The Impact of Earnings Management on Capital Markets: Ethical Consideration of the Players

INTRODUCTION In light of media attention to corporate scandals and numerous restatements of financial statement that occurred during 2001-2002 one common demand on company chief executive officers and chief financial officers became evident. This was to beat earnings forecasts by attainment of double-digit returns which subsequently drove up share prices of their respective companies. Why did this push for rapidly increasing stock prices that were experienced from the mid-1990s to the beginning of the 21st century evolve? Some (Jennings, 2004) say pressure on top management to inflate revenue and earnings figures was so great that CEOs and CFOs began to manage earnings in their quest to meet unrealistic demands of stockholders and other potential investors. This paper discusses the rise of the earnings management concept widely present during that time and its subsequent impact on stock price movement. The research then investigates situations that contributed to the earnings management schemes. Next, it compares stock price movement of 30 companies with three major stock market indices in an attempt to uncover management earnings situations. Finally, there is a discussion of ethics training of the parties involved that is aimed at elimination of earnings management schemes as they apply to annual financial statements. EARLY EARNINGS MANAGEMENT DETECTIONS Random isolated instances of corporate impropriety by CEOs, CFOs, and other top management officials surfaced during the first half of the 20th Century. The McKesson and Robbins Case in 1939 involved material overstatements of accounts receivable and inventories (Zeff, 2003). After that, all was fairly quiet until the middle 1960s when bankruptcies of Penn Central and Four Seasons Nursing Centers generated huge losses for investors. These were followed by the Equity Funding scandal in 1973 and W. T. Grant bankruptcy in 1975 (Largay, 1980). Corporate investors began to look suspiciously toward CEOs and external auditors, who had power and ample opportunities to manage financial statement information for personal gains. These improprieties now seem mild when compared to the ones of Enron, WorldCom, Adelphia, Global Crossing, Tyco, and K-Mart. EARNINGS MANAGEMENT FROM 1995-2002 In February 2001, Sunbeam Corporation received extensive media publicity involving the financial restatement process when the corporation filed for bankruptcy (Government Accountability Office, 2002). Shortly thereafter former CEO, Al Dunlap was charged with securities fraud. Sunbeam's management was involved in earnings management during the years 1996-1998. Dunlap came to the company in 1996 with promises to turn the company around. Liberal reserves were set up in 1996 to inflate the loss that year. The reserves produced overstatements of 1997 and 1998 earnings thereby giving the impression that Dunlap had turned the company around. Four former executives of General Re Corp. and a former executive of American International Group Inc. were convicted of inflating AIG's (New York Times, 2008) reserves through reinsurance deals that amounted to $500 million in 2000 and 2001 in order to artificially boost company stock prices. Reinsurance policies are backups purchased by insurance companies to completely or partly insure the risk they have assumed for their customers. Enron's problems first surfaced in the latter part of 2001. Global Crossing and WorldCom followed in early 2002 and not far behind was Adelphia, Tyco, and K-Mart among others. The market continued the growth trend of the late 1990s through early 2002, but finally gave way to the wave of corporate scandals around the first of April 2002. The market appeared to bottom out in September, made some recovery through the latter part of 2002, but then hit bottom again in early 2003. Enron's collapse was perhaps the first major shock for the investing public. Questions about its operations and declining stock price began to surface in early October 2001. …