The Role of Cognition and Ethical Judgment in Earnings Management Behavior

Abstract

We investigate whether individuals' cognitive processes and ethical judgment contribute to earnings management behavior apart from economic incentives. If the motivation for earnings management is purely economic, earnings management behavior should not occur in a setting that lacks economic incentives. Drawing on cognitive psychology theories (Kahneman & Tversky, 1979; Simon, 1996), we theorize that earnings targets establish implicit aspiration levels that act as mental frames of reference against which unmanaged earnings performance is evaluated and, ultimately, affect whether earnings are managed. Using an experimental method, we find that in the absence of direct economic incentives, a considerable proportion of participants managed earnings to achieve earnings targets. We document patterns of earnings management behavior that are consistent with the tenets of cognitive psychology. Interestingly, we observe earnings management behavior even when such behavior is judged to be highly unethical. While we find that ethical judgment can help regulate earnings management behavior, ethical judgment mitigates earnings management behavior to a lesser extent when earnings management can help achieve an otherwise unmet earnings target. Our findings suggest that cognition and ethical judgment play important roles in earnings management behavior.