CFOs’ Incentives and Earnings Management Ethics Impact on their Financial Decisions


Essay, 2015

13 Pages


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Inhaltsverzeichnis

ABSTRACT

INTRODUCTION

LITERATURE REVIEW
Hypothesis Creation and Literature Analysis
Incentives and Earnings Management
The Mediating Role of Moral Disengagement

RESEARCH METHODOLOGY
The Research Participants
Procedure and Task
Dependent and Independent Variables

RESEARCH RESULTS

DISCUSSION

REFERENCES

APPENDIX

The CFOs’ Incentives and Earnings Management Ethics Impact on their Financial Decisions: Moral Disengagement Mediating Role

ABSTRACT

Despite the regulatory reforms targeted at limiting aggressive earnings management and financial reporting continues to be a major concern of the regulators, standards setters and the industry practitioners. To bring the practice to light and offer mitigative solutions, the paper carries out an experiment to investigate the impact of two independent variables on the discretionary CFO’s expense control. Incentive conflict, one of the independent variable is manipulated at two different levels (past and present). EM-Ethics (earnings management ethics) is the other CFOs independent variable (low vs. high). And it is measured as the CFOs assessment of the ethicalness of the primary earnings management motivations. We discover that the EM-Ethics and incentive conflict interact to determine the discretionary accruals for the CFOs such that (a) when the incentive conflict is absent, the CFOs with high (low) EM-Ethics do tend to resist (give in) the corporate incentive through booking higher (lower) expense accrual. (b) when the incentive conflict is absent, the CFOs with (high) low EM-Ethics do tend to resist (give into) the incentive through booking (lower) higher expense accruals. The practical and theoretical implications of the research findings are discussed.

Keywords: Moral disengagement, Earnings management, Dispositional ethics

INTRODUCTION

Earnings management encompasses expenses and revenue manipulation to obtain required financial reporting results. (Whalen 34). Earnings management has contributed to the downfall of a number of companies, like the Sunbeam and Enron. The down fall of conglomerates like Enron due to earning management has led to creating and development of stiffer regulatory changes by the standard setting authorities and the accounting profession (SEC 23; Elias, 15). For example, Sir David Tweedie, the chair of IASB (International Accounting Standards Board) in the 2002 testimony lamented of the widespread use of earnings management in most of the companies at that time. He was addressing the UK Parliament Select Committee on Treasury. Again I the year 1998, Arthur Levitt, the US SEC (Securities Exchange Commission) Chair, sounded an alarm that the financial markets earnings management were undermining the financial markets credibility and eroding the investor confidence (Livett 67). This trend has been recently witnessed in some global markets.

However, irrespective of the regulatory attempt and effort to deal with the aggressive financial reporting, (for instance the 2002 Sarbanes-Oxley Act), earnings management still persist and has been as a result exacerbated by the incentives of the managers (Cohen et al. 43). Therefore, it is necessary to understand earnings management concept and to study the possible ways to reduce the potential effects of earning management (SEC 3).

To deeply investigate this issue, this research paper undertakes an experiment to study and analyze the joint effects of the incentive conflict. For example, the absence and presence of personal financial incentive that have a potential conflict with the cooperate financial incentive and the CFOs’ (chief financial officers) assessments of the ethicalness of the primary motivations for the earnings management (referred to here as EM-Ethics and dichotomized as low or high), on the behavior of earnings management (Shin & Zhou 22).

In these study settings, an individual financial incentive (personal incentive) is one meant to increase the present period expenses with the aim of maximizing the potential bonus over a period of two years (Levitt 5). A corporate financial incentive on the other hand is open meant to minimize the expenses with the intention of achieving the company goals and objectives. The study manipulates its incentive conflict ,reason being that similar earlier studies discovered that the incentives assumes a significant role in the behaviors of earnings management (Ibrahim and Philippon, 55; Nurns and Kedia 22). The estimation of EM-Ethics specially designed for this research is a 14-item construct based on the managers’ motivations for controlling earnings that have been singled out in the seminal survey conducted by Graham et al. (9). The paper concentrates on, a dispositional measure, since, as put across by Al-Khatib et al. (15), the individual is the right and appropriate analysis unit when investigating ethics. And this is because it is the individual’s on codes of ethics that influences his or her behaviors ultimately.

LITERATURE REVIEW

Hypothesis Creation and Literature Analysis

Incentives and Earnings Management

Earnings management is a typical example and a scenario of an agency cost where conflict of interest between the principal (like a superior, firm, and shareholders) and the agent (like a manager) forces the agent to maximize her or his own economic benefits and interests at the expense of the principle (Jensen and Meckling 98). One of the methods to manage earnings is through expenses or revenue manipulation through making income decreases or income increasing discretionary accruals (Noronha et al., 23; Levitt 56). The manager’s accruals do seem to be income increasing when the managers develops incentives to accelerate earnings and seems income decreasing when they have incentives to defer the earnings. For example, using expanses, the management may overstate the involved costs when the company becomes highly profitable, especially where the company profits exceeds the expected financial profits or alternatively underestimate the involved costs to maximize the company profits in the present period. Such actions can be taken to prevent short falling short of a earnings target or a bonus threshold or alternatively to improve the IPO issue price (Cohen et al. 44; Holthausen et al. 77).

In an effort to reduce earnings management in an organization, the management may focus on the compensation contracts structure, which includes a base salary frequently together with a cash bonus (Jensen Mecking, 4; Crocker and Slemrod 66). A cash bonus can either be a variable (for example, based on the body achieving some specific financial objective) or may be a percentage of a salary (for example a retention bonus). In these study settings, it is the variable bonus element of the contract of compensation that gives a personal incentive to manage earnings through a self-interested discretionary accruals.

In this research setting, bigger discretionary expense accruals will help in maximizing the bonus payout potential over a period of two years but will however conflict with the corporate financial incentive to reduce the overall expenses. Therefore, it is expected that when the CFOs have a conflicting individual / personal incentive with a corporate incentive, they will seem to be larger discretionary expense accruals compared to when the lack conflicting incentives. That means that we expect the CFOs to look smaller (larger) discretionary expense accruals representative of income decreasing (increasing) earnings management when a conflicting individual financial incentive with a corporate financial incentive is absent (present). Therefore hypothesis:

H1 EM-Ethics and conflict incentive will interact in a way that in the absence (presence) of a personal/ individual conflic9tng incentive with a corporate financial incentive, CFOs having low EM-Ethics will give a smaller (larger) discretionary expense accruals when compared to the high EM-Ethics CFOs.

The Mediating Role of Moral Disengagement

We posit that the incentives and EM-Ethics are activated through moral disengagement, with low (high) disengagement propensity diminishing (exacerbating) earnings management behavior. That we means that we expect that the CFOs EM-Ethics will influence their tendencies significantly to morally disengage and submit to incentives.

The following effect is therefore hypothesized:

Fig. 1 Mediated-moderation model

illustration not visible in this excerpt

The hypothesis H3 incentive conflict will moderate the relationship between the moral disengagement tendencies of the CFOs and their decisions on the discretionary expense accruals, in a manner that the moral disengagement tendencies of the CFOs are influenced by their own personal EM-Ethics levels.

RESEARCH METHODOLOGY

The Research Participants

The research participants in this project are 83 experienced preparers of financial statements (financial officers with the “CFO” title or equivalent). These CFOs are 28.53 years of experience in professional work. 65% of the participants had prior or current experience working in a publicly traded firm. Another 74% of the CFOs have experience working as external auditors. The participants showed experience with the job of recording expense accruals on a seven-point scale recording a mean of 6.12 (reverse-recorded). Where I means “not at all” while 7 means “extremely.”

Procedure and Task

The research participants were all given case materials containing the background information of the company, advisory projects under process and unbilled consulting schedule, post-experimental questionnaire and the task objective. They were then informed to assume that they were the ones in charge of the publicly traded firm and asked to consider accrual decision for the year end relating to consulting job that is in process, but for which there is no billing that has taken place. The participants, each in his/ her own condition were told that staying focused on controlling the present year costs will assist the form meet the corporate financial objectives and targets. Every participant was awarded with the identical services schedule given by vendors, estimated contract amounts and project status information.

Dependent and Independent Variables

The main dependent variable is the recommendation of the discretionary expense accrual of the participant. The dependent variable question the participants had t respond to is: “what amount do you recommend to be recorded for advisory and consulting services which are not yet billed?” the participants were given the option to recommend zero accrual to be made for the services.

A mediating variable is employed to test H3: moral disengagement which was estimated using 8-items measure of a personal/individual propensity to disengage morally (a=0.76).

The research respondents rated every item on a seven-point scale where 1 means “disagree strongly” and 7 means “agree strongly.” This means that the higher the individual score the higher his/her propensity to disengage morally. The two independent variables, EM-Ethics and incentive conflict create a complete factorial design; 2 9 2.

The absence or presence of incentive conflict was operationalized through giving the correspondents with individual financial incentive that either did not conflict (e.g. a fixed bonus or conflicted (e.g. a variable bonus) with the corporate financial incentive. As a result, the respondents in the in the absent condition in the incentive conflict are informed that, irrespective of any entry of expense, they get a 25% guarantee fixed bonus of base salary of $200,000 in both the first and second year. Therefore, there is no conflict existing between the company’s incentive and individual personal incentive to minimize expense. The same is applied to the absent condition, where the participants in the incentive conflict current condition are also given information on their decision implication. To be more specific, in the present condition incentive conflict, the correspondent’s bonuses vary depending on the targets achieved for minimizing the expenses of the plant. The bonus also vary as a base salary percentage (base salary is $200,000). The year 1 projected plant expenses are $77.1million, which is $3 million. The participants are therefore informed that the cusion provides them the chance to record an amount not exceeding $3 million without destroying any part of the maximum 40% bonus for the first year and increases the chance of getting their bonus in the second year.

RESEARCH RESULTS

Hypothesis testing and manipulation check

The incentive conflict manipulation check shows that the correspondents understood the manipulation. Only one research correspondent identified their incentive conflict incorrectly (e.g. whether their bonus was variable or fixed). Removing this correspondent from the study does not alter any of the drawn references. Hypothesis 1 and H2 are tested through A 2 9 2 ANOVA method where EM-Ethics, incentive conflict and their interaction serve as the CFOs’ rank transformation and independent variables for the expense accrual amount for the unbilled advisory and consulting services in the dependent variable. Mediated-modernization procedure is used to test hypothesis 3 as recommended by Muller et al. (P. 45). Cells means and the ANOVA results are provided in table 1. The first column shows that the model is significant, overall (p = 0.049, F = 2.74).

Test of Hypothesis 1

The hypothesis 1 predicts/ posits that the CFOs will show a record smaller (larger) discretionary expense accruals in the absence (presence) of individual financial incentives that conflicting with the corporate financial incentives. To effectively test hypothesis 1, the results of the primary effective incentive conflict are examined in the 2 9 2 ANOVA framework. Column B in table 1 gives discretional results that are consistent with expectations, even though they are not significant. The recommendations for CFOS expenses accruals are specifically higher when there is incentive conflict (present) mean $825,162) than when there is no incentive conflict (absent) mean = $692,152. Thus, hypothesis 1 is not supported.

Test of Hypothesis 2

The hypothesis 2 predicts/ posits that the incentive conflict and EM-Ethics will interact in a manner that in the absence (presence) of an individual financial incentive conflicting with a corporate financial incentive, the CFOs possessing low EM-Ethics will give smaller (larger) discretionary expense accruals in comparison to financial incentives. On the other hand, the CFOs possessing low EM-Ethics will give smaller (larger) discretional expense accruals in comparison with CFOs with high EM-Ethics.

Table 1 reports discretionally and significant consistent interaction between incentive ethics and EM-Ethics in predicting the expense accrual amounts for the CFOs (p = 0.003, F = 8.19), giving support to hypothesis 2. As earlier predicted and expected, non-tabulated comparisons within the conditions of incentive conflict show that high (low) CFOs EM-Ethics expense accruals are significantly smaller (larger) when there is incentive conflict (p = 0.029, F = 4.25). When there is no incentive conflict, (high) low CFOs’ expense accruals EM-Ethics are significantly smaller (larger), as predicted (p = 0.023, F = 4.25).

illustration not visible in this excerpt

Test of Hypothesis 3

From the research results, we find that the CFOs having low EM-Ethics gives significantly greater moral disengagement propensity as compared to the CFOs having high EM-Ethics (p = 0.002, non-tabulated means = 13.40 and 10.70 in that order, one-tailed). Besides, moral disengagement is dichotomized to facilitate the H3 discussion and highlight the relationship between CFOs expense accruals, incentive conflict and moral disengagement more clearly.

illustration not visible in this excerpt

In line with the experiment theoretical development, the paper findings shows that the CFOs registering lower moral disengagement tendencies yields larger (smaller) expense accruals in the absence (presence) of individual financial incentives that have a conflict with corporate financial incentive (p = 0.14, non-tabulated means = $575,882 and $865,950 in that order, one-tailed), and as a result overriding both company and individual incentives to manage the earnings. The CFOs that records relatively higher moral disengagement tendencies make smaller (larger) expense accruals in the absence (presence) of individual financial incentives that have conflicts with company financial incentives (p = 0.09, non-tabulated means being = $823,000 and $560,208 in that ordered, one-tailed), as a result pursuing the company and individual incentives achievements in managing earnings.

Consistent with the earlier studies, (Grant, 2008; Shin Zhou, 2007) H3 is tested using the mediated-modernization regression method as recommended by Muller et al. (2005). Muller (2005) says that three conditions have to be satisfied to prove that the mediator (in our case the moral disengagement) on the dependent variable (which is accrual) relies on the mediator (which is incentive conflict).

First, the incentive conflict (moderator) and the EM-Ethics (independent variable) interaction must significantly predict the accrual (dependent variable (table 2). Secondly, the EM-Ethics independent variable effect must significantly predict the moral disengagement (mediator) (eq 2, table 2). Thirdly, the interaction between incentive conflict (the moderator) and the moral disengagement (the mediator) must predict the accrual (dependent variable) significantly while at the same time controlling the mediator and the communication between the moderator and the independent variable (Levitt 54).

Therefore, the interaction between the moderator and the independent variable should be minimized (or insignificant in the situation of full mediation) in magnitude (p = 0.021, b = 0.237, one-tailed, table 2, eq 3) in comparison to the interaction between the moderator and the independent variable shown in the first step (p = 0.003, b = 0.310, one tailed, table 3 eq 1). MacKinnon et al. (2002) Sobel test reveals that this decline is statistically significant (p = 0.038, z = 1.78, one-tailed). Therefore, the overall incentive conflict (moderation) of the study independent variable (EM-Ethics) is partially being accounted for by the research mediator, the moral disengagement.

DISCUSSION

The research results only gives the directional (statistically not significant) support for the prediction/ expectation that the absence (presence) of individual financial incentive conflicting with the company financial incentive, the CFOs to seem to engage less (more) self-interested earnings management. The results are consistent with the literature hypothesis, the CFOs’ EM-Ethics communicates with the incentives to determine their earnings management behaviors. More specifically, the results show that the CFOs who have recorded high (low) EM-Ethics to tend to resist (give in) the incentives to manage earnings through booking (i) higher (lower) expense accruals in the presence of individual financial incentive that is in conflict with the company financial incentive. On the other hand, (ii) higher (lower) expense accruals in the absence of individual financial incentive that have a conflict with company financial incentives. The experiment results reveal that the influence of both corporate financial incentives and the individual financial incentives declines for high EM-Ethics CFOs. This means that a CFO’s ethical predisposition towards earnings management brings forth constraints on the earnings management behavior.

illustration not visible in this excerpt

Again, in line with the research hypothesis, the results suggest that there is support for a mediated-modernization impact whereby the EM-Ethics CFOs; significantly influences their propensity to disengage morally and give into the incentives. Again, in turn, the moral disengagement propensity affects the level of CFOs’ expense accruals differentially depending on their incentives. In other words, the incentive conflict (the overall moderation) is being partially accounted for by the moral disengagement (the experiment mediator).

REFERENCES

Cohen, D. A., Dey, A., & Lys, T. Z. (2008). Real and accrual-based earnings manipulations in the pre- and post- Sarbanes-Oxley periods. The Accounting Review, 83, 757–787.

Ghosh, D., & Olsen, L. (2009). Environmental uncertainty and managers’ use of discretionary accruals. Accounting, Organizations and Society, 34, 188–205.

Jensen, M. C., & Meckling, W. H. (1976). Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics, 3, 305 360.

Levitt, A. (1998). The numbers game. The CPA Journal, 68, 14–19.

Moore, C. (2008). Moral disengagement in processes of organizational corruption.

Journal of Business Ethics, 80, 129–139.

Muller, D., Judd, C. M., & Yzerbyt, V. Y. (2005). When moderation is mediated and mediation is moderated. Journal of Personality and Social Psychology, 89, 852–863.

Sarbanes-Oxley Act of 2002. Public Law No. 107–204[H.R.3763]. Washington, D.C.: Government Printing Office.

Shin, S., & Zhou, J. (2007). When is educational specialization heterogeneity related to creativity in research and development teams? Transformational leadership as a moderator. Journal of Applied Psychology, 92, 1709–1721.

Tweedie, D. (2002). The UK Parliament Select Committee on Treasury. UK: House of Commons.

APPENDIX

Earnings Management Ethics (EM-Ethics) Construct A

Items

Indicate your agreement with the following statements. Using accounting discretion allowed

within GAAP, I am willing to make an accrual…

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13 of 13 pages

Details

Title
CFOs’ Incentives and Earnings Management Ethics Impact on their Financial Decisions
Author
Year
2015
Pages
13
Catalog Number
V313013
ISBN (Book)
9783668307889
File size
650 KB
Language
English
Tags
Moral disengagement, Earnings management, Dispositional ethics
Quote paper
Dennis Nangabo (Author), 2015, CFOs’ Incentives and Earnings Management Ethics Impact on their Financial Decisions, Munich, GRIN Verlag, https://www.grin.com/document/313013

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