Ethical Obligations and Decision Making in Accounting, 4/e 16
metrics, and they had never before taken steps to alert investors that Hastings’ personal
Facebook page might be used as a medium for communicating information about Netflix.
Netflix’s stock price had begun rising before the posting, and increased from $70.45 at
the time of the Facebook post to $81.72 at the close of the following trading day. The
SEC did not initiate an enforcement action or allege wrongdoing by Hastings or Netflix.
Several large companies, including computer-maker Dell Inc. and eBay Inc., use Twitter
to announce financial and other key information to investors. Many simultaneously send
out news releases or report the information in filings to the SEC. The SEC’s
announcement of the new policy will allow them to use social media more. Only 14.4%
of companies communicate with shareholders via social media, according to a 2012
17. Do you agree with each of the following statements? Explain.
• EBITDA makes companies with asset-heavy balance sheets look healthier than they
may actually be.
• EBITDA portrays a company’s debt service ability— but only some types of debt.
• EBITDA isn’t a determinant of cash flow at all.
Ethical Obligations and Decision Making in Accounting, 4/e 17
Fortune magazine had an informative story on the abuses of EBITDA as a measure of
true earnings on December 28, 2011. Top Five Reasons Why EBITDA Is A Great Big Lie.
The following is a summary of the key points made in that article.8
EBITDA makes companies with asset-heavy balance sheets look healthier than they
may actually be.
Understanding the amount of asset depreciation is of limited value in determining the
present viability of a company; instead, it’s a measure of what the company has spent, in
the past, on capital expenditures. However, a company in distress needs cash. EBITDA
ignores the company’s future asset needs. EBITDA leaves the viewer blind as to both
short- and long-term asset replacement needs — and those require cash, debt, or both.
EBITDA portrays a company’s debt service ability – but only some types of debt.
EBITDA is a measure created by investment bankers to answer the question “How much
debt can a buyer put on this company after it’s acquired?” And, for that, EBITDA does a
fine job, depending upon which spot in the debt structure a creditor occupies. The type of
debt held by a given creditor may leave that creditor in a position that is either
advantageous or highly precarious. Consider a hypothetical company that generates
EBITDA ignores working capital requirements (isn’t a determinant of cash flow at
all).
A positive EBITDA does not necessarily reflect that a retail store has to start ordering for
the holiday season, which means cash is going to be tied up in inventory. This means that
the company is going to need cash, which it may not have. So either it has to borrow
Ethical Obligations and Decision Making in Accounting, 4/e 18
18. Critics of IFRS argue that the more principles-based standards are not as precise as,
and therefore easier to manipulate than, the more rules-based GAAP. The reason
for this is that IFRS requires more professional judgment from both auditors and
corporate accountants with regard to the practical application of the rules. The
application of professional judgment opens the door to increased opportunities for
earnings management. Do you agree with these concerns expressed about
principles-based IFRS? Relate your discussion to the research results discussed in
this chapter.
IFRS are considered principles-based and allow for professional judgment to be applied.
The standards are more flexible in dealing with all economic and business situations.
Some might argue that allowing that much judgment introduces bias. U.S. GAAP is
considered rules-based or more prescriptive. Many feel that this tightens up accounting
and introduces consistency into the system. An argument against rules-based system is
that a rule is needed for every situation and the system later becomes unwieldy in size
and complexity. Although more guidance may give some comfort, it often becomes
difficult to ensure that standards are all consistent. It does not matter whether the
standards model is labeled as principles-or rules-based; the bottom line is that the model
selected needs to be robust, consistent, and manageable.
Ethical Obligations and Decision Making in Accounting, 4/e 19
reduction in earnings management. Earnings management was assessed as the frequency
of small profits compared to small losses, a technique used in past studies. Australia,
France, and the United Kingdom were selected for examination, as these three countries
were unable to adopt IFRS before the 2005 mandatory transition date, thus eliminating any
early adoption benefits. According to their research, earnings management remained
consistent in Australia and the United Kingdom after IFRS adoption. However, in France,
earnings management appeared to increase, suggesting that earnings quality was not
improved overall by adopting IFRS.
19. In the Enron case, the company eventually turned to “back–door” guaranteeing of
the debt of Chewco, one of its SPEs, to satisfy equity investors. Assume that a $16
million loan agreement required that Enron stock should not fall below $40 per
share. If the share price did decline below that trigger amount, either the loan would
be called by the bank or the bank could choose to increase the guaranteed number
of Enron shares based on the new price (assume $32). If the bank decides to increase
the number of shares guaranteed, what would be (1) the original number of shares
in the guarantee and (2) the new number of shares? Why would it be important
from an accounting and ethical perspective for Enron to disclose information about
the guarantee in its financial statements?
By guaranteeing the SPE’s debt, Enron was still at risk for repayment of the SPE’s debt
thereby failing to transfer the risk. At a minimum, the situation should have been fully
Ethical Obligations and Decision Making in Accounting, 4/e 20
In the example originally given, Enron would have pledged 400,000 shares of stock at
$40 per share to collateralize the $16 million loan. When the share price was reset to $32
20. In the study of earnings quality by Dichev et al., CFOs stated that “current earnings
are considered to be high quality if they serve as a good guide to the long-run profits
of the firm.” Discuss how and why current earnings may not be a good barometer of
the long-term profits of the firm.
Current earnings of a firm may not be a good barometer of the long-term profits of a
firm if those earnings are fraudulent. Examples of firms like Enron and WorldCom are
firms that had profitable currents earnings based upon fraud. When earnings are
manipulated in a given year, the shareholders may believe future earnings will show a
Ethical Obligations and Decision Making in Accounting, 4/e 21
What the chart above highlights, and the McKinsey study has twice observed, is that Wall
Street analysts can be herd animals and get somewhat anchored on a trend. They tend to
be late to revise earnings up, to be late to revise earnings down and to move in
groups. Beyond anchoring, we believe this is also due to pain avoidance. It is painful to
21. The auditor of Beastie Company is reviewing the following client information for
the prior year ended December 31, 2015, and all four quarters of 2016.
Ethical Obligations and Decision Making in Accounting, 4/e 22
Estimated Accruals in pretax earnings (in millions)
December
12/31/15
Quarter
ended
3/31/16
Quarter
ended
6/30/16
Quarter
ended
9/30/16
Quarter ended
12/31/16
Total
s
Characterize the accruals as discretionary or nondiscretionary. What are the potential
issues that the auditors should address given these numbers?
Accruals related to employee vacation pay are nondiscretionary because a company has
an obligation to pay employees when on vacation so it is a mandatory payment. Accruals
for charitable contributions are discretionary. The company is under no obligation to
The auditor normally examines documentation to test the existence of accrued liabilities
and other payables and to understand the nature and purpose of the accounts. For some
accounts it is necessary to further test by recomputation that amounts have been allocated
to the proper period or to establish their reasonableness by performing analytical
procedures.
For example, the auditor may:
a. Compare real estate tax notices with properties held.
b. Examine payroll records, payroll tax filings and subsequent cash payments;
recomputed accrued payroll amounts to determine allocation to the proper period; and
review the reasonableness of relationships among the payroll accounts when testing
accrued payroll and payroll taxes payable.
Ethical Obligations and Decision Making in Accounting, 4/e 23
22. Explain the meaning of the following two statements and why each may be true:
a. Where management does not try to manipulate earnings, there is a positive effect on
earnings quality.
When management does not try to manipulate earnings, then the earnings are reliable,
assuming it has been properly recorded in conformity with GAAP, and earnings quality is
high. However, even though management does not manage earnings it does not mean the
b. The absence of earnings management does not, however, guarantee high earnings
quality.
Where management does not try to manipulate earnings, there is a positive effect on
earnings quality. The earnings data is more reliable because management is not
influencing or manipulating earnings by changing accounting methods, recognizing one-
time items, or deferring expenses or accelerating revenues to bring about desired short-
term earnings results. The absence of earnings management does not guarantee high
earnings quality. This is true because some information or events that affect future
earnings may not (and cannot) be disclosed in the financial statements.
Earnings management and earnings quality have many things in common. Higher
earnings management will lead to lower earnings quality. However, lack of earnings
management (low earnings management) does not guarantee high earnings quality (or
accounting figures high quality in general), because there are other factors that affect the
Ethical Obligations and Decision Making in Accounting, 4/e 24
23. Big Pharma has been criticized for making deals that may bring harm to
shareholder interests. Evaluate the following transaction from earnings
management and ethical perspectives: A pharmaceutical drug company agreed to
make payments to wholesalers if they bought drugs they did not need. The company
paid $66 million to wholesalers who then “bought” $720 million of the company’s
drugs for which no customers existed.
Deals made to have wholesalers buy drugs they don’t need in return for payments by
pharmaceutical companies are designed to inflate revenues that probably will never be
collected and in amounts that are far in excess of the payments made to the wholesalers to
24. In well-governed companies, a sense of accountability and ethical leadership create
a culture that places organizational ethics above all else. What role does
organizational culture play in preventing financial shenanigans from being used to
manage earnings?
Organizational culture is the underpinnings of an ethical environment that sets a positive
ethical tone with leaders who are committed to ethical behavior. In organizations that live
by ethical values, employees are more likely to identify with those values and commit to
carry them out. Even employees who may lack the ethical foundation can be swayed by
social forces within the organization to act ethically.
Ethical Obligations and Decision Making in Accounting, 4/e 25
accountability among employees. The need to obey the law is viewed as a positive aspect
of organizational life, rather than an unwelcome constraint imposed by external
authorities.
25. Evaluate the following statement: Do the ends of positive organizational
consequences justify the means of earnings management?
In a paper titled “Managers’ Ethical Evaluations of Earnings Management and Its
Consequences,” (2011), Johnson, Fleischman, Valentine and Walker studied the ethics of
earnings management by examining the specific ethical dilemma that arises when a
choice to engage in earnings management results in positive organizational
consequences. This study focuses on the consequences of earnings management behavior
in response to the question: Do the ends of positive organizational consequences justify
the means of earnings management?10
The authors investigate manager evaluations of, and reactions to, a scenario in which a
hypothetical employee makes a choice whether or not to engage in earnings management
behavior, with consequences that are either favorable or unfavorable to the organization.
Ethical Obligations and Decision Making in Accounting, 4/e 26
Extraordinary Items
I was recently reviewing the FASB website for Accounting Standard Updates and I came
across the following update to be implemented for fiscal years ending after 12/15/15:
http://www.fasb.org/cs/ContentServer?c=FASBContent_C&pagename=FASB%2FFASB
Content_C%2FProjectUpdatePage&cid=1176164211686
It looks like the FASB intends to eliminate “extraordinary items” from the income
statement, citing that it detracts from the overall understandability of the financial reports
I also came across a discussion by Sarah McVay’s (currently at University of
Washington) dissertation.
McVay, S. 2006. “Earnings Management Using Classification Shifting: An Examination
of Core Earnings and Special Items”. The Accounting Review, Vol 81, 501-531.
In this paper, she finds evidence that managers will reclassify certain expenses from
ordinary income (more permanent income) to extraordinary items (more temporary
income) in order to beat the market’s expectations (since the market is focused on
