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The Roles of Cynicism, CFO Pressure, and Moral Disengagement on FIN 48 Earnings Management

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Abstract

Archival research reports that managers often use the FIN 48 uncertain tax liability accrual to manage earnings. To assess solutions to this problem, we deconstruct the ethical and psychological reasoning that leads to FIN 48 opportunistic behavior. Hence, we employ a survey of seasoned accounting managers to assess the influences of cynicism, two measures of moral disengagement, and pressure from a CFO on the propensity to engage in FIN 48 earnings management. Specifically, we manipulate the influence of the study scenario supervisory CFO as either a latent bully or a transformational leader. While the CFO bully main effect condition enhances FIN 48 earnings management, the CFO transformational leader condition interacts with less cynical accounting managers to reduce FIN 48 earnings management. We also find that both dispositional trait and situational state moral disengagement factors independently mediate the relationship between the cynicism model antecedent and FIN 48 earnings management. Collectively, study findings provide implications for both theory and practice.

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Notes

  1. We also initially included a manipulation for auditor attentiveness (amenable vs. skeptical). This auditor manipulation was unfortunately not significant. Given the complexity of the model we test, we therefore exclude the auditor variable from the study for purposes of parsimony. Relatedly, we interviewed a fraud examiner practitioner who cautioned us that external auditors only uncover fraud 4% of the time. This fact is included in the Association of Certified Fraud Examiners (ACFE) latest report: Report to the Nations—2020 Global Study on Occupational Fraud and Abuse. Given this fact, it perhaps is not surprising that our auditor skepticism variable was not significant.

  2. We subsequently introduce and assess the role of two distinct moral disengagement measures on FIN 48 earnings management, a dispositional trait measure as well as a situation-specific state moral disengagement measure.

  3. We are especially interested in theoretical antecedents that are positively associated with moral disengagement and that also will be highly relevant to FIN 48 earnings management based on our subject matter knowledge. This explains why we did not employ empathy and moral identity which are both negatively associated with moral disengagement. Cynicism is the only Detert et al. (2008) antecedent that fits well with our parsimonious study design that attempts to measure the predictive role of accounting manager negative affect in the FIN 48 context. We chose to not investigate variations of locus of control because it is commonly investigated in previous accounting research, and has also already been assessed in conjunction with unethical earnings management (Dayanandan et al., 2012), and does not measure negative affect, which we deem as essential for our study antecedent variable.

  4. To obtain the sample, we carefully canvased all available sources, including MTurk and Centiment, which were unable to access such a unique sample.

  5. We deem it necessary for accounting managers to have a FIN 48 familiarity level in excess of the “4” midpoint or neutral level.

  6. To test participant attentiveness to our CFO scenario experimental treatment, we ask a manipulation check question. Of our sample, 75% correctly answered the CFO check. Our results are slightly less significant when considering this manipulation check success, which we attribute to reduced statistical power. We therefore choose to not discard participants based on our manipulation check finding.

  7. Bergkvist and Rossiter (2007) find that even single items extracted from multi-item scales generally display equal predictive validity. In the present study, we employ two items rather than a single item.

  8. The Bandura et al. (1996) moral disengagement scale was aimed at children. Detert et al. (2008) adapted the scale for undergraduates.

  9. The Bandura et al. (1996) scale has four items for each of the eight dimensions, resulting in a 32-item scale. Moore et al. (2012) reduced the scale to one item for each of the eight dimensions, resulting in a parsimonious 8-item scale.

  10. We acknowledge that our situational state moral disengagement measure is an adapted measure from Moore et al. (2012), designed specifically for the FIN 48 context only. We emphasize the difference between scale development versus scale adaption. Therefore, we do not intend to portray this measure as a new general trait moral disengagement measure that would be relevant and generalizable to other non-FIN 48 accounting contexts. Our state measure development process is consistent with Churchill’s (1979) 8-step process to develop a measure, which is also employed in other accounting studies (Robinson et al., 2018), as follows: 1. Specify domain of construct, 2. Generate sample of items, 3. Collect data, 4. Purify measures, 5. Collect data, 6. Assess reliability, 7. Assess validity, and 8. Develop norms.

  11. We took additional steps to ensure that we maximize the construct validity of our continuous dependent variable (FIN48EM—Peer) that we employ in our regression analysis. For example, after participants choose their slider scale response, a second screen shows participants what their response is, including how much of an adjustment their response is from the initial unbiased adjustment that meets the specific more likely than not (MLTN) requirements of FIN 48 (e.g., your adjustment for your peers from the initial unbiased MLTN FIN 48 accrual is “__”). The screen then prompts participants if this is the response they desired, if so, they can then press continue, and if not, the screen queries what they would like to change their response to and the process then repeats itself to protect from unintended or misunderstood responses.

  12. In addition, the means for Cynicism, TraitMD, and StateMD are 5.182 (CFO bully) and 5.145 (transformational leader); 3.705 (CFO bully) and 3.944 (transformational leader); and 4.359 (CFO bully) and 4.7312 (transformational leader), respectively. These mean differences are not statistically significant.

  13. Barsky (2011) adapted two moral disengagement items out of the eight total.

  14. We employed the single factor test (Podsakoff et al., 2003) and found the following variance explained when limiting combined study scales to one factor: 49.2%, and 44.2% when the Trait moral disengagement items are not also included along with the State moral disengagement items. These findings, combined with the experimental design that further minimizes common method bias, suggests that this form of bias is not a serious concern. For example, we also provided other design strategies to further mitigate common method bias. As suggested by Tourangeau et al. (2000), considerable effort was taken to ensure that the scale questions were clear, unambiguous, simple, concise, and not double-barreled which also helps mitigate problems related to common method bias.

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Acknowledgements

The following study represents the lead author’s dissertation, and the second author was the dissertation chair. We wish to thank participants at the 2018 and 2019 behavioral tax symposium in Washington D.C. We are also grateful for workshop participant comments at Texas Tech University, the University of North Texas, and Kansas State University. We wish to thank other members of Dr. West’s dissertation committee, including Mayukh Dass and Kirsten Cook. We also thank Amy Hageman, Lil Mills, Ryan Huston, Tim Rupert, Denise Dickens, and Anne Magro for their especially helpful suggestions to enhance this manuscript.

Funding

One of the authors received funding from the University where they earned their PhD.

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Authors and Affiliations

  1. Department of Accounting, Kansas State University, 1301 Lovers Lane, Manhattan, KS, 66506, USA

    Ashley Nicole West

  2. School of Accounting, Texas Tech University, Box 42101, Lubbock, TX, 79409, USA

    Gary M. Fleischman

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  1. Ashley Nicole West
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Correspondence to Gary M. Fleischman.

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All contributing authors received approval from the institutional review board (IRB) at their respective institution. The authors followed all IRB protocols, including providing an informed consent statement that participants had to agree to before participants took the study survey.

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Appendices

Appendix A FIN 48 Explanation

The FIN 48 Two-Step Process (ASC 740–10: Recognition and Measurement)

The FASB established a two-step process to use when evaluating the amount of the recognized tax benefit that can be secured on the financial statements. The process is described in detail in ASC 740–10, and the following discussion is based on this standard. The FIN 48 process requires one to assume that each separate FIN 48 position has a 100 percent audit rate, and that the proper tax authority has full knowledge of all relevant information.

The first step in the FIN 48 process is recognition, which requires a firm to determine if any amount of the tax position in question is sustainable upon IRS examination, which we assume has been met in our scenario. If the position meets the more likely than not (hereafter MLTN) standard from the recognition step, then the FIN 48 calculation process moves to the second step: measurement, which requires a firm to determine how much of the tax position to recognize on the financial statements, which is the focus of the present study. The portion of the potential tax benefit not allowed on the financial statements based on the MLTN standard is referred to as the unrecognized tax benefit (UTB), which is booked as a liability (and added to the firm’s FIN 48 tax reserve) and is also booked as a tax expense on a firm’s financial statements, reducing earnings. In sum, a current year potential tax benefit minus the UTB equals the tax benefit allowed on the financial statements. Both the recognition and measurement steps require significant amounts of managerial discretion, that relates to the uncertainty, complexity, and ambiguity of the tax code and the calculations that are required to estimate how much of the tax benefit can be claimed versus disallowed as a UTB on the financial statements.

The FIN 48 Measurement Calculation

FIN 48 mandates managerial calculation of the individual probability assessment of each individual outcome starting with the probability of a full potential benefit, moving down to lesser benefit amounts and associated probabilities where each individual probability is stacked to calculate a running total of the combined cumulative probability. The outcome with the largest amount of tax benefit that meets the MLTN standard (greater than a cumulative probability of 50%) is allowed as a recognized tax benefit. In other words, the amount of the unrecognized tax benefit (UTB) that is disallowed is the difference between the full amount of the potential tax benefit minus the portion that does meet the MLTN standard.

For example, the table below demonstrates that the cumulative probability that all of the benefit in question is allowed is 5 percent, while the cumulative probability that only one-fourth of the deduction is allowed is 51 percent. In this example, the company would not be able to benefit from the entire potential tax deduction on its financials because such benefit fails the cumulative probability MLTN threshold (not greater than 50 percent). However, the example firm would be able to benefit from one-fourth of the benefit ($1,000,000) because the cumulative probability associated with this outcome is 51 percent, which does exceed the MLTN threshold of greater than 50 percent. In this example, FIN 48 mandates that the firm accrue a liability of $3,000,000 and a corresponding tax expense for the UTB on the financials (which also reduces earnings by $3,000,000), for the difference between the total potential benefit ($4,000,000), and the one-fourth benefit ($1,000,000) actually permitted, as shown below.

figure a

APPENDIX B Variable definitions

Variable

Definition

Scale

Focal variables

  

FIN48EM—Peer

The FIN 48 adjustment a participant’s peer is willing to make (is the study DV)

0 to 51—Higher scores indicate a higher FIN 48 adjustment

Cynicism

Two cynicism items summed together and divided by 2

1 to 7—Mean centered. Two items:

1) Most people would tell a lie if they could gain by it: and, 2) People claim that they have ethical standards regarding honesty and morality, but few people stick to them when the chips are down

Higher scores indicate a higher propensity to possess cynical dispositional characteristics

CFO

An experimental variable that manipulates the leadership style of the direct superior (CFO)

1 if a transformational leader CFO, 2 if a latent bully CFO

TraitMD

Eight moral disengagement trait items summed together and divided by 8

1 to 7—Mean centered. Higher scores indicate a higher propensity to morally disengage as a dispositional characteristic

StateMD

Eight moral disengagement state items summed together and divided by 8

1 to 7—Mean centered. Higher scores indicate a higher probability of morally disengaging based on the context of our scenario

Item

State moral disengagement

Moral justification

An additional FIN 48 adjustment benefits others, such as shareholders and co-workers

Euphemistic labeling

I want to be a team player so I will make a further FIN 48 adjustment

Advantageous comparison

My peers would have made a larger additional FIN 48 adjustment

Diffusion of responsibility

Because a FIN 48 adjustment reflects a group effort with my CFO, I can't be held solely responsible

Distortion of consequences

It’s okay to make a small additional FIN 48 adjustment because no one gets hurt

Attribution of blame

If the auditors don’t catch my additional FIN 48 adjustment, it is really partially their fault

Dehumanization

I have to do what my CFO wants because he/she is a dictator with no feelings

Displacement of responsibility

My CFO expects me to adjust it upwards, therefore it will be the CFO's responsibility

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West, A.N., Fleischman, G.M. The Roles of Cynicism, CFO Pressure, and Moral Disengagement on FIN 48 Earnings Management. J Bus Ethics 185, 545–562 (2023). https://doi.org/10.1007/s10551-022-05210-1

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