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JAMAR Vol. 2 · Number 2 · 2004 Ethical Decision Making on Various Managerial Accounting Issues Arnold Schneider* Abstract This study examines five managerial accounting issues that have ethical implications. These issues are based on situations described in managerial accounting textbooks. To induce truthful responses, an approach called the randomized response technique is used. With this technique, estimates are obtained for responses to sensitive questions relating to the five issues. Resul
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  JAMAR Vol. 2 · Number 2 · 2004 29 Ethical Decision Makingon Various ManagerialAccounting Issues  Arnold Schneider*  Abstract This study examines five managerial accounting issues that have ethical implications. These issues are based on situations described in managerial accounting textbooks. To inducetruthful responses, an approach called the randomized response technique isused. With this technique, estimatesare obtained for responses to sensitivequestions relating to the five issues. Results ranged from 9 percent to 51 percent of participants making decisions that are at least questionable from an ethical  perspective. Key Words Accounting EthicsRandomized Response TechniqueManagement Accounting * College of Management, Georgia Institute of Technology Introduction Many issues in the area of managerialaccounting have ethical implications. Thisis recognized by The Institute of Management Accountants, which has provided ethical guidance by developingStandards for Ethical Conduct for Management Accountants (IMA, 1983).These standards deal with issues involvingcompetence, confidentiality, integrity, andobjectivity.Managerial accounting textbooks arereplete with discussions of issues that haveethical implications.These issues range from performanceevaluation to cost reimbursement and thedecisions encompass managerial ones suchas amount of production as well asaccounting ones such as cost allocations.While the potential for managerialmanipulation or unethical conduct is oftenmentioned, rarely is evidence providedabout the actual occurrence of such behaviour.The purpose of this study is to providesome evidence about behaviour involvingethical issues in the context of five specificdecision areas found in the realm of managerial accounting. The five issueschosen were based on encounters with themwhile teaching managerial accounting. Literature on Ethics in ManagerialAccounting Managerial accounting research hasaddressed various ethical issues. Rogerson(1992) examined overhead allocated tocontracts and demonstrated that firms haveincentives to engage in pure waste by padding direct labour usage on contractswith cost-based revenues. Sayre, Rankin,and Fargher (1998) investigated the effectsof promotion incentives on the selection of investment projects by managers and foundthat the managers’ investment decisionsserved their own self-interests at theexpense of the owners’ interests. A number of studies on budgeting have shown thatwhen a subordinate’s information is used as  JAMAR Vol. 2 · Number 2 · 2004 30 a basis for his performance evaluation, thesubordinate has incentives to misrepresentresource requirements or productioncapabilities (e.g., Young, 1985; Waller,1988; Chow, et al, 1988; Nouri, 1994;Stevens, 2002). Many studies have provided evidence on how managersmanipulate earnings to maximize their compensation or enhance their performanceevaluation (e.g., Healy and Whalen, 1999; Nelson, et al, 2003). While thesemanipulations usually involve accountingchoices, some involve managerial decisionssuch as the research and developmentspending decisions examined by Dechowand Sloan (1991). The Issues The five issues selected for study allcome from decision situations appearingin managerial accounting textbooks.Two situations involve investmentdecisions, one entails a productiondecision, one deals with cost allocation,and one involves estimation judgment.Each of these five issues is detailed inthe Appendix and is explained in theremainder of this section.  Issue #1: Overproduction   The first issue relates to the propositiondiscussed in the previous section thatmanagers’ decisions may be motivated bythe desire to manipulate earnings.Specifically, Issue #1 involves thecontroversy over absorption costing (i.e.,full costing) versus variable costing.Advocates of the latter state that withabsorption costing, net income issusceptible to manipulation by managers because fixed overhead is a product costand, therefore, unit costs can be lowered bymerely increasing current production. Thislowers cost of goods sold and, in turn,yields a higher current net income. AsZimmerman (2000, p. 496) states,“Managers rewarded on total profitscalculated using absorption costing canincrease reported profits by increasing production (if sales are held constant). Amajor criticism of absorption costing is thatit creates incentives for managers tooverproduce, thereby building inventories.”Horngren et al. (2002, p. 609) also note that“if the company uses the absorption costingapproach, a manager might be tempted to produce unneeded units just to increasereported operating income.” An example of how profit was manipulated in this manner is provided by Kaplan and Atkinson (1998, p. 504), who mention a case where “thedivision manager had greatly increased production in quarters 2 and 3, with excess production accumulating as finished goodsinventory. The much higher rates of  production enabled period costs to beabsorbed into inventory.”The first research question in this studyaddresses the issue of whether participantswould decide to overproduce in order toincrease profits. The actual question asked,which can be found in Situation #1 of theAppendix, was “Would you decide tooverproduce in order to meet the targeted NIBT?” The objective is to measure the percentage who would be willing to produce more output than needed to meetdemand, an act which has ethicalramifications.  Issue #2: Cost Allocation The second issue relates to the proposition by Rogerson (1992) discussed earlier,which noted that firms which have contractswith cost-based revenues have incentives toengage in unethical behaviour when itcomes to allocating overhead costs.Specifically, Issue #2 involves arbitrarilychanging cost allocations so that a higher amount of revenue can be obtained from a product sold on a cost-plus basis.According to Schneider and Sollenberger (2003, p. 4-19): “When the prices of certainservices or products are cost based whileothers are market driven, managers areoften tempted to shift much of the overheadcosts to those cost-based services or  products.” Similarly, Hilton et al. (2000, p.375) state that “cost-plus contracts giveincentives to the supplier of the good or service to seek as much reimbursement as possible and, therefore, to allocate as muchcost as possible to the product for whichreimbursement is possible.” Horngren et al.(2003, p. 535) cite an example of an aircraftmanufacturer that builds standard planes for commercial customers under fixed-pricecontracts, and specialized fighter planes for   JAMAR Vol. 2 · Number 2 · 2004 31 the U.S. armed forces under cost-pluscontracts. They note that if themanufacturer “could shift indirect costsaway from (fixed-price) commercialcustomers and to the cost-plus contracts,”then the manufacturer would increase itsrevenues.Consequently, the second research questionasks whether participants would arbitrarilychange an established logically-based costallocation procedure to one which is morearbitrary in order to increase profits by wayof larger cost-based revenues. The actualquestion asked, which can be found inSituation #2 of the Appendix, was “Wouldyou arbitrarily change the cost allocation procedure to meet the targeted NIBT?”However, since this change is described asnot violating generally accepted accounting principles or any agreements with purchasers, the ethical implications aresomewhat nebulous.  Issue #3: Estimating Equivalent Units The third issue involves a misrepresentationabout an estimate that has an impact on thereported profit. In slightly different contextsdealing with budgeting situations, thestudies mentioned earlier have shown thatwhen a subordinate’s information is used asa basis for his performance evaluation, thesubordinate has incentives to misrepresentinformation. This phenomenon is tested inIssue #3, which involves estimating the percentage of completion of ending work in process inventory in a process costingsituation. By overestimating the degree of completion, a lower unit cost could beobtained by spreading the costs over alarger amount of equivalent units. Thiswould lower the cost of goods sold, and as aresult, increase profit. As Schneider andSollenberger (2003, p. 5-16) note,“Estimating the stage of completion of thework in process is an area particularlysusceptible to manipulation by productionmanagers . . . managers might be motivatedto overestimate the stage of completion . . .A higher estimate for the degree of completion of the work in process inventoryresults in a greater number of equivalentunits of output for the period. This, in turn,generates a lower cost per equivalent unit.”Hilton et al. (2000, p. 271) also indicate that“someone may have a motivation tooverestimate degrees of completion to keepcosts in inventory, thereby increasingincome.”The third research question, therefore, askswhether participants would misrepresent thedegree of completion of the ending work in process in order to report a higher profit.The actual question asked, which can befound in Situation #3 of the Appendix, was“Would you overestimate the ending work in process in order to meet the targeted NIBT?” Such misrepresentation wouldclearly violate notions of objectivity andintegrity.  Issue #4: Investment and Conflicting  Interests The fourth issue relates to the proposition by Sayre, Rankin, and Fargher [1998],discussed earlier, which noted thatmanagers’ investment decisions tend toserve their own self-interests rather than thefirm owners’ interests. Specifically, Issue#4 involves a conflict of interest in thecontext of an investment decision where the participant’s performance is evaluated based on return on investment (ROI). Thedecision setting is one where an investmentunder consideration has an ROI that would benefit the company, but would reduce thecurrent ROI of the participant. As discussed by Zimmerman (2000, p. 190), “Managershave incentives to reject profitable projectswhose ROIs are below the mean ROI for the division because accepting these projects lowers the division’s overall ROI.”Kaplan and Atkinson (1998, p. 505) alsostate that “actions that decrease divisionalROI may increase the economic wealth of the corporation.” They provide an exampleof a project whose ROI is between thecurrent divisional ROI of 22% and thedivision’s cost of capital of 15% andconclude that “the ROI measure causes thedivision manager to be motivated to refusethis investment, since, even though itreturns in excess of the cost of capital, . . .the project lowers the divisional ROI.”Another illustration is given by Horngren etal. (2002, p. 410), who indicate that “if  performance is measured by ROI, managersof divisions currently earning 20% may bereluctant to invest in projects that earn only15% because doing so would reduce their average ROI.”  JAMAR Vol. 2 · Number 2 · 2004 32 The fourth research question asks whether  participants would reject an investment thatwould benefit the company, but wouldlower the participant’s current ROI. Theactual question asked, which can be foundin Situation #4 of the Appendix, was“Would you reject this proposedinvestment?” The ethical implications hereare not totally clear. On one hand, amanager should make decisions that servethe best interests of the company andtherefore undertake the investment. On theother hand, if a manager has been instructedto maximize ROI, and is rewardedaccordingly, then it could be argued that inrejecting the investment, the manager is, ina sense, adhering to company policy .  Issue #5: Replacing Existing Assets The fifth issue, like the fourth, is also tiedto the proposition by Sayre, Rankin, andFargher (1998) that managers’ investmentdecisions are self-serving rather serving theowners’ interests. Issue #5, like Issue #4,again deals with an investment decisionwhere ROI is used as the performancemeasure. In this setting, the company uses book value in defining the amount of assetsin the denominator of ROI. A proposedinvestment in new machinery would benefitthe company in the long-term, but wouldlower the participant’s current ROI becausethe cost of the new machinery is muchhigher than the book value of the existingmachinery. This situation is described inHilton et al. (2000, p. 844) as follows: “Thetendency for net book value to produce amisleading increase in ROI over time canhave a serious effect on the incentives of investment-centre managers. Investmentcentres with old assets will show muchhigher ROIs than investment centres withrelatively new assets. This can discourageinvestment-centre managers from investingin new equipment.” Similarly, Horngren etal. (2002, p. 415-6) note: “To maximizeROI or residual income, managers want alow-investment base. Managers in firmsusing net book value will tend to keep oldassets with their low book value.” In a moreequivocating tone, Kaplan and Atkinson(1998, p. 518) argue that “we would notexpect that many managers wouldmanipulate their ROI measures sotransparently; nevertheless, . . . managerscan improve their ROI measure by postponing new investment and continuingto operate with fully or nearly fullydepreciated assets.The fifth research question asks whether  participants would reject an investment thatwould benefit the company in the long-term, but would lower the participant’scurrent ROI. The actual question asked,which can be found in Situation #5 of theAppendix, was “Would you reject theinvestment in the new machinery?” Like thefourth research question, the ethicalimplications here are not clear. In additionto the arguments made there, the benefit tothe company here is less evident because itis characterized only as a long-term benefit. Research Design Participants received a researchquestionnaire which contained backgroundinformation about a hypothetical companyand they were instructed to presume thatthey were division managers for thiscompany. They were then given five casescenarios involving managerial accountingdecisions, as described above. For the firstthree, the questionnaire indicated that theywould receive a significant cash bonus if the current year's targeted net income before taxes (NIBT) for the division wasobtained. For the last two cases, theinstructions indicated that they wouldreceive a significant cash bonus if theannual rate of return (ROI) for their division exceeded the cost of capital. Thehigher their division’s rate of return wasabove the cost of capital, the more cash bonus they would receive. After respondingto the five cases, the participants completeda page of demographic and other information.Since the cases involve sensitive issues,obtaining truthful responses is a major concern. Without some form of  protection, participants might be reluctantto admit that they would overproduce,arbitrarily change cost allocations,misrepresent equivalent units, or reject goalcongruent investments. Accordingly, thisresearch used an approach called therandomized response technique (RRT) toelicit decisions.
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