The selective misrepresentation hypothesis states that management has learned that they can manipulate the perception of their entity’s financial position. This is due, in part, to the increasing complexities of business which means that financial reporting is no longer based on direct observation of events but rather on summaries of these events. Additionally, financial reporting standards are often “arbitrary, complicated, and misleading.” These things have led to flexible financial reporting rules that allow for opportunity for management to misrepresent their company’s financial performance. The article looks at who benefits from these misrepresentations and what should be done to change it.
The first party that benefits from these misrepresentations is management. Often management compensation is directly related to a company’s earnings. This creates a natural incentive for management to increase profits. In addition to higher bonuses, managers can manipulate earnings numbers to impress shareholders and protect their jobs. One of the methods used by management to achieve desired income is to manipulate the LIFO inventory method. This method allows management to dip into the LIFO “reserves” and to make carefully timed year-end purchases. Efforts to change accounting standards to those that are closer to reality have been rejected as being unauditable or too volatile.
A second beneficiary of these loose accounting standards is the shareholders. Misrepresented financial statements generally make earnings appear smooth and less volatile than real earnings patterns. This lowers the market’s perceived risk of the firm and, in turn, increases the firm’s value.
Additionally, auditors benefit from flexible reporting rules. Auditors seek to have standards that provide the most benefit to their clients. These benefits can be seen in two ways. The first way is by having “rigid...