Ambiguity, ethics, and the bottom line - accounting

Business Horizons, May-June, 1989 by James R. Davis

The aforementioned tricks of the managerial trade are used often and apparently without any legal repercussions. So why are these tricks disturbing? Why shouldn't they continue to be used just as they have been for years? Perhaps one reason is because investors find little comfort in learning that a company is showing losses through the write-offs of huge sums of previously accrued income items. Likewise, those who extended credit on the basis of previous years' euphoric financial statements are very displeased to learn of large write-offs. Another reason is the unfair way in which the real substance of annual reports is often hidden in the footnotes, putting at a distinct and costly disadvantage those who are not agile at discerning the intricacies of accounting convolutions and distortions. But perhaps what is most disconcerting is that in some situations it is possible for management to follow generally accepted accounting principles in the preparation of the company's financial statements and yet still produce a picture that is so colored in management's favor as to completely mislead many investors. This happens as a result of corporate management's identity crisis, an anomaly that occurs when the self-preservation instinct of a company's executives collides with interests and objectives of the stockholders and society in general.

ECONOMIC REALITY VERSUS USEFULNESS

Regardless of organization type or size, management holds primary responsibility for reporting the results of operations and financial position. This responsibility involves both the selection of appropriate accounting policies and procedures and the development of adequate information systems. The managerial policies used in determining the bottom line also affect tax policy, regulatory actions, and internal record keeping. So how does management justify its manipulation of earnings figures? By claiming that financial statement disclosures are necessary only to the extent that they enhance the statement's usefulness. The utility of accounting data depends on both relevance and reliability. If management feels that certain data are not relevant to a stockholder's decisions or that failure to disclose certain data will not affect the reliability of its figures, then the usefulness of the statement is not affected and the investor is supposedly saved the trouble of deciphering the details of reporting practices. Of course, economic reality is de-emphasized when arbitrary management decisions determine what data are beneficial and what data are detrimental to the financial statement's utility.

The American Institute of Certified Public Accountants (AICPA) has, however, drawn up a list of "red flags" that should alert auditors or other financial statement users to cases where economic reality has been excessively misrepresented to increase financial statement utility. The list includes the following:

1. Large, unusual transactions at the end of the year;

2. Large discrepancies between physical and book inventory;