Earnings management and the environment – we hit you either way

When companies massage the books, the environment takes a hit, indicates a recent article on the Canadian Accountant website

Here are some extracts:

  • Earnings management may be a form of financial fraud, but there are plenty of defenders who say accounting standards allow for managerial discretion in reporting earnings. Besides, when firms manipulate their books, aren’t they hurting themselves more than anyone else? 
  • It’s this seeming lack of an identifiable victim that has led many accounting professionals and researchers to conclude that it’s no big deal. New research, however, reveals a darker story. 
  • Two recent studies show how a company’s obsession in meeting earnings expectations can victimize vulnerable employees. One documented higher workplace injury and illness rates in firms that meet or just beat analyst forecasts — the result of increases in employee workloads and out-of-the-ordinary reductions of discretionary expenses.
  • A second study connected earnings management to corporate wage theft, which happens when firms fail to pay employees for overtime or force them to under-report the number of hours worked. 
  • A new study… showed an even wider fallout from earnings management — an increase in air pollution, with long-term health consequences…From the perspective of a company looking for a quick fix, cutting pollution abatement expenses is often a better alternative than cutting research and development or advertising, which could damage its mid- or long-term interests. By switching off the scrubbers, the firm passes on the long-term costs of a dirtier environment to the community where it operates. 

The article concludes: “It’s time that the accounting profession, researchers and capital market regulators take earnings management more seriously. We need to know what companies are doing just to find a few pennies of earnings per share to meet quarterly or annual targets — and who ends up paying for such practices.”

The article seems to me to overstate its founding premise, that accountants and others generally don’t take earnings management “seriously.” The first paragraph I quoted above refers to “plenty of defenders who say accounting standards allow for managerial discretion in reporting earnings” as if targeting a bunch of unprincipled cynics, and yet as written, that’s merely a factual statement. Part of the problem is that the term is somewhat flexible and malleable. To the extent that earnings management refers to (say) the deliberate misstatement of results to meet a pre-determined target, it’s surely widely understood as being inappropriate. At the same time, of course, almost any set of financial statements makes heavy use of judgments and estimates, some of them perhaps selected from within wide acceptable ranges of possibility, and the impact of one number on the bottom line versus another is inevitably in the mind of preparers when making such selections. In that sense, it’s impossible entirely to disentangle “earnings management” from basic “financial statement preparation.” But if the companies adequately disclose those estimates and judgments, a user can understand, at least to some degree, how those areas might have contributed to “a few pennies of earnings per share” (the Canadian Accountant article links to another piece on the Strategic Finance website which focuses primarily on the “ ‘knowledge gap’ that exists between the managers who know the purpose of their accounting decisions and the users of the statements who lack insight into the goals underlying reporting decisions”).

That aside, obviously the authors can’t and don’t claim that if earnings management and other market-driven pressures were sharply reduced or eliminated, then companies would become worthy environmental leaders. It’s from that perspective that the finding takes on a certain dark poignancy – if companies are willing to screw the environment for the sake of a relatively meaningless short-term reporting benefit, then how much would they be willing to screw it for the sake of their broader business goals, hefty executive compensation packages and so forth? The most depressing thing about the article, to me, is the broader implication (intended or not) that maintaining favour in the eyes of the capital markets is to a great extent inherently inconsistent with sound environmental practice. For another perspective on that, a valuable recent opinion piece on the Responsible Investor website sets out how corporate disclosure and practice in this area often just amounts to “bullsh*tting others (or) bulls*tting yourself. The intention may be more sincere for the (latter), but it is bullsh*t just the same.”

One might get the sense from the Canadian Accountant article (not that the authors say this – I’m extrapolating to make a point) that there exists for any corporation an appropriate or “normal” level of earnings that might be achieved if earnings management and other unsavoury practices could be eliminated. But the very nature of capitalism is to push hard and fast, prioritizing its own short-term interests over all others. Even in the most egregiously objectionable cases of earnings management, the immediate price we end up paying is just a fraction of the ever-accumulating long-term tab…

The opinions expressed are solely those of the author

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