Managing Earnings

Accounting has a long history of being an ethical profession. In recent years, however, some companies have asked their accountants to help "manage earnings."

What does it mean to manage earnings?

Who is more likely to be involved in such a situation, the financial accountant or the management accountant? Why?

Do you believe that managing earnings is ethical? Discuss the rationale for your answer.

The major role of financial reporting is to effectively communicate financial information to outsiders in a timely and credible manner. To do so, managers are given opportunities to exercise judgment in financial reporting. Managers can use their knowledge about the business to improve the effectiveness of financial statements as a means of communicating with potential investors and creditors. However, earnings management is also likely to occur when managers have incentives to mislead their financial statement users by exercising discretion over accounting choices in financial reporting like we have seen with such companies as Enron and Syntax.
Early literature in the area of earnings management examined the impact of accounting choices on the capital market. Its primary focus was to differentiate between two competing hypotheses. The Mechanistic Hypothesis, which was common in the 1960s accounting literature, states that financial statement users do not utilize sources of information other than firms' financial reports. Investors arrive at their decisions based solely on the face value of firms' reported financial information. This theory shows how in such situations, investors can arrive at their opinions by utilizing other sources. The mechanistic theory predicts that the relationship between accounting earnings and stock prices is a purely mechanical one. That is, investors can be thoroughly misled by firms' accounting methods and choices. Being misled is last thing we