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.
Earnings management has attracted a lot of attention in academic research. 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
