Enron, Worldcom, Global Crossing, and Adelphia; the mere mention of these companies conjure up images of corruption and greed. Clearly, top executives at these organizations committed crimes and have been convicted in the appropriate courts of law. By and large the public response and reaction to these scandals has been to increase the scrutiny of managers as evidenced by the provisions of Sarbane-Oxley. These highly publicized regressions are examples of extreme cases of earnings management, but what about less extreme incidences that do not cross the line into outright fraud? Are managers who smooth earnings or otherwise engage in less invasive earnings management activities greedy and corrupt?

In a larger institutional environment, the problem might not be widespread greed of corrupt managers, but rooted in a wider systemic problem associated with pressures to maximize shareholder value. Institutional theorists (DiMaggio, 1991; DiMaggio & Powell, 1991a; Meyer & Rowan, 1991; Suchman, 1995) point to the role institutional order plays in the actions of organizations. Organizations and managers do not operate independent of the institutional environment, but rather are nested in an institutional order (Holm, 1995) that provides the framework for organizational action and sets the standard by which organizations are deemed legitimate. Organizations that lack legitimacy may be chastised and their actions challenged (Scott, 1991). Organizations are not totally at the mercy of the institutional order; they can also act to change the institutions (Barley & Tolbert, 1997; Holm, 1995) or act to manage the appearance of legitimacy (Suchman, 1995). From an institutional perspective, earnings management could be the result of organizations trying to maintain their legitimacy in the eyes of other institutional actors.

The current intellectual conversation surrounding earnings management is framed by the agency model of self-interest (see Cheng & Warfield, 2005; Dechow & Sloan, 1991; Guidry et al., 1999 F. Guidry, A. Leone and S. Rock, Earnings-based bonus plans and earnings management by business unit managers, Journal of Accounting and Economics 26 (1999), pp. 113–142. Article | PDF (204 K) | View Record in Scopus | Cited By in Scopus (36)Guidry, Leone, & Rock, 1999, for examples). A problem with this focus is that it keeps the discussion centered on the micro-behaviors of management and fails to extend the discourse to potential systemic or environmental pressures that impact management’s tendencies to manipulate financial numbers. Given the role that financial numbers play in providing a measure of success, standardization, and legitimacy (Richardson, 1987) in a capitalistic system of commerce, reflecting on earnings management through an institutional lens can broaden our understanding of the motivational aspects of the activity beyond pure greedy self-interested behavior. Past agency-based studies of earnings management explain a modest amount of variance, normally in the 1–5% range (e.g. Davidson, Jiraporn, Kin, & Nemec, 2004; Larker, Richardson, & Tuna, 2004). While this low explanation of variance has been attributed to the nature of a concept that by definition is meant to be undiscoverable (Kury, 2006), part of the lack of explanatory power may be due to the myopic focus on micro-motivations of earnings management. The theoretical framework presented in the article is meant to provoke a broader examination of earnings management, one that considers institutional forces.

The discussion of earning management from an institutional perspective also furthers our understanding of institutional theory by exploring a phenomenon at a higher institutional field level than is typically examined. Most empirical work in institutional theory focuses on industry or profession field levels. For instance, Rao (1994) focused on the early automotive industry in his study of racing as an organizational legitimacy building certification contest for automakers (see [Fligstein, 1991] and [Galaskiewicz, 1991] for further examples of industry level). Researchers have also found professions as a fruitful context to explore institutional concepts as with DiMaggio’s (1991) study of art museums and Greenwood and colleagues exploration of the accounting profession (Greenwood, Suddaby, & Hinings, 2002). While these studies all broaden our understanding of institutional concepts in their particular context, Friedland and Alford (1991) point out that organizations are nested in many institutional fields. As Holm’s (1995) study of Norwegian fisheries points out, organizations and actors must be mindful of the different levels of nesting.

Publicly traded corporations in the United States are embedded in their sector or industrial level field (Scott & Meyer, 1991), but are also members of a larger societal level (Scott, 2001) institutional field: that of “The US financial markets”. These corporations, while being mindful of their industry level pressures, must also tend to the larger financial markets. In “the US financial market” field, managers are cognizant of the institutional logic – governing principle (Friedland & Alford, 1991) – that drives the markets: “maximizing shareholder value”. It is this pursuit of maximizing shareholder value that provides the unique opportunity to explore “the US financial market” field and the role that accounts play in its perpetuation.

The discussion in the following sections provide insight into the field level phenomenon of earnings management, not as the agency-based self-interested behavior, but rather as a decoupled activity – a distancing of structures and activities – that allows an organization to maintain its legitimacy when performance suffers. The basics and key concepts of institutional theory are presented in Section 2. Section 3 situates and proposes a case for earnings management in an institutional context. Implications for earnings management and institutional theory are then presented in Section 4. Section 5 reflects what an institutional argument for earnings management means for the institutional logic of “maximizing shareholder value”.

2. The basics of institutional theory

This section discusses the basics of institutional theory from an organizational theory/sociological perspective. While explanations of institutional theory can be found in many disciplines – economics, politics, or international relations as examples (DiMaggio & Powell, 1991a; Scott, 2001) – the perspective best suited for examining the earnings management in an institutional context is the sociological one, which “emphasizes the ways in which action is structured and order made possible by shared systems of rules that both constrain the inclination and capacity of actors to optimize as well as privilege some groups whose interests are secured by prevailing rewards and sanctions” (DiMaggio & Powell, 1991a, p. 11). The sociological perspective brings in a cultural-cognitive dimension that is more dynamic than those perspectives based primarily on regulation (Scott, 2001). The following discussion begins with Scott’s (2001) three pillar analytic framework of institutions, which helps to clarify and focus how institutions work. Next is a discussion of institutional fields which includes the boundaries they set and the institutional logics that provide a foundation of what it means to operate in the field. The institutional concept of legitimacy and its role in replicating the institutional logic is presented, followed up by a discussion of the concept of decoupling as a means to maintain legitimacy while deviating from the established structure. This review of the institutional literature provides a foundation to explore the phenomenon of earnings management as an institutional activity in Section 3.

2.1. The three pillars of institutions

Scott (2001) provides an analytic framework that is helpful in examining the nuances, resilience, and drivers of institutions. His framing for institutions is one of three pillars: regulative, normative, and cultured-cognitive (Scott, 2001). It is through these three pillars that institutions are replicated, transmitted, nested in multiple systems, and while enduring, face pressures for change. The regulative pillar focuses on rules and laws that support the institutional order. Deephouse’s (1996) study of commercial banks which examined legitimacy conferred by bank regulators is an example of this rules based study of institutions. The second pillar, the normative, focuses on the norms and social obligations associated with maintain institutional norms. DiMaggio and Powell (1991b) equate this pillar with professionalism. DiMaggio’s (1991) research in the diffusion of professional norms amongst US art museums from 1920 to 1940 are examples of how the normative pillar has been explored. Scott’s (2001) final pillar is the cultural-cognitive pillar which takes a social constructivist point of view of institutions. From this perspective institutions are seen as self-constructing and rationalized by actors’ perceptions of the institutions in which they are embedded. In the cultural-cognitive pillar institutions are seen as a shared understandings or common beliefs held by institutional actors.

A central theme in institutional theory is the stability of institutional order. This stability provides institutional actors with an understanding of how the institution operates and what are the expectations of accepted behavior. Within each pillar are mechanisms that steer organizations toward conformity with the institutional order and create similarities between organizations known in institutional theory as isomorphism (DiMaggio & Powell, 1991b). The regulative pillar is based on explicit rules or laws that force institutional actors to comply with the institutional order and likewise sanction noncompliance (Scott, 2001). Within the regulative pillar organizations become similar through coercive isomorphism (DiMaggio & Powell, 1991b). Organizations must comply with governmental requirements such as reporting requirements, product safety laws, labor laws, and tax laws, to name a few. Failure to comply with these laws can open organizations and managers up to liability and governmental penalties. Through regulation and the mechanism of coercive isomorphism all publicly traded US corporations have similar governance structures, standard operating procedures for those areas that fall under the purview of regulation (e.g. employee handbooks, employee safety manuals, etc.), and similar financial reporting in the form of the annual report.

Compliance in the normative pillar is based on social obligation and binding expectations (Scott, 2001). Roles play an important part in perpetuating the institutional order. DiMaggio and Powell (1991b) make the argument that normative isomorphism comes in the form of professionalism. Through professional training, certification, or accreditation, the mores of the institution are perpetuated. Several professions are evidenced in US corporations, for instance the accounting, banking, legal, and engineering professions all hold prominent positions in the corporate organizations. As a result the representative departments’ across organizations are structured and function in relatively similar manners. This isomorphism is a product of the professional roles that these organizational actors play.