Running head: CASE STUDY 3: ETHICAL ISSUES 1

Case Study 3: Ethical Issues: Earnings Management

Liberty University
CASE STUDY 3: ETHICAL ISSUES 2

Question 1: Identify the ethical issues involved with the “cookie jar” reserves and the

economic consequences for parties affected by the chief accounting officer’s actions.

- The identifiable ethical issues involved with “cookie jar” reserves are that they mislead

investors and shareholders, especially in regard to the organization’s financial

performance, by reporting their liabilities throughout different reporting periods from

which the loss actually occurred.

- While there are flexibilities within the generally accepted accounting principles, or

GAAP, that may technically allow organizations to use accounting techniques that may

provide more favorable results, this method is highly dishonest.

- The United States Securities and Exchange Commission, SEC, has disallowed such

practices as “cookie jar reserves” and has deemed this practice illegal. This is because

the practice misleads investors which may result in losses for both the organization as

well as the investors.

- As previously stated, both investors and shareholders are misled by this practice which

can result in economic losses as investors are “tricked” into investing in an organization

that appears to be financially healthy.

Analysis

The alleged actions of the chief accounting officer of Mystery Technologies, Inc., can be

described as alarming and dishonest to say the least. The Security and Exchange Commission,

SEC, alleges that over a five year period, Mystery Technologies, Inc., misreported several

aspects of their financial performance within their financial statements. One example of this

misrepresentation that was given was that about $10 million in losses were reported in different

accounting periods from which the losses actually occurred. This action has been given the

nickname “cookie jar reserves”. This created a situation where the financial statements were

being manipulated to report revenue that the organization was not actually earning. The

financial statements presented by Mystery Technologies, Inc., reported a net income of $13.4

million rather than a loss of $2.4 million deceiving investors and shareholders, as well as the

public (Revsine, Collins, Johnson, Mittelstaedt, & Soffer, 2021).

There are, of course, ethical issues involved with the alleged actions taken by the chief

accounting officer. The identifiable ethical issues involved with “cookie jar” reserves are that the

organization misled investors and shareholders, especially in regard to the organization’s

financial performance, by reporting their liabilities throughout different reporting periods from

which the loss actually occurred. Investors as well as shareholders will look at the information

within the financial statements such as cash flow, earnings, etc. in order to get a better idea of

how the company they are considering investing in is performing and ultimately make any major

financial decisions regarding this company. Investors and shareholders will use the information

within the financial statements to create certainty around the decision-making process. This

misrepresentation clouds this certainty and will negatively impact the relationship between the

investor, shareholder, and the organization.

While there are flexibilities within the generally accepted accounting principles, or

GAAP, that may technically allow organizations to use accounting techniques that may provide

more favorable results, this method is highly dishonest. The question can be raised, why would

the chief accounting officer engage in such dishonest behavior? I believe the chief accounting

officer was acting under clouded discretion in an effort to improve the appearance of the

financial statements by revenue disclosure in such a way (Revsine, et al., 2021). This may have

been an attempt to better improve the position of the organization in the eyes of investors.

Studies have been conducted that show that the degree of honesty in reporting on financial

statements can be negatively impacted when the results of the financial statement may be less

than favorable (Cardinaels, 2016). If the chief accounting officer’s bonuses or merit increases

are tied to the performance reported on these quarterly reports, this can also have a potential

impact on the level of integrity shown when producing these reports.

While the GAAP may allow some flexibilities regarding these accounting techniques, the

United States Securities and Exchange Commission, SEC, has disallowed such practices as

“cookie jar reserves” and has deemed this practice illegal. This is because the practice misleads

investors which may result in losses for both the organization as well as the investors. As

previously stated, both investors and shareholders are misled by this practice which can result in

economic losses as investors are “tricked” into investing in an organization that appears to be

financially healthy. This goes back to the previous discussion regarding the relationship between

the organization and the investors as well as the shareholders. Not only will this relationship

have a great negative impact, but future investors will be weary to invest in an organization that

has engaged in illegal and/or questionable accounting practices.

References

Cardinaels, E. (2016). Earnings benchmarks, information systems, and their impact on the degree

of honesty in managerial reporting. Accounting, Organizations and Society, 52, 50-62.

doi:10.1016/j.aos.2015.09.002

Revsine, L., Collins, D. W., Johnson, W. B., Mittelstaedt, H. F., & Soffer, L. C. (2021).

Financial reporting & analysis. New York, NY: McGraw-Hill Education.