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Economic Analysis

prices it sets for stocks, it will do so promptly, and with- strengthening the hand of the board of directors and the
out regard to the source of that information. audit committee; enhancing the professionalism of out-
Even if the final net income number on a company’s side auditors; and requiring fairness sign-offs by the chief
income statement has been enhanced by earnings manage- executive officer (CEO) and the chief accounting officer.
ment, the efficient market hypothesis holds that analysts Those regulations may help keep the pressures in balance,
and other readers of the financial statements will correct and reduce the incidence of earnings management.
for that overstatement, preparing an adjusted or pro forma But in the end, fair financial reporting depends on
income statement backing out the items that artificially the integrity of the company’s financial team. Every CEO
benefited the reported results. That will be true only so needs a well-respected accountant at his or her side, to
long as information about the artificial enhancements is help temper the temptation within the company to man-
fully disclosed. Information about earnings management age earnings. Every company needs a high-integrity chief
can be disclosed to the readers of the income statement in accounting officer who is prepared to say, “No, we should-
several ways: n’t give in to the pressure—I can’t let our company go
down that path.”
• The impact of material, unusual events or transac-
tions should be highlighted as separate line items in
the income statement (Accounting Principles Board BIBLIOGRAPHY
American Institute of Certified Public Accountants. (1973).
Opinion 30)
Reporting results of operations. Accounting Principles Board
• The footnotes to the financial statements should Opinion No. 30. New York: Author.
describe the earnings impact of any changes in Dechow, Patricia M., and Skinner, Douglas J. (2000). Earnings
accounting policy, or changes in estimates (Financial management: Reconciling the views of accounting academics,
Accounting Standards Board Statement No. 154) practitioners and regulators. Accounting Horizons, 14(2),
235–250.
• The management’s discussion and analysis (MD&A)
Financial Accounting Standards Board. (1978, November).
segment of SEC filings should “Describe any
Statement of financial accounting concepts no. 1. Norwalk, CT:
unusual or infrequent events or transactions or any Author.
significant economic changes that materially affected
Financial Accounting Standards Board. (2005, May). FASB state-
the amount of reported income” and “The discus- ment 154: Accounting changes and error corrections—A replace-
sion and analysis shall focus specifically on material ment of Accounting Principles Board (APB) opinion no. 20 and
events … that would cause reported financial infor- FASB statement no. 3. Norwalk, CT: Author.
mation not to be necessarily indicative of future Levitt, Arthur, Jr. (1998, September 28). The “Numbers game.”
operating results” (U.S. SEC Regulation S-K) Speech given at New York University Center for Law and
Business. Also, reprinted in The CPA Journal, December
A company’s management might argue that they had 1998.
good reasons for changing the process they had followed McKee, Thomas E. (2005). Earnings management: An executive
in establishing reserves, or even for offering sales incen- perspective. Mason, OH: Thomson.
tives at the end of a period. Such moves cannot be—and Panel on Audit Effectiveness. (2000). Earnings management and
should not be—constrained under the flexibility that is fraud. In Report and Recommendations. Stamford, CT:
inherent in accrual accounting systems. The market Author.
should not be deceived so long as the effect of those U.S. Securities and Exchange Commission. (2004). Regulation
adjustments is fully detailed in the notes or the MD&A. S-K, Section 229.0 Retrieved February 15, 2006, from
http://www.sec.gov/divisions/corpfin/forms/regsk.htm
But without full disclosure, the enhanced income state-
ment may well present a misleading picture of the com-
pany’s operations. An income statement, enhanced by Robert J. Sack
earnings management without adequate disclosure, may
well be a fraudulent income statement.

A HIGH-INTEGRITY FINANCIAL ECONOMIC ANALYSIS
ORGANIZATION IS THE BEST Economic forces affect decisions made in personal busi-
DEFENSE ness activities, as well as within business organizations,
As Levitt said, the pressure to practice earnings manage- government entities, and nonprofit organizations.
ment is not new—what is new is the intensity of that pres- Changes in economic conditions affect and are affected by
sure. With the passage of the Sarbanes-Oxley Act of 2002, supply and demand, strength of buying power and the
the community has established some contrapressures: willingness to spend, and the intensity of competitive

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