Dealing with Ethical Dilemmas: A Look at Financial Reporting by Firms Facing Product Harm Crises

Abstract

A product harm crisis (PHC) undermines a firm’s reputation as well as its managers’ career outlook. Managers usually face an ethical dilemma during a PHC as they choose to be transparent about the crisis’ financial implications or to obfuscate them to neutralize the negative impact of the PHC for their self-interests. We find evidence that managers engage in income-increasing earnings management when their firms experience PHCs. Such behavior reduces the likelihood of customer loss and CEO forced turnover in the short run but carries long-run negative consequences in terms of a higher likelihood of accounting restatement and weaker future operating performance. Our evidence suggests that earnings management in a PHC is deceptive and unethical. However, managers in firms that are subject to stricter external monitoring and managers in firms with proactive ethical policies are less likely to engage in upward earnings management in PHCs.

Keywords: product harm crisis, earnings management, ethical financial reporting, firm reputation

JEL Classification: M14, M41