Ethics and professional judgement in reporting - Earnings ma...

Learning Outcomes

This article examines the ethical responsibilities and professional judgement required in financial reporting, especially the tension between earnings management and faithful representation. You will learn to recognise forms of earnings management, understand the principle of faithful representation, identify threats to ethical behaviour, and evaluate how ethical principles frame the preparation of financial statements in accordance with IFRS Standards.

ACCA Strategic Business Reporting (SBR) Syllabus

For ACCA Strategic Business Reporting (SBR), you are required to understand both the ethical principles supporting corporate reporting and the ways in which management judgement influences the quality of financial information. This article supports your revision on:

• The importance of ethical and professional behaviour when preparing reports
• Risks and consequences of unethical behaviour in accounting, including earnings management
• Application of faithful representation and professional judgement
• How ethical threats affect reporting decisions
• Evaluating if financial statements comply with ethical and reporting standards

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which of the following best describes "earnings management"?
   1. Increasing profits only when permitted by accounting standards
   2. Using policy choices and estimates to influence reported earnings
   3. Disclosing all errors and omissions immediately
   4. Recognising all income on a receipts basis

2. Which ethical principle is directly compromised when management intentionally misstates profits to meet targets?

3. True or False? Faithful representation requires information to be neutral and free from error.

4. Briefly explain why professional judgement is required in selecting accounting estimates and policies.

5. What are two common negative outcomes of unethical financial reporting behaviour?

Introduction

Ethics and professional judgement sit at the centre of high-quality financial reporting. Users of financial statements rely on the integrity of reported information to make decisions. The ACCA Code of Ethics and Conduct outlines the standards accountants must meet, including integrity, objectivity, professional competence, confidentiality, and professional behaviour. However, real-world pressures such as profit targets or lending covenants may tempt management to use earnings management techniques that undermine faithful representation. This article explores how applying sound ethical judgement and following ethical codes is essential for faithful and trustworthy financial reporting.

The Meaning of Earnings Management

Earnings management involves selecting accounting methods, policies, or estimates to influence reported financial results, often to achieve specific targets or present a more favourable view of performance than is justified.

Key Term: earnings management
The use of judgement in financial reporting and in structuring transactions to alter financial results, often to mislead users or to achieve particular objectives.

Key Term: professional judgement
The application of relevant training, knowledge and experience to make informed accounting decisions in situations where standards offer guidance but not precise rules.

Earnings management is not always unlawful but becomes unethical when it intentionally misleads users, contravenes standards, or presents a biased view of performance.

Common drivers of earnings management include:

• Pressure to meet profit, bonus, or financial covenants
• Fear of breaching loan agreements
• Desire to boost share price ahead of a listing
• Avoidance of reporting losses

Tactics might include early or delayed revenue recognition, manipulation of bad debt or inventory provisions, or selective classification of exceptional items.

The Principle of Faithful Representation

The Conceptual Framework states that financial information must faithfully represent the economic substance of transactions, not merely their legal form. This requires information to be complete, neutral, and free from error, so users can trust the reported position and performance.

Key Term: faithful representation
Depiction of transactions and events in a manner that is complete, neutral, and free from error, so that users can rely on the information presented.

Misuse of professional judgement to bias the accounts in a particular direction—especially to overstate profit or hide losses—results in a loss of faithful representation.

The Role of Professional Judgement

Many IFRS Standards require management estimation—such as impairment testing, provisions, and fair value measurements. Accountants must use judgement to arrive at estimates that are reasonable and unbiased.

Key Term: professional scepticism
A questioning mindset that recognises the possibility of misstatement due to error or fraud, and critically assesses evidence when making judgements.

Applying professional judgement responsibly means considering all relevant facts, documenting assumptions, and avoiding decisions that favour one interest at the expense of others.

Ethical Principles in Reporting

The ethical principles in the ACCA Code guide accountants' behaviour in all aspects of reporting:

Key Term: integrity
The requirement to be straightforward and honest in all professional and business relationships.

Key Term: objectivity
Not allowing bias, conflict of interest, or undue influence of others to override professional or business judgements.

• Integrity is compromised when information is falsified or concealed.
• Objectivity is lost if personal gain motivates the selection of accounting policies or estimates.

Accountants are also required to maintain competence, protect confidentiality, and behave in ways that do not harm the profession or public trust.

Worked Example 1.1

A listed company’s CEO instructs the finance team to delay recording supplier invoices until after year end in order to improve reported profitability. The finance director is aware that this overstates both profit and net assets, but complies due to concern about losing their job.

Question:
Identify the ethical and reporting issues with this action. Which ethical principles are being breached?

Answer:
Delaying invoice recognition intentionally misstates profit and the financial position, breaching the principle of faithful representation. Integrity and objectivity are both compromised, as the finance director has participated in presenting information dishonestly and allowed personal pressures to override their professional judgement. This constitutes unethical behaviour with potential regulatory penalties.

Types of Earnings Management

Earnings management can take many forms, including:

• Aggressive (inflating profits) or conservative (deferring profits)
• Use of “cookie jar reserves” (unwarranted provisions to smooth earnings)
• Channel stuffing (sending more goods to distributors to boost revenue temporarily)
• Selective capitalisation vs expensing

The boundary between acceptable judgement and manipulation is crossed when decisions are made to mislead, rather than to provide the most accurate picture possible.

Worked Example 1.2

A company changes its inventory valuation method from FIFO to weighted average solely to reduce this year's gross profit and lower tax payable. There is no genuine change in the nature of inventory purchased.

Question:
Does this change comply with ethical and reporting requirements?

Answer:
Changing accounting policies to achieve a particular profit outcome, rather than to improve relevance and faithful representation, is not acceptable. This is a form of earnings management that undermines comparability and transparency, and may breach the principle of integrity.

The Impact and Consequences of Unethical Reporting

Unethical earnings management may result in:

• Investor or lender mistrust
• Legal or regulatory sanctions
• Reputational harm
• Disciplinary action and loss of professional status

Key Term: self-interest threat
The risk that personal gain or pressure will influence a professional to act unethically, potentially compromising their objectivity and integrity.

Professional accountants must challenge inappropriate instructions, document their objections, and escalate concerns when necessary. ACCA provides helplines and guidance for reporting unethical conduct.

Exam Warning

In the exam, you may be given a scenario where management has incentives to manipulate results. Identify both the ethical threat and the impact on faithful representation, and refer clearly to ACCA’s ethical principles in your recommendations.

Revision Tip

Practice distinguishing between permissible use of judgement and earnings management intended to mislead. Clearly justify choices of accounting policies or estimates by referencing substance, not just form.

Summary

Ethics and professional judgement are key to preparing reliable, decision-useful financial reports. Accountants must resist the temptation or pressure to misstate results, instead ensuring their work is guided by integrity, objectivity, and a commitment to faithful representation. Recognising and avoiding earnings management is central to maintaining stakeholder trust and professional reputation.

Key Point Checklist

This article has covered the following key knowledge points:

• Explain what is meant by earnings management and why it occurs
• Define faithful representation and its importance in financial reporting
• Identify and apply ethical principles from the ACCA Code of Ethics and Conduct
• Distinguish between acceptable judgement and unethical behaviour
• Evaluate consequences arising from breaches of ethical conduct in reporting
• Apply professional scepticism and judgement in selecting policies and making estimates

Key Terms and Concepts

• earnings management
• professional judgement
• faithful representation
• professional scepticism
• integrity
• objectivity
• self-interest threat