Marshall School of Business
University of Southern California
Conservative Accounting
in the General Products Division
Teaching Note
Purpose of Case
This case was written to motivate an ethical discussion of earnings management activities. The
example presented here is different from most of those discussed because the earnings
management activities described in the case decrease income. That is, the accounting is
conservative. Conservatism makes more students conclude the actions are ethical. But arent
managers ultraconservative merely because they want to save profits they can turn in a later
accounting period if needed?
Suggested Assignment Questions
1. Do you approve of Roberts actions? Are they smart or stupid from the perspective of the
division? From the perspective of the corporation?
2. Are Roberts actions ethical?
3. Should Joanne tell anyone of Roberts request?
Case Analysis
1. What can be done to accelerate expenses and defer revenues?
Expenses that can be accelerated: R&D, advertising, discretionary maintenance, many
reserves (e.g., for bad debts, inventory obsolescence).
How to defer revenues: Dont ship the product before the end of the accounting period.
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2. Is this earnings management? How do you define what is or is not earnings management?
A narrow definition of earnings management is An intervention in the earnings reporting
process. This definition captures all accounting manipulations (e.g., changing judgments
about reserves or accounting policies), but it does not include the actions described in
question 1 (of case analysis) above.
I think a broader definition of earnings management is better. It is: Actions taken to make
performance look better (or worse) than it otherwise would be in the short run. In addition,
3. Are the actions Robert proposes taking smart or stupid?
4. Are the actions Robert proposes taking ethical?
Determine the facts
These facts should describe who, what, where, when, and how. Among the facts that should be
brought out are:
GPDs profits are significantly above plan.
Define the ethical issues
Stakeholders: Robert
Joanne (controller)
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Major ethical principles
2. Fairness
4. Virtues (e.g., integrity, honesty)
Ethical issues
An ethical issue can usefully be discussed if someone is hurt or put at risk. Is anyone hurt or put
at risk here? The answer is clearly yes. Still, compensating rights or principles may mean
1. GPD personnels well being (e.g., job security, bonus) vs. corporations right to fair
financial reporting
3. GPD personnels well being vs. Roberts (and Joannes) obligation to act with honesty,
integrity, and objectivity.
4. Roberts well being vs. stockholders right for maximum returns.
Will conservative accounting adversely affect stock price
Will conservative accounting adversely affect GPD personnels motivation?
5. Joannes desire and obligation to be a good team player within GPD vs. Joannes fiduciary
obligation as controller to have the division do fair and accurate financial reporting.
This list can be extended, but at least these issues should be identified.
Another way to portray the trade-offs is to list the stakeholders in a column. Then, add two
columns to the right, one titled Who benefits? and the other titled Who is harmed? For each
of the decision alternatives, put check marks in one of the right hand columns to show which
stakeholders benefit and which are harmed or put at risk.
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Decision alternatives and their probable consequences
1. Joanne carries out Roberts wishes
GPD achieves budget targets in current and future accounting periods. All GPD
management personnel retain their jobs, keep their stress low, and earn large bonuses
and possibly promotions.
Altman will pay inflated bonuses.
Layoffs in other divisions?
2. Robert abandons earnings management plans and reports unmanipulated earnings.
3. Joanne tells her controller superior of Roberts plan.
Joanne gets fired for not being a team player.
By this point in the discussion, or even earlier, some students will have begun to state their
ethical position. For example, they may say that this is standard practice or that this is deceptive.
The instructor should ask students to stick to the analysis and defer their conclusions until step 4.
Compare the alternatives with the ethical principles and choose the best
alternative
Students should balance the consequences against their primary principles or values and select
the alternative that best fits. Take a vote. Insist that everyone make a choice. Examine the
rationale for different positions.
Pedagogical Suggestions
The case discussion can be done with the entire class or with small groups. If the entire class
discusses the case, elicit the four-step method responses shown above. At the last step, have the
class vote regarding the appropriate conclusion. Then elicit reasons as to why individual
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If the class is broken into small groups, have each group analyze the case and reach a conclusion
(if they can). Then bring all the groups together toward the end of class for a reporting session.
Because the small group method is less directive, it should be used only after the instructor has
properly guided the class through a prior illustration of the proper use of the four-step ethical
analysis framework.
If it does not come out naturally, the class should be asked to put themselves in Joannes
position. What should she do? What if jawboning to Robert does not work? If she takes the
issue to her superiors, it will probably cost her her job. When does earnings management
If the instructor so desires, it is easy to motivate a discussion of what top managers at Altman
should do to control GPDs earnings management activities (and others like them). For
example, can an effective policy prohibiting earnings management activities be written? Would
a code of conduct be effective? Can internal controls be made stricter?
In conjunction with this or other similar cases (e.g., Graves Industries, Disctech Inc., Don
Russell: Experiences of a Controller/CFO), I have found it useful to report to students the
findings of surveys conducted to try to draw the line between ethical and unethical earnings
management actions. These surveys have found a striking lack of agreement between people in
K.A. Merchant, and J. Rockness, The ethics of managing earnings: an empirical investigation,
Journal of Accounting and Public Policy (1994), 7994.
W.J. Bruns, Jr., and K. A. Merchant, The Dangerous Morality of Managing Earnings,
Management Accounting (August 1990), pp. 2225.