What Is Ethics?
Foundations of Ethics
Norms, Values, and the Law 6 Ethical Relativism 8 Situation Ethics 8 Cultural Values 10
The Six Pillars of Character 11 Trustworthiness 12 Respect 15 Responsibility 15 Fairness 15 Caring 16 Citizenship 16
Reputation 16 The Public Interest in Accounting 18
Professional Accounting Associations 18 AICPA Code of Conduct 19
Virtue, Character, and CPA Obligations 20 Modern Moral Philosophies 21
Teleology 22 Deontology 25 Justice 27 Virtue Ethics 28
Application of Ethical Reasoning in Accounting 29 DigitPrint Case Study 31
Scope and Organization of the Text 33 Concluding Thoughts 34 Discussion Questions 35 Endnotes 37 Chapter 1 Cases 41
Case 1-1: Harvard Cheating Scandal 42 Case 1-2: Giles and Regas 43 Case 1-3: NYC Subway Death: Bystander Effect or Moral Blindness 45 Case 1-4: Lone Star School District 46 Case 1-5: Reneging on a Promise 47 Case 1-6: Capitalization versus Expensing 48 Case 1-7: Eating Time 49 Case 1-8: A Faulty Budget 50 Case 1-9: Cleveland Custom Cabinets 51 Case 1-10: Telecommunications, Inc. 52
Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting 54
Ethics Reflection 54 Kohlberg and the Cognitive Development Approach 55
Heinz and the Drug 56 Universal Sequence 58
The Ethical Domain in Accounting and Auditing 59 Rest’s Four-Component Model of Ethical Decision Making 59
Moral Sensitivity 60 Moral Judgment 60 Moral Motivation 60 Moral Character 60
Rest’s Model and Organizational Behavior 61 Professional Judgment in Accounting: Transitioning from Moral Intent to Moral Action 63
Diem-Thi Le and Whistleblowing at the DCCA 64 Behavioral Ethics 67
Ethical Decision-Making Model 68 Application of the Model 71 Concluding Thoughts 72 Discussion Questions 72 Endnotes 74 Chapter 2 Cases 77
Case 2-1: WorldCom 78 Case 2-2: Better Boston Beans 79 Case 2-3: The Tax Return 80 Case 2-4: Shifty Industries 81 Case 2-5: Blues Brothers 83 Case 2-6: Supreme Designs, Inc. 84 Case 2-7: Milton Manufacturing Company 85 Case 2-8: Juggyfroot 87 Case 2-9: Phar-Mor 88 Case 2-10: Gateway Hospital 90
Chapter 3 Creating an Ethical Organization Environment and Effective Corporate Governance Systems 91
Ethics Reflection 91 Seven Signs of Ethical Collapse 92
Pressure to Maintain the Numbers 93 Fear of Reprisals 93
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Loyalty to the Boss 93 Weak Board of Directors 94
A Culture of Conflicting Interests 94 Innovation and Ethics 95 Community Involvement and Ethics 95 Organizational Influence on Ethical Decision Making 95 Individual-Organization Interchange 96 Ethical Dissonance Model 96
Business Ethics 98 Guiding Principles 98 Values 99 Ethical Standards 99 Business Ethics versus Personal Ethics 100 Ends versus Means 101 Trust in Business 101 Johnson & Johnson: A Case of Dr. Jekyll and Mr. Hyde? 103 Employees Perceptions of Ethics in the Workplace 105
Stakeholder Perspective 107 The Case of the Ford Pinto 107
Fraud in Organizations 109 Fraudulent Business Practices 109 Occupational Fraud 110 Financial Statement Fraud 112
Foundations of Corporate Governance Systems 114
Defining Corporate Governance 115 Views of Corporate Governance 115 The Importance of Good Governance 116 Executive Compensation 117
Corporate Governance Mechanisms 119 The Role of the Board of Directors 119 Audit Committee 120 Internal Controls as a Monitoring Device 122 Internal Auditors 123 Audited Financial Statements 125 NYSE Listing Requirements 125 Code of Ethics for CEOs and CFOs 127 Compliance Function 128
Bernie Madoff’s Ponzi Scheme 128 Whistleblowing 131
Detection, Reporting, and Retaliation 131 Incentivizing Whistleblowing under Dodd-Frank 134 Accountants’ Obligations for Whistleblowing 134 Has the Whistleblowing Program Been Successful? 135 The Ethics of Whistleblowing 136
Concluding Thoughts 137 Discussion Questions 137 Endnotes 140
Chapter 3 Cases 149 Case 3-1: The Parable of the Sadhu 150 Case 3-2: Amgen Whistleblowing Case 154 Case 3-3: United Thermostatic Controls 156 Case 3-4: Hewlett-Packard 160 Case 3-5: IRS Whistleblower and Informing on Tax Cheats 162 Case 3-6: Bennie and the Jets 163 Case 3-7: Exxon-XTO Merger 164 Case 3-8: Disclosure of Steve Jobs’s Health as Apple CEO: A Public or Private Matter? 167 Case 3-9: Bhopal, India: A Tragedy of Massive Proportions 168 Case 3-10: Accountability of Ex-HP CEO in Conflict of Interest Charges 174
Chapter 4 AICPA Code of Professional Conduct 175
Ethics Reflection 175 The Public Interest in Accounting: An International Perspective 177 Investigations of the Profession: Where Were the Auditors? 178
Metcalf Committee and Cohen Commission: 1977–1978 179 House Subcommittee on Oversight and Investigations: 1986 180 Savings and Loan Industry Failures: Late 1980s–Early 1990s 181
Treadway Commission Report: 1985; COSO: 1992; and Enterprise Risk Management: 2004 181 The Role of the Accounting Profession in the Financial Crisis of 2007–2008 183 AICPA Code of Professional Conduct and State Board Requirements 186
National Association of State Boards of Accountancy 187 Professional Services of CPAs 188
AICPA and IFAC Principles of Professional Conduct 190 Conceptual Framework for AICPA Independence Standards 191
Threats to Independence 191 Safeguards to Counteract Threats 193 Financial Relationships That Impair Independence 193 Providing Nonattest Services to an Attest Client 194
SEC Position on Auditor Independence 195 SEC Actions Against Auditing Firms 195 The PeopleSoft Case 196
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Insider Trading Scandals Damage the Reputation of the Accounting Profession: Former KPMG Audit Partner, Scott London 196 Former Deloitte & Touche Management Advisory Partner, Thomas Flannigan 197
SOX Provisions 198 Restrictions on Nonattest Services 198
Integrity and Objectivity 200 Principles of Professional Practice 201 Responsibilities to Clients 203 Other Responsibilities and Practices 206
Commissions and Referral Fees 206 Advertising and Solicitation 207 Form of Organization and Name 208 Acts Discreditable—Client Books and Records; CPA Workpapers 210 Acts Discreditable—Negligence in the Preparation of Financial Statements or Records 212
Ethics and Tax Services 213 Rule 101—Independence 213 Rule 102—Integrity and Objectivity 214 Rule 201—Professional Competence and Due Care 214 Rule 202—Compliance with Professional Standards 214 Tax Compliance Services 214 Statements on Standards for Tax Services (SSTS) 214 Substantial Authority 216 Realistic Possibility of Success 216 Reasonable Basis 216 Tax Shelters 218
PCAOB Rules 219 Rule 3520—Auditor Independence 219 Rule 3521—Contingent Fees 219 Rule 3522—Tax Transactions 219 Rule 3523—Tax Services for Persons in Financial Reporting Oversight Roles 220 Rule 3524—Audit Committee Pre-Approval of Certain Tax Services 220 Rule 3525—Audit Committee Pre-Approval of Nonauditing Services Related to Internal Control over Financial Reporting 221 Rule 3526—Communication with Audit Committees Concerning Independence 221
Concluding Thoughts 221 Discussion Questions 222 Endnotes 225 Chapter 4 Cases 229
Case 4-1: America Online (AOL) 230 Case 4-2: Beauda Medical Center 233 Case 4-3: Family Games, Inc. 234
Case 4-4: First Community Church 235 Case 4-5: Lee & Han, LLC 236 Case 4-6: Gee Wiz 237 Case 4-7: Family Outreach 238 Case 4-8: HealthSouth Corporation 239 Case 4-9: Healthcare Fraud and Accountants’ Ethical Obligations 242 Case 4-10: Independence Violations at PwC 243
Chapter 5 Fraud in Financial Statements and Auditor Responsibilities 246
Ethics Reflection 246 Fraud in Financial Statements and the Audit Function 247 Nature and Causes of Misstatements 249
Errors, Fraud, and Illegal Acts 249 Reporting an Illegal Act 251 Auditors’ Responsibilities for Fraud Prevention, Detection, and Reporting 252 The Fraud Triangle 252 Incentives/Pressures to Commit Fraud 253 Opportunity to Commit Fraud 254 Rationalization for the Fraud 255 Tyco Fraud 255
Fraud Considerations in the Audit 259 Fraud Risk Assessment 260 Fraud Associated with Management Override of Controls 260 Rite Aid Fraud and Failure of Internal Controls 262 Communicating About Possible Fraud to Management and Those Charged with Governance 262 Management Representations and Financial Statement Certifications 263
Contents of the Audit Report 264 Background 264 Introductory Paragraph 265 Management’s Responsibility 265 Auditor’s Responsibility 265 Opinion 267 Types of Audit Opinions 267
Generally Accepted Auditing Standards (GAAS)—Overview 269
GAAS Requirements 271 Audit Evidence 272 Limitations of the Audit Report 273 Reasonable Assurance 273 Materiality 273
What Is Meant by “Present Fairly”? 275 Audit Risk Assessment 277
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Internal Control Assessment 278 Internal Control—Integrated Framework 278
PCAOB Standards 282 AS 4: Reporting on Previously Reported Material Weakness 283 AS 5: An Audit of Internal Control over Financial Reporting That Is Integrated with an Audit of Financial Statements 283 AS 6: Evaluating Consistency of Financial Statements 284 AS 8—Audit Risk 285 AS 9—Audit Planning 285 AS 10—Supervision of the Audit Engagement 285 AS No. 11—Consideration of Materiality in Planning and Performing an Audit 286 AS No. 12—Identifying and Assessing Risks of Material Misstatement 286 AS No. 13—The Auditor’s Responses to the Risks of Material Misstatement 286 AS No. 14—Evaluating Audit Results 286 AS No. 15—Audit Evidence 287 Communications with Audit Committees 287 Auditor’s Evaluation of the Quality of the Company’s Financial Reporting 289 Financial Statements Restatements 291 PCAOB Enforcement Program 293
Concluding Thoughts 294 Discussion Questions 295 Endnotes 297 Chapter 5 Cases 303
Case 5-1: Computer Associates 304 Case 5-2: ZZZZ Best 307 Case 5-3: Imperial Valley Thrift & Loan 311 Case 5-4: Audit Client Considerations and Risk Assessment 317 Case 5-5: Krispy Kreme Doughnuts, Inc. 319 Case 5-6: Dunco Industries 321 Case 5-7: First Community Bank 322 Case 5-8: Fannie Mae: The Government’s Enron 324 Case 5-9: Royal Ahold N.V. (Ahold) 329 Case 5-10: Groupon 333
Chapter 6 Legal, Regulatory, and Professional Obligations of Auditors 335
Ethics Reflection 335 Client Confidentiality, Fraud, and Whistleblowing 337
Confidentiality Obligation and Fraud 337 Dodd-Frank and Whistleblowing 337
Ethical and Legal Responsibilities of Officers and Directors 339
Duty of Care—Managers and Directors 339 Duty of Loyalty 339 Director Duty of Good Faith 339 Business Judgment Rule 340 Caremark Opinion 340 Shareholder Derivative Suit—Citigroup Subprime Lending 340 Clawback of Incentive Compensation from Executive Officers 341 Audit Committee and Business Judgment Rule 342
Legal Liability of Auditors: An Overview 343 Common-Law Liability 343 Liability to Clients—Privity Relationship 344 Liability to Third Parties 345 Actually Foreseen Third Parties 345 Reasonably Foreseeable Third Parties 346 Auditor Liability to Third Parties 348
Statutory Liability 350 Securities Act of 1933 352 Key Court Decisions 353 Securities Exchange Act of 1934 354
Interaction of Ethics and Legal Liability 356 Court Decisions and Auditing Procedures 357 Liability for Securities Violations 359
Honest Services Assessment in Criminal Matters 359 Is There a Difference Between Lying and Stealing in Securities Fraud? 360
Insider Reporting and Trading 361 Leaking Nonpublic Information 361 Auditor Betrayal of Client Confidences and Insider Trading 363
Private Securities Litigation Reform Act (PSLRA) 365
Reporting Requirements 365 Proportionate Liability 366
Sarbanes Oxley (SOX) Legal Liabilities 367 Section 302. Corporate Responsibility for Financial Reports 367 Section 302. Liability in Private Civil Actions 368 Section 302. Liability in Civil and Criminal Government Actions 369 Perspective on Accomplishments of SOX 369
Other Laws Affecting Accountants and Auditors 370 Foreign Corrupt Practices Act (FCPA) 370 SEC Charges Pfizer with FCPA Violations 371 FCPA Violations and Tyco 375 FCPA and Whistleblowing 375
Federal Sentencing Guidelines for Organizations 375
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Concluding Thoughts 377 Discussion Questions 378 Endnotes 380 Chapter 6 Cases 385
Case 6-1: SEC v. Halliburton Company and KBR, Inc. 386 Case 6-2: Con-way Inc. 390 Case 6-3: Insider Trading and Accounting Professionals 392 Case 6-4: Anjoorian et al.: Third-Party Liability 393 Case 6-5: Vertical Pharmaceuticals Inc. et al. v. Deloitte & Touche LLP 396 Case 6-6: SEC v. DHB Industries, Inc., n/k/a Point Blank Solutions, Inc. 397 Case 6-7: Livingston & Haynes, P. C. 400 Case 6-8: Kay & Lee, LLP 405 Case 6-9: Reznor v. J. Artist Management (JAM), Inc. 406 Case 6-10: SEC v. Zurich Financial Services 407
Chapter 7 Earnings Management and the Quality of Financial Reporting 410
Ethics Reflection 410 Motivation for Earnings Management 412
Earnings Guidance 412 Income Smoothing 414
Analysis of Earnings Management from a Financial Reporting Perspective 415
Definition of Earnings Management 415 Ethics of Earnings Management 416 How Managers and Accountants Perceive Earnings Management 418 Accruals and Earnings Management 419 Acceptability of Earnings Management from a Materiality Perspective 420 Current Auditing Standards and Presumptions 424
Financial Statement Restatements 426 The Nature of Restatements 426 Restatements Due to Errors in Accounting and Reporting 427
Earnings Management Techniques 428 Financial Shenanigans 429
1. Recording Revenue Too Soon or of Questionable Quality 429 2. Recording Bogus Revenue 430 3. Boosting Income with One-Time Gains 430 4. Shifting Current Expenses to a Later or Earlier Period 430
5. Failing to Record or Improperly Reducing Liabilities 430 6. Shifting Current Revenue to a Later Period 431 7. Shifting Future Expenses to the Current Period as a Special Charge 431
Descriptions of Financial Shenanigans 431 The Case of Xerox 432 Sanctions by the SEC on KPMG 433 The Case of Lucent Technologies 433 The Story of Enron 435 FASB Rules on SPEs 441 Enron’s Role in the Creation and Passage of SOX 442 Lessons to Be Learned from Enron 442
Earnings Quality 442 Concluding Thoughts 443 Discussion Questions 444 Endnotes 447 Chapter 7 Cases 451
Case 7-1: Nortel Networks 452 Case 7-2: Solutions Network, Inc. 456 Case 7-3: Cubbies Cable 458 Case 7-4: Solway, Inc. 460 Case 7-5: Dell Computer 461 Case 7-6: Sweat Construction Company 463 Case 7-7: Sunbeam Corporation 465 Case 7-8: Diamond Foods 468 Case 7-9: The North Face, Inc. 470 Case 7-10: Vivendi Universal 473
Chapter 8 International Financial Reporting: Ethics and Corporate Governance Considerations 475
Ethics Reflection 475 The Influence of Culture on International Financial Reporting 477 Restoring the Public Trust: An International Perspective 479 International Financial Reporting Environment 480
Movement toward IFRS 480 Harmonization of Standards 480 Comparability of Financial Statements 481 Convergence of Standards 482 Condorsement 483 Auditing, Corporate Governance, and Ethics Considerations 484 True and Fair View versus Present Fairly 485
IFRS for Small and Medium-Sized Entities 485
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Principles versus Rules-based Standards 487 Ethical Considerations 487 Earnings Management Concerns 488 Examples of Rules-based versus Principles- Based Standards 489 The Problem with Provisions and Reserves 491
Global Business Ethics 492 Global Code of Ethics 495 Global Fraud, Bribery, and Suspected Illegal Acts 496
Global Fraud 496 Global Bribery 497 Responding to a Suspected Illegal Act 499
Comparative Corporate Governance 501 Legal and Cultural Considerations 501 Comply or Explain Principle 502 Corporate Governance in Germany 503 Corporate Governance in China 504 Corporate Governance in India 507
CLSA Corporate Governance Watch 2012 508 Concluding Thoughts 510
Discussion Questions 510 Endnotes 513 Chapter 8 Cases 517
Case 8-1: SEC v. Siemens Aktiengesellschaft 518 Case 8-2: Parmalat: Europe’s Enron 521 Case 8-3: Satyam: India’s Enron 526 Case 8-4: Royal Dutch Shell plc 530 Case 8-5: Autonomy 534 Case 8-6: Olympus 537
Major Cases 542 Major Case 1: Adelphia Communications Corporation 543 Major Case 2: Royal Ahold N.V. (Ahold) 551 Major Case 3: MicroStrategy, Inc. 556 Major Case 4: Cendant Corporation 561 Major Case 5: Navistar International 567 Major Case 6: Waste Management 572
Name Index 579
Subject Index 583
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