At its inception in 1972, the Financial Accounting Standards Board was charged with establishing “standards of financial accounting and reporting.” Implicit was a responsibility to discourage the practice of earnings management by narrowing the range of acceptable accounting alternatives.
The authors contend that diversity of acceptable accounting principles is only one of three distinct sources of earnings management. Type 1 management comprises selection among generally accepted accounting principles. Since they must be disclosed in footnotes to financial statements, these alternatives are visible to outside users.
Type 2 income management stems from the behind-the-scenes accounting judgments required in the implementation of accounting principles—for example, determination of depreciation lives. Type 3 entails business (as opposed to accounting) choices, such as those regarding the timing of asset purchases and retirements. Perhaps John C. Burton, former chief accountant of the Securities and Exchange Commission, had Type 3 management in mind when he said, “The way you keep score determines at least in part the way you play the game.”
From an examination of the Standards Board’s Statements Nos. 2,5,8 and 12, the authors conclude that, while the Board has certainly narrowed the range of Type 1 earnings management, it has permitted, and occasionally even facilitated, Type 2 and Type 3 management.