By Scott B. Jackson
I recently watched the holiday classic “Groundhog Day.” If you aren’t familiar with the movie, it centers around a man experiencing Groundhog Day over and over. While watching the movie, I couldn’t help but think of “earnings management,” which is a subject I have studied for many years.
How are the movie and the subject of earnings management connected? Like “Groundhog Day,” earnings management (and other accounting abuses) occur over and over, despite the Securities and Exchange Commission’s century-long effort to curb accounting abuses. The recent FTX Ponzi scheme is a stark reminder of the persistent nature of the problem.
One question that has attracted little attention is, “Why is regulation often ineffective at eliminating accounting abuses?” Evidence from two recent studies provides a partial answer. The studies focus on “earnings management.” This is a euphemistic label for an array of accounting abuses that are often tolerated within organizations. Here is a common definition:
“Earnings management occurs 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.”
To illustrate earnings management, consider the following real-world example: A company was a few pennies shy of the consensus earnings forecast. To avoid the earnings shortfall, the company reversed an excessive reserve on the balance sheet, effectively resulting in an income-increasing expense in the current period.
An authorship team of which I am a part wanted to explore why earnings management is so prevalent. In our first study, which was published in the Journal of Business Ethics in 2022, we posited that organizations may hire managers who have dark personality traits (for example, narcissism) because their disposition to push ethical boundaries aligns with organizational objectives, particularly in the accounting function. Prior studies suggest that narcissists rise through organizations because they convince others they possess superior abilities, despite their accompanying negative traits.
Using several validation studies and experiments, we find that experienced executives and recruiting professionals sometimes favor hiring an accounting job candidate who has elevated dark personality traits into a high-level accounting position over an otherwise better-qualified candidate who lacks such traits. This tends to happen when the organization faces earnings pressure from capital markets. Almost all public companies face such pressure.
This hiring preference arose despite the recognition that the favored job candidate was more likely to get entangled in questionable behaviors, such as fraud. The study helps illuminate why individuals who have dark personality traits may ascend to positions of power and authority in the accounting function of organizations.
In our follow-up study, which is nearly complete, we focus on how organizations attract certain types of individuals into the accounting function. As a brief backdrop to this study, prior research shows that narcissistic executives are more likely to be associated with earnings management and other questionable corporate behaviors. We examine the creation of job postings and the response of different types of individuals to those job postings. We find that as pressure for earnings management increases, executive recruiters exhibit a preference for job posting terms that portray the ideal chief accounting officer candidate as a “Rule-Bender” (versus “Rule-Follower”).
To convey the concept of a “Rule-Bender” versus a “Rule-Follower” (the former tends to make a worse accountant and the latter tends to make a better accountant), the job posting used language such as “results-oriented” and “develops creative solutions” versus “process-oriented” and “relies on time-tested solutions,” respectively. We also find that job seekers with greater narcissism are more attracted to job postings that include “Rule-Bender” language.
These results suggest that earnings management is likely to be facilitated early in the recruiting process, as recruiters select language conveying a need for individuals who are inclined towards rule-bending, and like-minded job candidates tend to respond to such job postings.
What is the takeaway from these two studies? It appears that the types of people who are attracted to, and favored for, high-level accounting positions are the individuals who are predisposed to do questionable things. In contrast, the individuals who resist earnings management are either disfavored in the hiring process or less attracted to certain types of accounting job descriptions formulated by potential employers.
What should we make of our evidence? Our results suggest that regulatory efforts to curtail earnings management may achieve greater success if those efforts simultaneously target the human and cultural dimension of earnings management that is played out through the employee selection and attraction process. Indeed, the former chairman of the Securities and Exchange Commission, Arthur Levitt, hinted at doing more than enacting additional regulations when he called for “nothing less than a fundamental cultural change on the part of corporate management as well as the whole financial community” to eliminate earnings management.
Scott Jackson teaches undergraduate and graduate courses in financial and managerial accounting in the School of Accounting at the Darla Moore School of Business. His research has received multiple awards for its impact on practice.