Understanding Earnings Management: A Christian Perspective

When a company’s earnings fall short of expectations, some leaders may look for ways to “fix” the numbers, at least on paper. This practice, known as earnings management (EM), involves using accounting techniques or business decisions to present financial results in a more favorable light. While these actions may technically comply with accounting rules, they often raise ethical concerns and undermine trust.

This post explores what earnings management is, how it happens, why it matters, and how Christian business leaders can respond with wisdom, stewardship, and integrity.

What is Earnings Management?

Earnings management refers to the strategic adjustment of revenues or expenses to influence the reported profits. By carefully choosing when to recognize income or defer costs, managers can make the numbers look better than they are.

For example, Healy and Wahlen (1999) described EM as the use of judgment in financial reporting that can mislead stakeholders or manipulate outcomes based on financial metrics. This might help a company meet analyst expectations or avoid reporting a loss, but it can also distort the truth about the company’s financial health.

Research has shown that companies frequently engage in EM to avoid reporting small losses. In a well-known study, Burgstahler and Dichev (1997) found that many businesses reported just enough profit to avoid appearing unprofitable, even when actual results suggested otherwise.

How Companies Manage Earnings

There are three main ways managers adjust financial results:

1. Accrual-Based Earnings Management (AEM): Adjusting accounting estimates like bad debt or warranty expenses.

2. Real Earnings Management (REM): Making actual business decisions, like overproducing inventory or delaying expenses, to affect earnings.

3. Classification Shifting: Moving certain items within the income statement to make core earnings appear stronger.

   
   

Each method adheres to the technical limits of accounting standards but can still create a misleading financial picture.

The Role of Non-GAAP Metrics and Inventory Accounting

Non-GAAP reporting adds another layer of complexity. Companies often present “adjusted” financial results that exclude certain expenses or one-time items. These figures can make earnings look more appealing, especially when GAAP-based numbers fall short (Black et al., 2017).

Inventory accounting also creates room for manipulation. Managers can choose between FIFO, LIFO, or weighted average methods, all of which affect the cost of goods sold and profit margins. In some cases, businesses produce more inventory than needed to reduce unit costs and increase short-term profit, at the risk of long-term waste.

Trade-Offs and Decision Pressure

Regulatory scrutiny has made it harder to rely on accrual adjustments. In response, managers may resort to drastic measures, such as cutting research and development, to keep earnings in line with expectations. Research by Zang (2012) showed that managers often take real actions throughout the year and then fine-tune the results using accruals at year-end.

These choices are not always easy. Some may preserve the bottom line but hurt long-term value. Others may comply with the rules but cross ethical boundaries. Detecting EM requires more than a glance at the numbers. It takes discernment, industry knowledge, and a deep understanding of company operations.

Governance, Gender, and Accountability

Strong corporate governance makes EM harder to carry out. Independent boards, active audit committees, and adequate internal controls help ensure that financial reporting stays accurate and fair (Bansal, 2023).

Studies also suggest that gender dynamics play a role. Firms with female CEOs or more women on audit committees often report earnings more conservatively (Barua et al., 2010). However, compensation structures and cultural pressures can influence this behavior regardless of gender (Harris et al., 2019; Guo et al., 2024). The key takeaway is that accountability structures—not just demographics—play a crucial role in maintaining ethical financial practices.

The Impact of Regulations

High-profile scandals, such as Enron and WorldCom, reshaped financial reporting. The Sarbanes-Oxley Act of 2002 (SOX) introduced stricter rules and greater accountability. In the years following, many companies reduced their reliance on accrual-based EM and leaned more heavily on real operational decisions (Cohen et al., 2008).

Internationally, U.S. companies tend to use real EM more frequently than companies reporting under IFRS, partly due to the more rigorous enforcement of U.S. accounting rules (Zeng, 2015; Evans et al., 2015). In 2003, the SEC introduced Regulation G, which requires companies to reconcile non-GAAP figures with standard GAAP results—another important step toward greater transparency.

Financial Integrity Through a Biblical Lens

A biblical worldview brings clarity to the ethical concerns surrounding EM. Scripture is clear: God values honesty and fairness in all aspects of life, including business. Proverbs 11:1 says, “A just balance and scales are the Lord’s; all the weights in the bag are his work.” Misrepresenting earnings to manipulate perception is no different from tipping the scales in ancient marketplaces.

Financial manipulation also breaks the commandment against bearing false witness (Exodus 20:16). When a business distorts its financial story, it misleads stakeholders and fails to honor God with its stewardship.

Psalm 24:1 reminds us that all resources belong to God. We are called to manage them wisely, not for personal gain or image control, but for the good of others and the glory of God. Jesus taught that those who are faithful with little will be trusted with more (Luke 16:10). Financial integrity—especially in the small things—is a test of character, trust, and leadership. This is why earnings management and biblical ethics matter to the follower of Christ.

The Importance of Ethical Leadership

Ethical leadership is crucial in combating earnings management. Leaders must set a tone of integrity and transparency. They should encourage open discussions about financial practices and foster an environment where ethical behavior is rewarded.

When leaders prioritize ethical standards, they not only protect their organizations but also build trust with stakeholders. This trust is invaluable, especially for churches and ministries that rely on the support of their communities.

Practical Steps for Christian Business Leaders

As Christian business leaders, we have a unique opportunity to model integrity in our financial practices. Here are some practical steps to consider:

1. Educate Your Team: Ensure that everyone understands the importance of ethical financial practices. Provide training on accounting standards and the implications of earnings management.

   
   

2. Establish Clear Policies: Create and enforce policies that promote transparency and accountability in financial reporting. Make it clear that unethical behavior will not be tolerated.

   
   

3. Encourage Open Communication: Foster an environment where team members feel comfortable discussing financial concerns. Encourage them to speak up if they notice any discrepancies or unethical practices.

   
   

4. Lead by Example: Demonstrate integrity in your own financial practices. Be transparent about your decisions and the reasons behind them.

   
   

5. Seek Accountability: Surround yourself with trusted advisors who can provide guidance and hold you accountable to your ethical standards.

   
   

Final Thoughts

Earnings management may be common, but that does not make it right. Business leaders and financial professionals face real pressure, but shortcuts and manipulations only offer temporary relief. Long-term trust is built on honest reporting, wise stewardship, and ethical decision-making.

For Christian professionals, the standard is even higher. We are called to lead with transparency, walk in truth, and trust God for the results. When we commit to integrity in our financial practices, we reflect both good business and faithful discipleship.

By embracing these principles, we can ensure that our financial practices honor God and serve our communities effectively. Let’s strive to be the trusted financial partners that our churches, ministries, and Christian-owned businesses in Alaska need.