Ethical Obligations and Decision Making in Accounting, 4/e 1
Chapter 7 Discussion Questions1
Suggested Discussion and Solutions
1. In Arthur Levitt’s speech that was referred to in the opening quote he also said:
“…I fear that we are witnessing an erosion in the quality of earnings, and therefore,
the quality of financial reporting. Managing may be giving way to manipulation;
Integrity may be losing out to illusion.” Explain what you think Levitt meant by this
statement. What role do financial analysts’ earnings expectations play in the quality
of earnings?
The financial reporting process becomes unreliable when corporate managers, auditors,
and analysts all work together to deceive the investing public. The reason for the auditing
process is to independently verify that the financial statements present fairly financial
position and results of operations. Manipulation of financial reports leads to
Extended Discussion
What are Consensus Earnings?
Consensus earnings estimates are watched by many investors and play an important role
in measuring the appropriate valuation for a stock. Investors measure stock performance
on the basis of a company’s earnings power. To make a proper assessment, investors seek
a sound estimate of this year’s and next year’s earnings per share (EPS), as well as a
meet those targets within the penny.” Back in the early 2000s, “the practice had become
so enshrined in the culture of Wall Street that the men and women running public
companies often thought of little else. They become preoccupied with short-term
“success,” a mindset that can hamper or even destroy long-term performance for
shareholders. I call this the tyranny of quarterly earnings…
Tyranny is a slippery thing. Rarely does it make itself known for what it is right from the
start. Once you get under the domination of making the quarter — even unwittingly — you
start to compromise in the gray areas of your business, that wide swath of terrain between
A few companies, such as Thomson First Call, Reuters and Zacks Investment Research,
compile estimates and compute the average or consensus. Consensus numbers can also be
found at a number of financial websites, including Yahoo! Finance and MSN
MoneyCentral. Some of these sites also show how estimates get revised upwards or
downwards.
Consensus estimates of quarterly earnings are published for the current quarter, the next
quarter and so on for about eight quarters. In some cases, forecasts are available beyond
2. Are the use of non-GAAP financial measures ethical?
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One of the objectives of the Sarbanes-Oxley Act of 2002 (SOX) was to “eliminate the
manipulative or misleading use of non-GAAP financial measures and, at the same time,
enhance the comparability associated with the use of that information.” Consequently, the
SEC issued Regulation G, “Conditions for Use of Non–GAAP Financial Measures,” in
January 2003. It requires companies using a non- GAAP measure to disclose that the
measure isn’t misleading and to provide a reconciliation between their measure and the
most directly comparable GAAP measure. The GAAP presentation must have equal or
greater prominence. Management must disclose the reasons why the non-GAAP measure
provides useful information to investors and offer a statement of additional purposes for
which the non-GAAP measure is used. Only GAAP financial information can be
3. Relevance and faithful representation are the qualitative characteristics of useful
information under SFAC 8. Evaluate these characteristics from an ethical
perspective. That is, how does ethical reasoning enter into making determinations
about the relevance and faithful representation of financial information?
Relevance relates to the usefulness of financial information and whether all necessary
information has been made available for stakeholders to be able to make informed
decisions. Faithful representation addresses the honesty and integrity of the information.
Is it biased or slanted to be misleading? Relevance and faithful representation requires the
accountant to display the values of trustworthiness, honesty, integrity, reliability, respect,
fairness, and responsibility. Representational faithfulness refers to the requirement for
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4. Evaluate earnings management from a utilitarian perspective. Can earnings
management be an ethical practice? Discuss why or why not.
From a utilitarian perspective, the market, shareholders, investors, and other stakeholders
want a company to be profitable over the long-run. Quarterly financial reporting
introduces variability into earnings and other trends. Earnings management can smooth
the short term earnings and have little effect on the long-term earnings. Accrual
accounting is a form of earnings management for the short-term. Examples of accrual
accounting that manage earnings in the short term are accrued liabilities including
warranties at period end. These accrual adjustments enable the financial statements to be
reported more smoothly in the short-term without changing the long term results. Accrual
accounting provides smoothed short term financial reporting while not distorting the
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The $1.8 billion estimate doesn’t include the potential liability from a class action lawsuit
The point is that VW will estimate its future liability which, obviously, is not easy to do.
What if its 2015 earnings were extremely low? It could under-estimate the liability and
5. Evaluate the following statements from an ethical perspective:
“Earnings management in a narrow sense is the behavior of management to play
with the discretionary accrual component to determine high or low earnings.”
“Earnings are potentially managed, because financial accounting standards still
provide alternative methods.”
Refer to the discussion above about the use of accruals to manage earnings. The example
of VW illustrates how management can play with the numbers to reflect earnings based
on what it wants rather than what it should be.
The statements reflect that earnings management is a means to an end, that being
increasing earnings. The methods of managing earnings may either be ethical or
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6. Comment on the statement that materiality is in the eye of the beholder. How does
this statement relate to the discussion in the chapter of how to gauge materiality in
assessing financial statement restatements? Is materiality inconsistent with the
notion of representational faithfulness?
One of the definitions of materiality is that it is the amount that would cause an investor
to change his mind about investing in a company. Normally, a rule of thumb for
materiality is the amount that would change a net income to a loss or vice versa, or 5% of
revenue. However, many investors have their own definition.
Ask students what their definition of materiality is. One student in a class said that
materiality is the amount of money that he would not care about if his check book was
out of balance (i.e., $1). One student claimed that it was the amount that students were
making per hour on one of their jobs. Another student said it was the amount of money,
in aggregate, that would mean that he could complete his college education without
7. Needles talks about the use of a continuum ranging from questionable or highly
conservative to fraud to assess the amount to be recorded from for an estimated
expense. Discuss his concept of a continuum and the choices within a range from an
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ethical perspective. That is, how might a decision about the selection of one or
another amount in the continuum relate to it being an ethical position to take?
In Needles’s continuum, a neutral treatment is in the middle of the continuum reflecting
the mid-ground between high and low misstatements of GAAP. The continuum shows a
highly conservative amount on one end and fraudulent on the other. This continuum may
be thought of as a road with the two extremes being the curbs on either side of the road.
The idea is to stay between the two curbs. The two extremes distort the financial
statements and disclosures. These extremes do not reflect the virtues of honesty, full
8. In 2010 LinkedIn reported trade payable obligations totaling $10.8 million in other
accrued expenses within accrued liabilities instead of accounts payable. In 2011,
note 2 in the 10-K financial statements described the use of accrued liabilities
instead of accounts payable as a classification. Do you believe LinkedIn’s accounting
qualifies as a financial shenanigan? Why or why not?
Accounts payable is a liability account; normally it is considered a current liability or
payable in one year or less. Using the term “liabilities” instead of “payable” does not rise
9. Comment on the statement that what a company’s income statement reveals is
interesting but what it conceals is vital.
Here are some examples of where the earnings on the income statement revealed
information but concealed important facts about the true nature of the amount thereby
bringing into question the quality of earnings.
Revenue Gross-Up: Revenue Gross-Up is a practice that many internet firms used in the
early part of this decade. The companies would report the entire sales price a customer
paid at their site when in reality the companies kept only a small percentage of the
Related Service Agreements. Related service agreements may cause revenue
recognition problems. So for example, if a computer system is sold on a bundled basis at
$125 million at the time of installation and $25 million per year for each of the three
years of service, then the company should book $125 million at the time of installation
and $25 million per year for the length of the service contract. Xerox received one of the
largest civil penalties of the time for its leasing arrangements when it bundled the sale,
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10. Maines and Wahlen state in their research paper on the reliability of accounting
information: “Accrual estimates require judgment and discretion, which some firms
under certain incentive conditions will exploit to report non-neutral accruals
estimates within GAAP. Accounting standards can enhance the information in
accrual estimates by linking them to the underlying economic constructs they
portray.” Explain what the authors meant by this statement with respect to the
possible existence of earnings management.
The authors note that accrual estimates may be skewed under the right circumstances.
These accruals can be adjusted up or down to reflect desired results (earnings
management) rather than portray economic reality. For example, the bonuses payable to
top managers might be increased or decreased based on reported earnings with reference
to the earnings desired by management rather than to show the true liability agreed-to by
the CEO.
11. Krispy Kreme was involved in an accounting fraud where the company reported
false quarterly and annual earnings and falsely claimed that, as a result of those
earnings, it had achieved what had become a prime benchmark of its historical
performance, that is, reporting quarterly earnings per share that exceeded its
previously announced EPS guidance by 1¢. One method used to report higher
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earnings was to ship two or three times more doughnuts to franchisees than ordered
in order to meet monthly quotas. Would you characterize what Krispy Kreme did as
earnings management? Explain.
There are a variety of definitions of earnings management. Schipper defines it as a
“purposeful intervention in the external reporting process, with the intent of obtaining
some private gain (as opposed to, say, merely facilitating the neutral operation of the
process).” Healy and Wahlen define it as “when managers use judgment in financial
reporting and in structuring transactions to alter financial reports to either mislead some
stakeholders about the underlying economic performance of the company, or to influence
contractual outcomes that depend on reported accounting numbers.” Both of these
12. Safety-Kleen issued a major financial restatement in 2001. The next year, the
company restated (reduced) previously reported net income by $534 million for the
period 1997–1999. PwC withdrew its financial statement audit reports for those
years. Do you believe that financial restatements and withdrawing an audit report
are prima facie indicators that a failed audit has occurred? Explain.
Audit failure occurs when the auditor issues an incorrect audit opinion because it failed to
comply with the requirements of auditing standards. How does one decide if the audit is a
failure when the audit is properly planned and performed to detect material misstatements
but there was financial statement fraud by top management? It is possible to have a
proper audit and a misstatement goes undetected. It is also possible to have a problematic
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13. Revenue recognition in the Xerox case called for determining the stand-alone selling
price for each of the deliverables and using it to separate out the revenue amounts.
Why do you think it is important to separate out the selling prices of each element of
a bundled transaction? How do these considerations relate to what Xerox did to
manage its earnings? Do you think the new revenue recognition standard will
change the criteria in accounting for transactions like at Xerox?
Vendors often provide multiple products or services to their customers as part of a single
arrangement or a series of related arrangements. These deliverables may be provided at
different points in time or over different time periods. As a simple example, a vendor
may enter into an arrangement with a customer to deliver and install a tangible product
along with providing one year of maintenance services. In this arrangement, there are
three deliverables: (1) the product, (2) installation, and (3) maintenance services. Issues
Bundled transactions may have two or more components that require different accounting
methods (or treatments). An example might be the lease of equipment under an operating
lease, the maintenance of the leased equipment throughout the lease term, and the sale of
addition equipment unrelated to the leased equipment. The maintenance of the leased
equipment would be accounted for as executory (future contingency) costs. Another
example would be a cell phone company that offers a free phone as a reward for signing a
two-year service contract with the cell phone company. The same monthly service fee is
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Under the new standard, companies under contract to provide goods or services to a
customer will be required to follow a five-step process to recognize revenue:
1. Identify contract(s) with a customer.
3. Determine the transaction price.
5. Recognize revenue when the entity satisfies each performance obligation.
The new revenue recognition standard is more principles-based and may result in
financial reporting that, in some cases, is more reflective of the underlying economics.
The rule’s expanded disclosure requirements will help financial statement users
understand the nature, amount, timing, and uncertainty of revenue and cash flows arising
from contracts with customers.
14. Tinseltown Construction just received a $2 billion contract to construct a modern
football stadium in the City of Industry, located in southern California, for a new
National Football League (NFL) team called the Los Angeles Devils of Industry. The
company estimates that it will cost $1.5 billion to construct the stadium. Explain
how Tinseltown can make revenue recognition decisions each year that enable it to
manage earnings over the three-year duration of the contract.
Tinseltown should follow the percentage-of-completion method and recognize revenue
over the life of the contract based on a ratio of costs incurred to date to total estimated
costs on the contract. Using this approach leads to a proper matching of costs and
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here is no matching occurs and generally this method should not be used unless
uncertainty exists about the accuracy of the estimates.
Since the percentage-of-completion method involves costs estimates, it allows for
manipulation of the numbers and earnings management. For example, if the company
legitimately incurs $500 million in costs the first year, then 1/3 of the revenue
($666,666,667) should be recognized assuming the estimate of total costs remains at $1.5
15. Explain how a company might use the accounting rules for impairment of long-lived
assets to manage earnings.
The accounting for impairment of long-lived assets to be held and used depends on
judgments of fair value. Generally, if the fair value of the asset is less than the carrying
amount of an asset, an impairment loss is recognized. Under U.S. GAAP (Statement of
Financial Accounting Standards No. 144: Accounting for the Impairment or Disposal of
Long-Lived Assets), an impairment loss exists when the financial statement carrying
amount exceeds its fair value and is not recoverable. A carrying amount is not
The FASB rules require judgment in estimating future cash flows and fair value, thereby
providing an opportunity to manage the estimates and affect current and future earnings.
The amount of discretionary choice available to management in a decision to charge an
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This question provides an opportunity to incorporate a discussion of International
Financial Reporting Standards (IFRS) and provide students with one example of how
FASB and IFRS differ. IFRS provides (International Accounting Standard No. 36:
Impairment of Assets) that an impairment loss is recognized when the carrying amount is
greater than the “recoverable amount.” The recoverable amount is the greater of the fair
value minus costs to sell and the value in use (i.e., the present value of future cash flows
IAS 36:
Net selling price (40,000-1,000) $39,000
Value in use 46,000
Impairment loss $4,000
FASB 144:
Undiscounted cash flows $48,000
Fair value 47,0006
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16. The SEC’s new rules on posting financial information on social media sites such as
Twitter means that companies can now tweet their earnings in 140 characters or
less. What are the problems that may arise in using a social media platform to
report key financial data including the potential effects on shareholders and the
company?
On April 2, 2013, the Securities and Exchange Commission issued a report that makes
clear that companies can use social media outlets like Facebook and Twitter to announce
key information in compliance with Regulation Fair Disclosure (Regulation FD) so long
as investors have been alerted about which social media will be used to disseminate such
information.
Regulation FD requires companies to distribute material information in a manner
reasonably designed to get that information out to the general public broadly and non-
exclusively. It is intended to ensure that all investors have the ability to gain access to
material information at the same time.