1.04 0.3009

Q4A_7OTHER 0.0009 0.54 0.5926

Q5A_1CEOCFO 0.0023 1.79 0.076

Q5A_2COST -0.0014 -0.92 0.362

Q5A_3COLT -0.0032 -1.61 0.111

Q5A_4CSH -0.0003 -0.13 0.8934

Q5A_5FSH -0.0017 -1.00 0.3211

Q5A_6DH 0.0004 0.20 0.839

Q5A_7OTHER 0.0018 0.87 0.3875

Adjusted R-squared 0.2453 0.3720

F-statistic 12.9149 0.0000 4.7627 0.0000

3.6871 0.0015

1.3075 0.2558

Panel B OQ2 Accounting is not Lying

Wald test F-statistic Q4

Wald test F-statistic Q5

TABLE 5

45

TABLE 6

Regression of Q2_2 on Economics, Ethics and Lying

Coeff Prob. Coeff Prob. Coeff Prob.

C 0.6235 0

0.4695 0

0.4603 0

Q3_1ACC -0.1876 0.0015

-0.1159 0.0251

-0.0991 0.059

Q3_2OP 0.3243 0

0.2570 0.0001

0.2571 0.0001

Q3_3COM 0.0367 0.6139

0.0174 0.7861

-0.0028 0.9671

Q4A_1CEOCFO -0.0009 0.2982

-0.0007 0.3741

-0.0008 0.3018

Q4A_2COST 0.0002 0.8248

0.0003 0.6703

0.0003 0.7003

Q4A_3COLT 0.0000 0.9697

0.0001 0.866

0.0003 0.7586

Q4A_4CSH -0.0006 0.4243

-0.0001 0.8423

0.0001 0.8416

Q4A_5FST 0.0007 0.5043

0.0009 0.3218

0.0008 0.3826

Q4A_6DH -0.0007 0.5196

-0.0010 0.2848

-0.0011 0.2558

Q4A_7OTHER -0.0006 0.6155

-0.0009 0.3691

-0.0007 0.4748

Q5A_1CEOCFO 0.0002 0.8014

-0.0001 0.9299

0.0000 0.9449

Q5A_2COST -0.0003 0.7907

-0.0006 0.4881

-0.0004 0.6622

Q5A_3COLT 0.0027 0.0199

0.0015 0.1706

0.0011 0.3382

Q5A_4CSH 0.0001 0.898

-0.0006 0.4874

-0.0005 0.5822

Q5A_5FSH -0.0006 0.5452

-0.0001 0.8778

-0.0001 0.9313

Q5A_6DH 0.0020 0.118

0.0016 0.1548

0.0015 0.1717

Q5A_7OTHER -0.0005 0.6901

-0.0005 0.6543

-0.0004 0.7258

Q6A_1 -0.0016 0.0803

-0.0010 0.238

-0.0010 0.2458

Q6A_2 -0.0001 0.8809

-0.0002 0.8228

-0.0004 0.6224

Q6A_3 0.0006 0.5727

0.0008 0.3903

0.0008 0.3996

Q6A_4 -0.0007 0.5211

-0.0009 0.314

-0.0009 0.3092

Q6A_5 -0.0005 0.6422

0.0001 0.9544

0.0004 0.6828

Q6A_6 -0.0014 0.3572

0.0000 0.9907

-0.0001 0.9528

Q6A_7 0.0004 0.6807

-0.0008 0.3508

-0.0007 0.4169

Q13_1NOACTION

0.0005 0.2419

0.0005 0.2217

Q13_2ACC

0.0037 0

0.0028 0.0003

Q13_3OPR

-0.0023 0.001

-0.0017 0.0663

OQ2

0.1218 0.058

OQ3

-0.0960 0.3011

Adjusted R-squared 0.2887

0.4811

0.4822

Included observations: 138