Most people understand that GAAP are the set of rules, practices, and conventions that describe what is acceptable financial reporting for external stakeholders, but they may find it surprising that a single, normal, everyday accounting choice may be either ethical or unethical.

The difference between an ethical and an unethical accounting choice is often merely the degree to which the choice is carried out.

GAAP does not tell managers what specifically is normal and what is extreme. It is more like a speed limit sign that simply says, ‘Don’t Drive Too Fast!’

Since a company extends credit as an incentive for customers to buy, estimated losses from those who do not pay are considered a cost of the current period even though it will not be known until future periods, which customers will not pay, and what the amount of non-payment will be.

GAAP requires that an estimate of uncollectible accounts be recorded as an expense in the same fiscal year as the revenue from the product is recorded.

A company has operating income of $100,000 before the estimate of uncollectible accounts. Also, assume management estimates uncollectible accounts to be $6,000, or 2% of net sales of $300,000. However, the fact that uncollectible accounts will be $6,000 is not always so clear. Assume that for the past five years, average uncollectible accounts costs on the same level of sales have ranged from $4,000 to $8,000 (1.33% to 3.67% of net sales) with no specific pattern being apparent. A financial manager who wanted to report the highest possible current period income would be justified in using the $4,000 amount for the current year’s expense estimate even though $4,000 is the bottom of the historical range. That same manager might use $8,000 to be conservative in a year when the economy is weak.

The scenario would be crossing the ethical line to possible financial fraud even though GAAP does not draw a clear line of the ethical use of judgment or the unethical use. There is no ‘bright line’ in GAAP to tell managers what is and is not acceptable. It is also clear that while this illustration shows the magnified effect of just one judgment, we have seen earlier that management is presented with numerous structural and estimate decisions that can impact reported earnings.

A common criticism of earnings management is that it reduces transparency by obscuring the ‘true’ earnings of the company.

Arya, Glover, and Sunder (2003) state: “That earnings management reduces transparency is a simplistic idea. A fundamental feature of decentralization organizations is the dispersal of information across people. Different people know different things and nobody knows everything.

During years of high accruals, CEOs exercise unusually large numbers of options, and CEOs and other insiders sell large quantities of shares. It, nevertheless, is true that firms subject to fraud investigations are severely penalized when SEC investigations for fraud result (Christensen et al., 2010).

(1) Supporting evidence that this is so is sparse, perhaps even non-existent.

(2) Alternative explanations for the shapes of the distributions are often very evident.

• A simple explanation for the shape of the earnings distribution that is most often cited as evidence of earnings management; the relation between earnings and prices differs with the magnitude and the sign of earnings.

• Further examples that support the main point of their paper; evidence beyond the mere shape of a distribution must be brought to bear before researchers can draw conclusions regarding the presence/absence of earnings management.

• A detailed analysis of the severe effects of sample selection in a recent study; this study erroneously concludes that the shape of an earnings distribution is evidence of earnings management.

The Securities and Exchange Commission accused Dell of misleading investors by using money the company received from the chip maker Intel to pad its quarterly earnings statements. Intel paid Dell in the form of rebates as part of an agreement to ensure that Dell would not use computer chips made by Advanced Micro Devices (AMD) in its personal computers and computer servers, according to the civil charges. “Dell was only able to meet Wall Street targets consistently during this period by breaking the rules.” Without the Intel payments, Dell would have missed the consensus estimate for earnings per share published by Wall Street analysts who followed the company in every quarter during its fiscal years from 2002 through 2006.

Microsoft failed to accurately report its financial results, causing overstatements of income in some quarters and understatements of income during other quarters. The SEC said that Microsoft enhanced its financial results by setting aside artificially large reserves to reduce revenues, with the idea of reversing that procedure to record the revenues in less profitable times.

Time Warner established reserves of $2,253 billion and $2,229 billion at December 31, 2009 and 2008, respectively. These estimates represent about 30 percent of gross accounts receivable in both years. Management explains that this is an “area of judgment affecting reported revenues and net income” and is based on analysis of “vendor sell-off of product, historical return trends, current economic conditions, and changes in customer demand”.

Estimated lives of its airplanes from 22 years to 27 years under the reasoning that improved maintenance methods enabled the company to get more useful years out of the aircraft. This change in accounting estimate, which does not require a consistency disclosure in the auditor’s report, had the effect of enabling southwest to continue to show year-to-year earnings growth.

Changing their accounting for pension plans in 2010 by shifting to market-to-market accounting. In the market meltdown from the financial crisis in 2008–2009, these companies incurred very large losses: $23 billion for AT&T and $12 billion for Verizon. Rather than recognize these losses on their income statements in 2008–2009 the companies elected in accordance with current U.S. standards to amortize them over future years (Rapoport 2011).

On the morning of Jan. 7, 2009, Ramalingam Raju, the chairman of troubled Indian IT outsourcing company Satyam Computer Services, sent a startling letter to his board and the Securities & Exchange Board of India. Raju acknowledged his culpability in hiding news that he had inflated the amount of cash on the balance sheet of India’s fourth-largest IT company by nearly $1 billion, incurred a liability of $253 million on funds arranged by him personally, and overstated Satyam’s September 2008 quarterly revenues by 76% and profits by 97%.