Does the possibility of being included on a corporate watch list – that is, a public list that identifies companies engaged in more aggressive accounting practices – influence managers’ decisions to engage in earnings management? To learn the answer, Erin L. Hamilton, Ph.D., CPA; Rina M. Hirsch, Ph.D., CPA; Uday S. Murthy, Ph.D.; and Jason T. Rasso, Ph.D., CFE; distributed a survey to managers of public companies who have considerable financial reporting experience.

Their findings are detailed in a 16-page report, “The Naughty or the Nice List: Earnings Management in the Days of Corporate Watchdog Lists,” published by IMA^® (Institute of Management Accountants). In addition to the survey findings, the report offers perspective on the forms earning management can take, the ethical questions it can raise, and whether common benchmarks for right vs. wrong in use, such as “Would you want this action publicized in the news?” had any effect.

Among the key findings of the survey:

• Managers engage in more aggressive (income-increasing) earnings management when they believe such behavior will not be revealed publicly.
• The prospect of being included on a corporate watch list changes managers’ accounting choices. When managers fear inclusion on a watch list, they are less likely to engage in aggressive (income-increasing) earnings management and more likely to engage in conservative (income-decreasing) earnings management.
• Managers generally view earnings management as unethical (particularly income-increasing earnings management), but frequently engage in such behavior despite these beliefs.
• Managers give considerable thought to how their aggressive accounting choices might be perceived by others (such as investors, regulators, and auditors).

As the report concludes, “These findings suggest that earnings management behavior is largely contingent on the extent to which the public is able to detect such behavior through the use of investment tools, company watch lists, and other means. Specifically, the more observable a company’s accounting practices are to the public, the less likely managers are to engage in aggressive (or potentially fraudulent) financial reporting…Managers should keep in mind, however, that some of the events that negatively impact accounting risk metrics (such as issuance of debt or equity, officer changes, and large fluctuations in account balances) simply occur in the normal course of a business. As such, it isn’t always possible for managers to avoid the appearance of aggressiveness. Nonetheless, managers should consider how their accounting choices may be perceived by the public because, in today’s environment, someone is always watching.”

For information on IMA’s other thought leadership resources, please visit the Insights and Trends page.