Abstract
Using an experiment with corporate financial managers (e.g., CFOs, controllers), we find that when red flags are present in the financial statements under their review, managers identify those red flags and, in turn, have greater concerns over earnings quality. In addition, when pressure to meet a financial target is high, managers are more concerned about earnings quality when red flags are present. We also document that when red flags are present, managers are more likely to report both internally to their CEO and, if their concerns are not resolved internally, externally to their auditor. Pressure to meet a financial target increases the likelihood managers report internally, but decreases their likelihood of reporting externally when red flags are present. Additional analyses document reporting differences between CFOs and controllers, and examine the important roles that short-term personal costs, job tenure, and a non-accounting background play in the ethical dilemma managers face when deciding whether to report externally.
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Notes
In regard to the reporting environment, Italy has enacted whistleblower protection legislation with features that are consistent with that of other countries. For example, similar to requirements mandated by the U.S. Sarbanes–Oxley Act of 2002, Italian publicly traded companies that want to receive a positive assessment of their internal control systems are required to adopt whistleblowing processes that allow employees to report irregularities or violations anonymously. Similarities also exist between Italy and other countries in regard to earnings management. Burgstahler et al. (2006) and Van Tendeloo and Vanstraelen (2008) provide insights into earnings management in European firms, and Leoni and Florio (2015) provide a comparison of the U.S. and Italian earnings management literatures.
Extant research suggests that managers are more apt to report concerns internally over externally (e.g., Robertson et al. 2011; Brink et al. 2013). Consistent with this notion, demographic data from our participants (presented in Table 1 and discussed in the Participants section) illustrate a strong preference for reporting internally vs. externally. Given this preference, we designed our experiment such that participants chose to report internally first and then considered reporting externally only after “inside the company nothing was done in response to your concern.” We believe this design choice reflects the decision-making process managers would employ in practice.
For the initial sample of 951 companies, 132 were public (13.88%; 132/951), while 819 were private (86.12%; 819/951). The final sample of 204 companies consisted of 37 public companies (18.14%; 37/204) and 167 private companies (81.86%; 167/204).
According to a 2010 EY survey of 669 CFOs from Europe, the Middle East, India, and Africa, only 27% had obtained the MBA degree (http://www.ey.com/Publication/vwLUAssets/Estudio_DNA_CFOs_2010/$FILE/DNA_CFOs_2.pdf).
Burgstahler et al. (2006) document that, within the European Union, private companies are much more prevalent than public companies and private companies exhibit higher levels of earnings management. In Italy, approximately 360 companies are publicly listed (http://www.borsaitaliana.it/homepage/homepage.htm), 7500 companies are owned by the State (http://www.panorama.it/economia/aziende/aizende-pubbliche-quanto-costano-stato), and 5.3 million companies are privately owned (http://www.digital4.biz/pmi/approfondimenti/quasi-53-milioni-le-imprese-in-italia_4367215623.htm). We acknowledge that private company managers do not face the pressures associated with widely dispersed investors, which may affect their willingness to report red flags (e.g., the market reaction to restatements is not as forefront in their minds as it would be for managers of publicly traded companies). To investigate differences between private and public company participants, we compare the responses provided by private and public company managers in our most extreme condition (PRESSURE high and RED FLAGS present or Condition 4 as described in Figure 1 and Table 3). Mean responses for CONCERN, INTERNALLY, and EXTERNALLY are not significantly different (p’s > .05) between private and public company managers.
Given that our study extends the work of Dichev et al. (2013), we compare our demographic data in Table 1 to that obtained from the survey participants in Dichev et al. (2013) who worked for private U.S. companies (see Table 1 in Dichev et al. (2013), where 54.93% of participants worked for a private company). Like our sample, the private company CFOs in Dichev et al. (2013) are most likely managing a manufacturing company with between $100-$499 million in sales. As one would expect, given that Italy is a smaller market than the U.S., our participants report a higher proportion of foreign sales. Our participants are also slightly younger, but have greater experience in their position. Last, the percentage of our participants with a public accounting background (41.32%) is very similar to the 41.26% observed by Dichev et al. (2013).
The experimental instrument was provided online and in Italian, the native language of the participants. The instrument was first developed in English. To develop the Italian version of the instrument, we followed the translation-back procedures outlined by Brislin (1986). Specifically, in the first stage, the experimental instrument was translated from English to Italian by one of the authors who is fluent in both languages. Then, another independent academic translated the Italian version back to English (back-translated English version). The original and back-translated English versions were then compared, and all discrepancies resolved by the translators. In a second stage, to assure that the material would be realistic and understood by respondents, the instrument was carefully pre-tested. First, the instrument was reviewed by Italian academic scholars to assess the clarity of the instrument. Afterwards, a pilot study was also conducted with a group of accounting managers from three Italian companies (with their input being incorporated into the instrument). Finally, the final instrument was reviewed once more by a panel of three Italian academic scholars.
Participants were post-experimentally asked to recall: 1) the difference between the company’s net income and cash flow from operations; and 2) the difference between the company’s sales growth and growth in NFMs (measured via scales, where 1 = “Very small” and 7 = “Very large”). Non-tabulated results indicate that those in the RED FLAGS present conditions rated both differences to be significantly larger than those in the RED FLAGS not present conditions (both p’s < 0.01). In addition, both of these measures have a significant impact on CONCERN, but the difference between the company’s net income and cash flow from operations appears to have a slightly stronger influence (t = 3.92, p = 0.001 vs. t = 2.23, p = 0.027 for the NFM red flag). All tests reported in the text and the tables are two-tailed.
Related to our PRESSURE manipulation, participants were asked to recall if Tecno’s percent return on assets just met or was well above the ratio required by First National Bank (measured via scale, where 1 = “Just met” and 7 = “Well above”). Non-tabulated results indicate that the mean response for those in the high-PRESSURE condition was significantly lower than those in the low-PRESSURE condition (p < .01).
Our manipulations of PRESSURE and RED FLAGS would be more likely associated with net income being overstated than understated (e.g., pressure related to the return on assets, net income substantially higher than cash flow from operations). Indeed, only three participants in the PRESSURE high/RED FLAGS present condition (Condition 4 in Table 3) indicated concerns that earnings were understated (our tests of hypotheses are robust to excluding these three participants from our analyses). However, to avoid demand effects, we provided our participants with the option to respond that net income was either understated, very accurate, or overstated.
We measured discussing concerns with the corporate controller with following: Based on your preliminary review, you stated that the 20XX net income for Tecno may be overstated/understated. To what extent would you discuss this concern with your corporate controller in charge of consolidating the divisions’ financial statements? The response scale was the same as INTERNALLY. We measured discussing concerns with the corporate controller prior to discussing concerns with the CEO (INTERNALLY). However, given our one-time access to participants, we were unable to discern the sequential process and iterations our participants would have followed given their experimental condition (e.g., having several meetings with the corporate controller before meeting with the CEO). Examining the sequential processes and iterations involved in reporting concerns over earnings quality internally and externally represents a fruitful avenue for future research.
Interestingly, even though shorter tenure and a CPA background are associated with a higher likelihood of reporting externally, we do not observe significant correlations between these two factors and responses to our red flag manipulation checks (see Footnote 10). Thus, managers with shorter tenure and CPA backgrounds were no more likely to identify the red flags, but were more apt to report their concerns externally.
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Acknowledgements
We thank Steven Dellaporetas (editor), two anonymous reviewers, Ann Backof, Denny Beresford, Owen Brown, Laura Burney, John Campbell, Tina Carpenter, Gia Chevis, Margaret Christ, Paul Demere, Marcus Doxey, Jenny Gaver, Frank Heflin, Emily Hickman, Joe Johnson, Kiridaran Kanagaretnam, Adam Koch, Brad Lail, Joshua Lee, Craig Lefanowicz, Justin Leiby, Kathleen Linn, Roger Martin, Paul Mason, Melanie Millar, Ulf Mohrmann, Eric Rahn, Andrea Roberts, Jesse Robertson, Jeri Seidman, Christy Sims, Eileen Taylor, Jane Thayer, Erin Towery, Ben Whipple, Jennifer Winchel, Julia Yu, and participants at the 2015 European Audit Research Network Symposium, the Raleigh-Durham Chapter of the Institute of Internal Auditors, the 2016 AAA Annual Meeting, the 2016 ABO Research Conference, the 2018 Hawaii Accounting Research Conference, and research workshops at Baylor University, the University of Georgia, the University of North Texas, and the University of Virginia for many helpful comments. We acknowledge the research assistance of Madison Bell, Addison Collins, Roberta Graziani, Mauro Izzarelli, Dylan Johnson, Devon Parker, Alexis Vann, Sadie Rockefeller, and Justin Vaughan. We are especially appreciative of the corporate managers who participated in our experiment.
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Appendices
Appendix A: Participant Recruiting Method
In order to increase the validity of our experimental study, we tried to obtain participation from experienced corporate financial managers. The first phase of the project involved the creation of a small working team, comprised of one of the authors, acting as the group coordinator, and two graduate students that were recruited and instructed to conduct the data collection process. The strategy used to recruit participants was to approach each potential respondent informally before sending the official invitation letter. This first step was taken to obtain some sense of commitment, to obtain personal details like a valid working email, and to increase the overall chance of receiving valid feedback once the experimental instrument was distributed.
Participants were recruited from a variety of industries/public and privately held companies and were employed in managerial roles related to the aims and scopes of the project (i.e., corporate financial reporting). Potential participants were identified in three ways. First, the research group began the recruitment process from the working network of one of the authors who had previously led other large-scale surveys in the field of managerial accounting. Thus, the research team started to approach Italian CFOs and Controllers who shared the same author’s LinkedIn groups (e.g., the Italian Association of Administrative and Financial Directors (ANDAF), the Italian Chief Financial Officer Group (CFO Italia), the Consolidation & Financial Reporting Group (CFR), the Strategic CFO, the Italian Controllers Group). Second, a list of CFOs, Controllers, and other accounting practitioners from a large variety of organizations was identified using Aida - Bureau Van, a database of public and private Italian companies. Finally, practitioners were also selected based upon their previous involvement and collaborations with the author’s past research. Once identified, an informal message was sent using the LinkedIn platform to introduce the aims and scopes of the project briefly, and a telephone call followed in case the potential respondent asked for more details on the project. This procedure allowed the research team to gain the trust of the selected respondents and assure the confidentiality of the results if they agreed to be involved with the project.
Individuals who indicated an interest in participating were presented with the informed consent document at the beginning of the survey. The document gave instructions for the study, highlighted that participation was on a voluntary basis, and gave assurances of confidentiality. The informed consent document also contained the identities of the data collection team and their contacts (email and mobile number) in order to answer to any questions. The survey was administrated using the Qualtrics platform. Respondents were free to end their participation at any time.
The data collection team followed up with participants as needed if they did not complete the survey, but the team was sensitive to the fact that participants were full-time employees that were participating voluntarily without any incentive or prize. The extent of follow-ups varied by participant, but the maximum number of follow-ups the data collection team made was three attempts. Typically, participants chose to participate after the initial attempt or one follow-up. Once the respondents completed the survey, a letter of thanks was sent. We did not note any significant difference in participation, reactions, or follow-ups that could be tied to a particular organization type, industry or region. In addition, we offered to provide feedback about the study to participants after the study was complete.
Appendix B—Portion of Experimental Materials
Note: Not seen by participants: The experimental instruments were programmed into Qualtric and completed online by participants. See Footnote 9 for information about how the instrument was translated from English to Italian. Also, all U.S dollars were converted to Euros.
The University of XXXX and XXXX University are conducting a study of financial and accounting managers’ decisions. We would greatly appreciate you participating in our study. The study will place you in the role of a financial manager of a hypothetical company, provide you with information about the company, and ask you to complete a survey. We estimate this study will take you less than 20 min to complete.
INITIAL QUESTIONS
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As part of your current job, are you in anyway involved with producing your company’s financial statements?
[Yes] [No]
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As part of your current job, are you in anyway responsible for your company’s financial statements?
[Yes] [No]
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Is the company you currently work for privately held or publicly traded?
[Privately Held] [Publicly Traded]
YOUR ROLE, TECNO SPORTING GOODS, AND AN INDUSTRY OVERVIEW
Assume you are the Chief Financial Officer of Tecno Sporting Goods. Tecno Sporting Goods consists of four divisions that are consolidated for financial reporting purposes. Each division has a controller in charge of preparing the division’s financial statements. The corporate controller (who works directly under you) is in charge of consolidating the divisions’ financial statements into one set of financial statements for Tecno Sporting Goods. Your corporate controller is primarily responsible for preparing Tecno Sporting Goods’ consolidated financial statements.
Your company’s main financing comes in the form of loans from First National Bank. First National Bank requires your company to provide audited financial statements annually. Your company’s debt covenant with First National Bank requires that you meet several financial ratios. If the debt covenant is violated/if these financial ratios are not met, First National Bank has the right to require that all future payments under the loans are due and payable immediately.
Tecno Sporting Goods is a manufacturer of sporting goods equipment. Specifically, Tecno Sporting Goods specializes in manufacturing balls and related products for soccer, tennis, basketball, and golf, as well as other sports. These products are typically sold to sporting goods retailers where they are purchased by individual consumers. The industry has four major manufacturers with Technogym Sporting Goods Co. holding the largest market share. Annual sales growth for Tecno Sporting Goods has been between 4-6% for the last two years. This sales growth is also in line with industry averages.
Tecno Sporting Goods was the subject of a recent business news article. Here are some highlights from the article:
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It is expected that the trend towards consolidation in the sporting goods industry will continue. Tecno Sporting Goods should benefit from the consolidation. Given Tecno Sporting Goods’ leadership in the industry, Tecno Sporting Goods may acquire other companies with valuable manufacturing technologies and build the product lines into successful businesses.
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Tecno Sporting Goods’ soccer balls enjoy a high level of acceptance among many youth soccer leagues in Italy. Trade magazines consistently give high marks to the soccer division’s products. Tecno Sporting Goods’ soccer division should continue to contribute to Tecno Sporting Goods’ sales and profits and offer technological contributions to the soccer industry. However, given a difficult economy, sales of high-end youth soccer equipment may decrease significantly over the next 2 years.
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In the coming years, new rule changes are expected in some of the sports for which Tecno Sporting Goods creates products. These rule changes, like a possible change in the weight of youth basketballs, will change the way many of Tecno Sporting Goods’ products are manufactured. Basketball teams and leagues will be required to buy new equipment to comply with some rule changes. Tecno Sporting Goods may benefit and possibly gain market share from some rule changes as they are already retooling their manufacturing processes in anticipation of these changes.
YOUR CURRENT SITUATION
Your company’s current fiscal year-end is 12/31/20X3. It is 2 weeks after your 20X3 fiscal year-end. Your corporate controller has recently obtained your four divisions’ annual financial statements. Your corporate controller and his staff are in the process of consolidating those financial statements into the 20X3 Tecno Sporting Goods fiscal year-end financial statements.
As described previously, your company’s main financing comes in the form of loans from First National Bank. Tecno Sporting Goods’ debt covenant with First National Bank requires that Tecno Sporting Goods meet several financial ratios (e.g., current ratio, return on assets). If these financial ratios are not met, First National Bank has the right to require that all future payments under the loans are due and payable immediately.
In order to perform your initial, preliminary, top-level review of Tecno Sporting Goods’ financial condition, you have asked your corporate controller for:
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preliminary, non-detailed 20X3 Tecno Sporting Goods financial statements (along with comparative financial statements from the two prior years)
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financial ratio calculations
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important operational data for Tecno Sporting Goods. Feel free to use a calculator or take notes when reviewing this information.
Note: Not seen by participants: Below is the low-PRESSURE manipulation (the paragraph below was highlighted yellow).
You have been informed by your corporate controller that Tecno’s 20X3 ratio for percent return on assets from the preliminary 20X3 consolidated financial statements easily exceeds the required ratio as stated in the First National Bank debt covenant.
Note: Not seen by participants: Below is the high-PRESSURE manipulation (the paragraph below was highlighted yellow).
You have been informed by your corporate controller that Tecno’s 20X3 ratio for percent return on assets from the preliminary 20X3 consolidated financial statements just barely meets the required ratio as stated in the First National Bank debt covenant.
In about a week, the consolidation process will be complete. At that time, detailed, consolidated financial statements for Tecno will be provided to your external auditor.
PRELIMINARY 20X3 TECNO SPORTING GOODS CONSOLIDATED FINANCIAL STATEMENTS (ALONG WITH THE TWO PRIOR YEARS)
INCOME STATEMENT ($ millions)
Year ended December 31, | |||
|---|---|---|---|
20X3 | 20X2 | 20X1 | |
Total sales | $771 | $728 | $699 |
Cost of sales | 287 | 269 | 256 |
Gross profit | 484 | 459 | 443 |
Operating expenses | 391 | 372 | 377 |
Operating income | 93 | 87 | 66 |
Income tax expense | 32 | 30 | 23 |
Net income | $61 | $57 | $ 43 |
BALANCE SHEET ($ millions)
As of December 31, | |||
|---|---|---|---|
20X3 | 20X2 | 20X1 | |
ASSETS | |||
Current assets | $ 393 | $ 364 | $364 |
Non-current assets | 540 | 517 | 467 |
TOTAL ASSETS | $933 | $881 | $831 |
LIABILITIES & OWNERS’ EQUITY | |||
Current liabilities | $ 170 | $ 167 | $ 151 |
Non-current liabilities | 166 | 159 | 154 |
Owners’ equity | 597 | 555 | 526 |
TOTAL LIAB. & OWNERS’ EQUITY | $933 | $881 | $831 |
Note: Not seen by participants: Below is the RED FLAGS not present manipulation.
STATEMENT OF CASH FLOWS ($ millions)
Year ended December 31, | |||
|---|---|---|---|
20X3 | 20X2 | 20X1 | |
Net income | $61 | $57 | $43 |
Total cash flows from operating activities | 52 | 48 | 35 |
Total cash flows from investing activities | (20) | (19) | (18) |
Total cash flows from financing activities | 3 | 2 | 2 |
Increase (decrease) in cash and cash equivalents | 35 | 31 | 19 |
Cash and cash equivalents at beginning of year | 116 | 85 | 66 |
Cash and cash equivalents at end of year | $ 151 | $ 116 | $ 85 |
Note: Not seen by participants: Below is the RED FLAGS present manipulation.
STATEMENT OF CASH FLOWS ($ millions)
Year ended December 31, | |||
|---|---|---|---|
20X3 | 20X2 | 20X1 | |
Net income | $61 | $57 | $43 |
Total cash flows from operating activities | (42) | 48 | 35 |
Total cash flows from investing activities | (20) | (19) | (18) |
Total cash flows from financing activities | 3 | 2 | 2 |
Increase (decrease) in cash and cash equivalents | (59) | 31 | 19 |
Cash and cash equivalents at beginning of year | 116 | 85 | 66 |
Cash and cash equivalents at end of year | $ 57 | $ 116 | $ 85 |
FINANCIAL RATIOS
20X3 | 20X2 | 20X1 | |
|---|---|---|---|
Current ratio (current assets/current liab.) | 2.31 | 2.18 | 2.41 |
Debt to equity (total liab./total equity) | 0.56 | 0.59 | 0.58 |
Leverage (non-current liab./total assets) Percent return on assets (net income/total assets) | 0.18 6.54% | 0.18 6.46% | 0.18 5.17% |
Gross margin (gross profit/total sales) | 0.62 | 0.63 | 0.63 |
Note: These financial ratios are consistent with Tecno Sporting Goods’s competitors/industry.
OPERATIONAL INFORMATION FOR TECNO SPORTING GOODS CO.
Note: Not seen by participants: Below is the RED FLAGS not present manipulation.
20X3 | 20X2 | 20X1 | |
|---|---|---|---|
Number of employees | 3,350 | 3,321 | 3,321 |
Production lines | 10 | 10 | 11 |
Patents | 6 | 6 | 7 |
Square meters of production space | 1,550,000 | 1,680,000 | 1,680,000 |
Number of retailers | 50 | 46 | 51 |
New products | 5 | 5 | 5 |
Note: Not seen by participants: Below is the RED FLAGS present manipulation.
OPERATIONAL INFORMATION FOR TECNO SPORTING GOODS
20X3 | 20X2 | 20X1 | |
|---|---|---|---|
Number of employees | 2,550 | 3,321 | 3,321 |
Production lines | 8 | 10 | 11 |
Patents | 5 | 6 | 7 |
Square meters of production space | 1,425,000 | 1,680,000 | 1,680,000 |
Number of retailers | 37 | 46 | 51 |
New products | 4 | 5 | 5 |
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Brazel, J.F., Lucianetti, L. & Schaefer, T.J. Reporting Concerns About Earnings Quality: An Examination of Corporate Managers. J Bus Ethics 171, 435–457 (2021). https://doi.org/10.1007/s10551-020-04436-1
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DOI: https://doi.org/10.1007/s10551-020-04436-1