Which of the following performance measures disincentives engaging in earnings management?

Earnings management occurs when companies manipulate financial reporting to meet targets, often leading to unethical practices or financial misstatements. The best way to disincentivize earnings management is to link performance to nonfinancial measures such as customer satisfaction and employee training, which cannot be directly manipulated through financial reporting.

Avoiding Short-Term Financial Manipulation:

When performance is tied to financial metrics (e.g., return on investment, stock price, or production quotas), there is a higher risk of earnings manipulation, such as shifting revenues, deferring expenses, or aggressive accounting practices.

Nonfinancial measures, however, emphasize long-term value creation and are harder to manipulate.

Sustainable Business Growth:

Customer satisfaction and employee training foster long-term profitability by improving product quality, brand reputation, and workforce capabilities.

Companies focusing on these measures build sustainable competitive advantages without distorting financial results.

Regulatory and Ethical Considerations:

Internal auditors, following IIA Standard 2120 (Risk Management), must evaluate risks related to unethical financial reporting.

Regulatory bodies (e.g., SEC, PCAOB, and COSO) emphasize reducing the risk of fraudulent financial reporting by incorporating broader performance measures beyond financial results.

A. Linking performance to profitability measures such as return on investment:

ROI and similar metrics can pressure executives to inflate earnings or cut necessary expenses to meet short-term targets.

B. Linking performance to the stock price:

Stock-based incentives can lead to earnings manipulation (e.g., stock buybacks, revenue recognition adjustments) to inflate stock prices artificially.

C. Linking performance to quotas such as units produced:

Production-based targets can result in overproduction or quality compromises, leading to inefficient resource allocation and long-term financial issues.

IIA Standard 2120 (Risk Management): Internal auditors must assess risks related to financial reporting integrity.

COSO’s Internal Control Framework: Emphasizes performance measures beyond financial results to ensure ethical management practices.

IIA Practice Guide: Assessing Organizational Governance: Encourages balanced scorecards, including nonfinancial KPIs, to reduce financial misstatement risks.

Step-by-Step Justification:Why Not the Other Options?IIA References:Thus, the correct answer is D. Linking performance to nonfinancial measures such as customer satisfaction and employee training. ✅