Printer Friendly

Toeing the line: the ethics of manipulating budgets and earnings.


Organizations that link accounting measures to pay frequently contend with a variety of undesirable, and often unethical, behaviors. The business press is replete with stories about how employees engaged in dysfunctional, questionably ethical, and sometimes illegal behaviors in order to make themselves look better on performance evaluations and obtain bonuses. These behaviors generally occur in two related contexts: (1) biasing information or otherwise coordinating activities to "game" the realization of budgets or (2) timing reported or actual economic events to shift income between periods, also known as earnings management.

There are several reasons why it is important to study the ethics views of accountants and other financial professionals about decisions made in these contexts. First, the Sarbanes-Oxley Act of 2002 (SOX) makes CFOs and controllers responsible for ensuring that financial processes, including budgeting and financial reporting, are sound and that information is reliable. Second, companies need to know the ethics views of employees who represent the source of much transactional data and on whom management accountants rely for developing a host of reports and analyses, such as budgets, forecasts, and project/product evaluations. If individuals benefit from financial incentive schemes, then the information may be biased and lead to sub optimal decision making. Third, employees may not even be aware of ethics issues related to budgets and earnings management, suggesting a need for intervention. Finally, it is instructive to know how individuals in supervisory roles might act to reinforce or reprimand employee behavior in these situations as part of management-development activities.

We sought to provide insights about such views among high-income, experienced accountants and financial professionals who are likely to have witnessed budget-gaming or earnings-management activities in their own organizations. We asked our subjects to judge the ethics of two fictitious individuals engaging in efforts to meet targets and gain bonuses in the face of favorable or unfavorable organizational outcomes. In addition, we asked respondents to put themselves in the role of supervisor to evaluate the behavior of these employees.


Compensation often is determined in part by meeting certain earnings targets, frequently rooted in the budget. Managers, in turn, have incentives to manipulate earnings, the budget, or both to maximize their pecuniary benefits (such as salary, commissions, or bonus) while avoiding actions that might make it more difficult to meet next year's performance standards. For example, they may choose various inventory and bad debt accounting methods, or they may manipulate revenues and expenses as the circumstances dictate.

Most individuals would regard behaviors to enhance an opportunity to receive a positive performance evaluation, pecuniary reward, or organizational acclaim and recognition as unethical. Many compensation experts believe that organizations can eliminate incentives to manipulate budgets or quotas and/or manage earnings only if managerial incentive contracts do not include accounting measures. Some commentators consider earnings management to be one of the most important ethics issues facing the accounting profession today. Individuals, however, may judge the practice as ethical or unethical depending on the action--although some people regard earnings management as unethical in all situations, regardless of intent.

Budget-based performance standards create incentives to "sandbag" or "game" the budget process, manipulate information, and engage in improper arrangements with customers. Most companies choose performance standards based on their business plan, budget, or prior-year performance. These metrics are "internal" standards because they are based, in large part, on managerial actions or performance in the current or prior year as compared with external standards that are not affected by managers. Income smoothing (earnings management) is more common in companies that use internal standards. Managers manage earnings to meet, but not exceed, the budget and to realize bonuses that are close to their target maximums.

Budget-based performance contracts are one of the most common causes of dysfunctional behavior in organizations. This approach to motivating people has induced them to engage in behaviors that include lying, cheating, and shirking. In addition, these systems fail to create enduring commitment, they increase dependency rather than empowerment among employees, and they lead to management cultures based on fear, all of which may lead to dysfunctional behaviors. Indeed, one of the most serious corporate-level consequences of tying the budget to pay is the tendency for the entity to compromise its integrity and reputation, possibly leading to fraudulent behavior by employees and managers alike. Academic and professional publications have reported numerous actual cases of budgetary gaming.

Given the widespread nature and acceptance (in some cases) of using the budget to influence pay, it is not always clear whether these behaviors are ethical or unethical. In the case of budgetary biasing, there are potentially positive and negative consequences. Whether gaming the budget is an accepted practice or not, behavioral norms in an organization are sometimes an explicit factor in determining the ethicality of budgetary manipulation. This behavior is often a response to management pressure: Higher levels of management are generally accepting of this practice and are concerned more with controlling slack instead of eliminating it. The Securities & Exchange Commission (SEC) and the courts agree that lying about the occurrence of business transactions, falsifying accounting records, and defrauding customers are illegal actions. It follows that these activities are also unethical.


When earnings approach an unacceptable level, executives' incentives to manage them upward are significant. When bonuses are near their maximum, however, further earnings increases will be rewarded little, and the incentive is to rein in today's earnings (shift them forward) in order to make future targets easier to achieve.

Earnings management, as judged by academics and professionals, may be ethical or unethical. Some regard earnings management accomplished by choices of accounting policies, accounting judgment, or timing of operating decisions as ethical--or at least more ethical than that done for personal gain (bonuses) or to deceive. Participants in some studies, including one of MBA students acting as shareholders, judge earnings management actions that benefit the firm as more ethical than earnings management that chiefly benefits the individual. Other studies report that judgments vary by the observer's role: External stakeholders regard any earnings management as unethical, while internal managers are more critical of accounting-related, rather than of operations-related, earnings management. Thus, there is a continuum of views about earnings management practices, with judgments depending on a combination of the specific action and the moral perspective of the individual.

Research shows that earnings-management practices impact the reputations of managers adversely because they affect judgments about a manager's morality, although a favorable work history tends to mitigate these judgments. Moreover, a manager found to engage in this behavior may suffer a loss of work-related opportunities and may be judged as "less moral" than managers who did not engage in earnings management.


We created four separate versions (A through D) of two ethical dilemmas (a total of eight scenarios) to test how accounting and other financial professionals judge ethical behavior in the contexts of budget gaming and earnings management. We based our scenarios on descriptions of actual events that occurred at Sears and Chrysler. Dilemma 1 concerns an employee's dysfunctional/unethical actions to improve performance versus the budget (achieving a quota), where the individual lies to and/or cheats customers in order to earn commissions and bonuses. Dilemma 2 is related primarily to earnings management in that the employee directly manipulates components of net income to maximize his personal bonuses.

Each employee was engaged in one of the following scenarios: (1) unethical behavior having favorable consequences for the organization, (2) unethical behavior having unfavorable consequences for the organization, (3) ethical behavior having favorable organizational consequences, and (4) ethical behavior having unfavorable organizational consequences.

We presented each of these scenarios through the eyes of two fictitious employees: Jim Yand, an auto mechanic, and Terry Patton, a car dealership manager. In the first scenario, a budget-gaming situation, Jim is anxious to meet and exceed quotas so that he can earn additional commissions and a bonus on repair sales. To help himself exceed these quotas, Jim decided to routinely recommend completely unnecessary (and expensive) auto repair services to unsuspecting customers, who are impressed with the perceived thoroughness of his work. The resultant increase in customer demand has boosted the repair shop's profits this year.

This same unethical gaming of the budget, however, could have turned out very poorly. If word had gotten out about Jim's strategy, the repair shop could have lost a number of good customers, causing overall profitability to drop this year.

Now let's examine two twists on an earnings management scenario that again involve unethical behavior. Terry Patton, the dealership manager, is anxious to maximize his incentive compensation, which is based on the dealership's budgeted net income. Terry receives a higher bonus if he achieves 120% of this target and a lower bonus if he achieves only 80% of it. The sliding scale between these two performance extremes is not linear and encourages achievement of net income in excess of the budget (100%). Terry calculates that if he accelerates or delays revenues and expenses to increase the variability of his dealership's net income, over time he will, on average, receive higher bonus income than if he does not manage revenues and expenses. He tells his friends at rival dealerships about his compensation strategy and is able to convince these very able managers to join his company because the compensation is so much more attractive. This causes Terry's company as a whole to become better managed and more profitable this year.

What happens, though, if Terry does not reach out to managers at rival dealerships but instead shares his strategy with his friends who are managers at dealerships of the same automaker? In this scenario, these other managers may also begin to manipulate revenues and expenses, causing the company as a whole to experience a decline in annual profits--which, if discovered, could be solely attributed to Terry's strategy.

Of course, ethical behavior, too, can have good and bad outcomes. In a different scenario, Jim Yand, our auto mechanic, has observed that a number of other employees at the shop are anxious to meet and exceed quotas so that they, too, may earn additional commissions and a bonus on repairs. To get there, these employees routinely recommend unnecessary and costly repairs. Jim, however, thinks this is a highly inappropriate strategy, which he speaks out against in an employee meeting, where he receives some support but also some criticism. Nevertheless, over the next several months, employees who followed Jim's recommendation attracted more customers to the repair shop than those who did not, increasing profits overall.

Consider, though, that Jim's ethical behavior could have had a negative effect on profits. Over the next several months, employees who followed his recommendation may have attracted fewer new customers and lost more long-standing customers compared to those who continued to suggest unnecessary services.

In an earnings-management scenario, what if our car dealership manager, Terry Patton, did the right thing at a managers' meeting and spoke out against manipulating revenues and expenses? Sure, he might have encountered the same sort of pushback that Jim Y and came up against, but the company as a whole might have been more profitable because of those managers who took Terry's advice to stop manipulating their dealer net income. Naturally, this strategy might have backfired as well--with an ethical behavior having a negative result--if some talented managers were so upset by Terry's comments that they left the company, suppressing overall profitability.


We assessed ethical judgment with a four-item "moral equity" measure used extensively in past work by ethics researchers. After reading each of the ethics scenarios, the respondents indicated the degree to which they perceived the actions presented were ethical or unethical based on the questions that appear in Table 1. We averaged the scores for an overall measure of ethical judgment. Finally, we asked respondents to indicate the action ("intention to intervene") they would take as a result of the behaviors depicted in the scenarios.

In all, we collected 276 responses from four different sources. Forty-six surveys came from professionals (primarily accountants) attending an ethics CPE session of IMA[R] (Institute of Management Accountants). The remaining respondents were enrolled in three MBA programs targeted to working professionals. We asked respondents to complete the survey only if they were currently employed and if they had worked at least three years.

Two-thirds of our sample were male, and more than three-quarters were employed in either the West or the Midwest regions of the United States. Key characteristics of the respondents include high levels of base salary (more than $75,000), occupational tenure exceeding nine years, significant variable pay that topped 21% of base salary, and employment in large organizations (1,000-plus employees). Thus, respondents are likely to have experienced or observed incentives to boost variable compensation by exceeding budgetary targets or managing earnings. (Table 2 provides a further breakdown of respondent data.)


First, we examined relationships (correlations) between ethical behavior exhibited in the scenarios, organizational outcome, ethical judgment, intention to intervene, and whether or not the respondent worked in accounting/finance. Ethical conduct accompanied by favorable organizational consequences (survey C) is associated with the strongest subject perceptions of ethical behavior in addition to increased intentions to intervene with encouragement. Not surprisingly, the opposite is true when unethical behavior is mixed with unfavorable consequences (survey B). It is noteworthy that subjects with an accounting/finance background were associated with stronger ethical judgments in situations that involved earnings management. Accountants may be more apt to recognize this type of behavior because of their education, awareness of accounting scandals or SOX, or their own experiences.

Decision makers were more neutral in their judgments about employees' unethical actions to engage in budget gaming or earnings management when the consequences favored the firm. They also favored a reprimand that was less severe. These findings suggest that supervisors face pressure when unethical subordinate behavior helps the organization. Conversely, in the context of an ethical budgeting situation, when organizational outcomes shifted from favorable to unfavorable results, supervisors were much less encouraging to their subordinates.

Next, we developed regression models to explain respondents' ethical judgments and intentions to intervene. In all, we developed four models (two each for budget gaming and earnings management) of the form:
   Ethical Judgment or Intention to Intervene =
   constant + ethical behavior of employee +
   organizational outcome + supervisor +
   accounting/finance employee

All of the models were highly significant and explained 64% to 93% of the variation in ethical judgments and intentions to intervene. Results of the models indicated three significant findings:

1. The ethics of employee behavior and organizational outcomes are significantly related to ethical judgment and intention to intervene.

2. Situation-specific ethics are more important than organizational outcomes for determining ethical judgment and intention to intervene.

3. Accounting/finance personnel are more sensitive to earnings management issues than are employees working in other areas.

In three of the four regression models, either ethical judgment or intention to intervene was positively related to organizational outcome. This implies that management's perceptions of ethicality and their intentions to reprimand unethical conduct are influenced by the resultant consequences. It is also interesting to note that accounting/finance employment is positively associated with ethical judgment in earnings-management situations. This implies that subjects in the accounting/ finance function are relatively more concerned with ethical issues that relate to earnings-management activity as compared with subjects in other business disciplines. Again, as mentioned earlier, this may be because these professionals are more familiar with this kind of behavior.

Finally, we tested differences in mean values of ethical judgment and intention to intervene. The results show that professionals' ethical judgments and intentions to intervene moderate (become less severe) when budgeting situations contain a mix of ethical behaviors and organizational outcomes. This occurs when unethical behaviors are associated with favorable outcomes and vice versa. For example, relative mean scores for ethical judgment moderate (became more neutral) at a statistically significant level when survey C (ethical behavior and favorable outcome) is compared with survey D (ethical behavior and unfavorable outcome) for both budget gaming and earnings management. It is interesting that if evaluations of survey B (unethical behavior and unfavorable outcome) are compared with survey A (unethical behavior and favorable outcome), there is not a significant change in ethical judgment.

The results support that intention to intervene moderates in all cases except budget gaming between surveys A and B. For example, when consequences changed from unfavorable (survey B) to favorable (survey A) regarding unethical behavior in earnings management, the mean score for intention to intervene changed significantly. Similarly, when consequences changed from favorable (survey C) to unfavorable (survey D) regarding ethical behavior in both scenarios, mean scores for a measure of intention to intervene again became more neutral.


Our results indicate that whether budget-gaming or earnings-management actions are ethical is the primary influence on decision makers' ethical judgments as well as on supervisors' intentions to intervene with reprimands or encouragement. Organizational outcomes are also significant. Ethical judgments of subjects and related intentions to intervene become more neutral when unethical actions produce favorable results, and vice versa, as in situations where ethical choices produce poor organizational results. This serves to highlight the ongoing problems organizations face in overcoming ethical conflicts. The finding that the "rightness" of an action dominates organizational outcome suggests that enhancing a firm's ethical culture may reduce incentives to engage in undesirable budget-gaming and earnings-management practices.

What are the implications of our results for accountants and businesses? Organizational characteristics such as an enhanced ethical environment (for example, formal ethics codes, ethics training, and socially responsible behavior), good management role models, and social pressure to reveal truthful information may deter budgetary gaming. Therefore, organizations should care fully cultivate an ethical atmosphere that is sensitive to the pressures employees may feel to game the budget through actions that involve cheating and/or manipulating earnings targets to maximize bonuses. In this same vein, some suggest that concern for maintaining a favorable reputation leads to lower budgetary slack creation. Other studies imply that management may want to empower employees with greater budgetary responsibility because this also tends to reduce unethical slack creating behaviors.

Seemingly, the only sure solution to these problems is to eliminate links between accounting measures and employee pay. We suggest that organizational ethics training include role-playing where both executives and rank-and-file employees are encouraged to make the ethically correct decision despite consequences that may be detrimental to the organization.

Management accountants--whether they function as CFOs, controllers, internal auditors, or simply as staff accountants--and their internal customers need to be sensitive to ethical dilemmas relating to the budget and earnings management. In addition to encouraging the ethical culture we have described, the preponderance of evidence suggests that management should sever the ties between compensation and budgetary/earnings performance. There are other ways to incentivize key employees, such as tying compensation to external metrics such as relative market share or other industry related (rather than internally focused) key performance indicators. Otherwise, the presence of unethical behaviors may compromise the reputation of management and the organization, leading to far greater consequences. For management accountants and other financial professionals who are in a position to influence key decision makers, now is the time to face these issues head-on.


Kenton B. Walker, Ph.D., is the chair of the department of accounting at the University of Wyoming College of Business in Laramie and a member of IMA's Denver-Centennial Chapter. You can reach Kenton at (307) 766-3154 or

Gary M. Fleischman, Ph.D., CMA, CPA, is an associate professor of accounting in the Rawls College of Business at Texas Tech University in Lubbock, Texas, and a member of IMA. You can reach him at (806) 834-7869 or
Table 1. Measuring Employees' Ethics

Ethical Judgment (measured using the Moral Equity Scale):

The following is a set of adjectives that allow you to share your
overall beliefs about the situation regarding auto mechanic Jim Yand's
behavior. (Please place a check mark in the space that accurately
reflects your opinion.)

                          1 2 3 4 5 6 7

                   Fair --:--:--:--:--:--:-- Unfair
                   Just --:--:--:--:--:--:-- Unjust
          Morally right --:--:--:--:--:--:-- Not morally right
Acceptable to my family --:--:--:--:--:--:-- Unacceptable to my family

Intention to Intervene:

Please use the following response scale and write the number that
indicates your perception regarding the actions that you would take
if you were Jim Yand's supervisor.

1 = Very Strong Reprimand
2 = Strong Reprimand
3 = Mild Reprimand
4 = No Action at All
5 = Mild Encouragement
6 = Strong Encouragement
7 = Very Strong Encouragement

Table 2. Respondent Demographics

Variable                                 Category

Age (years)
Base salary
Variable pay
Current job tenure (years)
Occupational tenure (years)
Gender                        Male
Functional classification     Operations/engineering

Industry classification       Manufacturing/consumer products
                              Miscellaneous services
                              Financial services

Geographic location           Midwest

Number of employees           Fewer than 100
                              100 to 999
                              1,000 to 9,999
                              10,000 or more

Variable                         Mean    Number of Responses

Age (years)                      34.91
Base salary                    $75,456
Variable pay                   $16,552
Current job tenure (years)        4.09
Occupational tenure (years)       9.48
Gender                                         179
Functional classification                      108

Industry classification                         98

Geographic location                            104

Number of employees                             52
COPYRIGHT 2013 Institute of Management Accountants
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 2013 Gale, Cengage Learning. All rights reserved.

Article Details
Printer friendly Cite/link Email Feedback
Author:Walker, Kenton B.; Fleischman, Gary M.
Publication:Management Accounting Quarterly
Geographic Code:1USA
Date:Mar 22, 2013
Previous Article:The hidden costs of customer dissatisfaction.
Next Article:Building accounting students' communication skills.

Terms of use | Privacy policy | Copyright © 2019 Farlex, Inc. | Feedback | For webmasters