Application of Ethical Reasoning in Accounting
In this section, we discuss the application of ethical reasoning in its entirety to a com- mon dilemma faced by internal accountants and auditors. The case deals with the classic example of when pressure is imposed on accountants by top management to ignore mate- rial misstatements in financial statements.
As we have seen, accountants have ethical obligations under the AICPA Code that require them to place the public interest ahead of all other interests, including their own self-interest and that of an employer or client, and to be independent of the client; make decisions objectively; exercise due care in the performance of professional services; and act with integrity. Many internal accountants, such as controllers and CFOs, are CPAs and members of the IMA. The IMA’s Statement of Ethical Professional Practice 76 is presented in Exhibit 1.6 . Other than independence, which is a specific ethical requirement of an external audit, the standards of the IMA are similar to the Principles of Professional Conduct in the AICPA Code. Most important, read through the “Resolution of Ethical Conflict” section, which defines the steps to be taken by members when they are pressured to go along with financial statement improprieties. Specific steps to be taken include discussing matters of concern with the highest levels of the organization, including the audit committee. Recall that Interpretation 102-4 of the AICPA Code contains a similar provision.
min622IX_ch01_001-053.indd 29min622IX_ch01_001-053.indd 29 09/08/13 4:46 PM09/08/13 4:46 PM
30 Chapter 1 Ethical Reasoning: Implications for Accounting
Members of IMA shall behave ethically. A commitment to ethical professional practice includes overarching principles that express our values, and standards that guide our conduct.
Principles IMA’s overarching ethical principles include: Honesty, Fairness, Objectivity, and Responsibility. Members shall act in accordance with these principles and shall encourage others within their organizations to adhere to them.
Standards A member’s failure to comply with the following standards may result in disciplinary action.
I. Competence Each member has a responsibility to:
1. Maintain an appropriate level of professional expertise by continually developing knowledge and skills. 2. Perform professional duties in accordance with relevant laws, regulations, and technical standards. 3. Provide decision support information and recommendations that are accurate, clear, concise, and timely. 4. Recognize and communicate professional limitations or other constraints that would preclude responsible judgment or
successful performance of an activity.
II. Confidentiality Each member has a responsibility to:
1. Keep information confidential except when disclosure is authorized or legally required. 2. Inform all relevant parties regarding appropriate use of confidential information. Monitor subordinates’ activities to
ensure compliance. 3. Refrain from using confidential information for unethical or illegal advantage.
III. Integrity Each member has a responsibility to:
1. Mitigate actual conflicts of interest, regularly communicate with business associates to avoid apparent conflicts of interest. Advise all parties of any potential conflicts.
2. Refrain from engaging in any conduct that would prejudice carrying out duties ethically. 3. Abstain from engaging in or supporting any activity that might discredit the profession.
IV. Credibility Each member has a responsibility to:
1. Communicate information fairly and objectively. 2. Disclose all relevant information that could reasonably be expected to influence an intended user’s understanding of
the reports, analyses, or recommendations. 3. Disclose delays or deficiencies in information, timeliness, processing, or internal controls in conformance with
organization policy and/or applicable law.
Resolution of Ethical Conduct In applying the Standards of Ethical Professional Practice, you may encounter problems identifying unethical behavior or resolving an ethical conflict. When faced with ethical issues, you should follow your organization’s established policies on the resolution of such conflict. If these policies do not resolve the ethical conflict, you should consider the following courses of action:
1. Discuss the issue with your immediate supervisor except when it appears that the supervisor is involved. In that case, present the issue to the next level. If you cannot achieve a satisfactory resolution, submit the issue to the next management level. If your immediate superior is the chief executive officer or equivalent, the acceptable reviewing authority may be a group such as the audit committee, executive committee, board of directors, board of trustees, or owners. Contact with levels above the immediate superior should be initiated only with your superior’s knowledge, assuming he or she is not involved. Communication of such problems to authorities or individuals not employed or engaged by the organization is not considered appropriate, unless you believe there is a clear violation of the law.
2. Clarify relevant ethical issues by initiating a confidential discussion with an IMA Ethics Counselor or other impartial advisor to obtain a better understanding of possible courses of action.
3. Consult your own attorney as to legal obligations and rights concerning the ethical conflict.
EXHIBIT 1.6 Institute of Management Accountants Statement of Ethical Professional Practice
min622IX_ch01_001-053.indd 30min622IX_ch01_001-053.indd 30 09/08/13 4:46 PM09/08/13 4:46 PM
Chapter 1 Ethical Reasoning: Implications for Accounting 31
DigitPrint Case Study DigitPrint was formed in March 2013 with the goal of developing an outsource business for high-speed digital printing. The company is small and does not yet have a board of directors. The comparative advantage of the company is that its founder and president, Henry Higgins, owned his own print shop for several years before starting DigitPrint. Higgins recently hired Liza Doolittle to run the start-up business. Wally Wonderful, who holds the Certified Management Accountant (CMA) certification from the IMA, was hired to help set up a computerized system to track incoming purchase orders, sales invoices, cash receipts, and cash payments for the printing business.
DigitPrint received $2 million as venture capital to start the business. The venture capitalists were given an equity share in return. From the beginning, they were concerned about the inability of the management to bring in customer orders and earn profits. In fact, only $200,000 net income had been recorded during the first year. Unfortunately, Wonderful had just discovered that $1 million of accrued expenses had not been recorded at year-end. Had that amount been recorded, the $200,000 net income of DigitPrint would have changed to an $800,000 loss.
Wonderful approached his supervisor, Doolittle, with what he had uncovered. She told him in no uncertain terms that the $1 million of expenses and liabilities could not be recorded, and warned him of the consequences of pursuing the matter any further. The reason was that the venture capitalists might pull out from financing DigitPrint because of the reduction of net income, working capital, and the higher level of liabilities. Wonderful is uncertain whether to inform Higgins. On one hand, he feels a loyalty obligation to go along with Doolittle. On the other hand, he believes he has an ethical obligation to the venture capitalists and other financiers that might help fund company operations.
We provide a brief analysis of ethical reasoning methods based on the following. First, consider the ethical standards of the IMA and evaluate potential actions for Wonderful. Then, use ethical reasoning with reference to the obligations of an accountant to analyze what you think Wonderful should do.
IMA Standards Wonderful is obligated by the competence standard to follow relevant laws, regulations, and technical standards, including GAAP, in reporting financial information. Of particular importance is his obligation to disclose all relevant information, including the accrued expenses, that could reasonably be expected to influence an intended user’s understanding (i.e., venture capitalists) of the financial reports. Doolittle has refused to support his posi- tion and told him in no uncertain terms not to pursue the matter. At this point, Wonderful should follow the Resolution of Ethical Conduct procedures outlined in the IMA Standards and take the matter up the chain of command. Typically, in a public corporation, this would mean to go as far as the audit committee of the board of directors. However, DigitPrint is a small company without a board, so Henry Higgins, the founder and president, is the final authority. If Higgins backs Doolittle’s position of nondisclosure, then Wonderful should seek outside advice from a trusted adviser, including an attorney, to help evaluate legal obligations and rights concerning the ethical conflict. The danger for Wonderful would be if he goes along with the improper accounting for the accrued expenses, the venture capitalists find out about the material misstatement in the financial statements at a later date, and then Wonderful is blamed both by the company and the venture capitalists.
Utilitarianism Wonderful should attempt to identify the harms and benefits of the act of recording the transactions versus not recording them. The consequences of failing to inform the venture capitalists about the accrued expenses are severe, not only for Wonderful but also for
min622IX_ch01_001-053.indd 31min622IX_ch01_001-053.indd 31 09/08/13 4:46 PM09/08/13 4:46 PM
32 Chapter 1 Ethical Reasoning: Implications for Accounting
DigitPrint. These include a possible lawsuit, investigation by regulators for failing to record the information, and, most important, a loss of reputational capital in the marketplace. The primary benefit to Wonderful is acceptance by his superiors, and he can be secure in the knowledge that he’ll keep his job. Utilitarian values are difficult to assign to each potential act. Still, Wonderful should act in accordance with the moral rule that honesty requires not only truth telling, but disclosing all the information that another party has a need (or right) to know.
Rights Theory The venture capitalists have an ethical right to know about the higher level of payables, lower income, and the effect of the unrecorded transactions on working capital; the com- pany has a duty to the venture capitalists to record the information. Wonderful should take the necessary steps to support such an outcome. The end goal of securing needed financing should not cloud Wonderful’s judgment about the means chosen to accomplish the goal (i.e., nondisclosure). Wonderful should ask whether he believes that others in a similar situation should cover up the existence of $1 million in accrued expenses. Assuming that this is not the case, he shouldn’t act in this way.
Justice In this case, the justice principle is linked to the fairness of the presentation of the financial statements. The omission of the $1 million of unrecorded expenses means that the state- ments would not “present fairly” financial position and results of operations. It violates the rights of the venture capitalists to receive accurate and reliable (fair presentation) financial information. As previously explained, a procedural justice perspective applied to the case means to assess the support for employee decisions on the part of the company. As a new employee, Wonderful needs to understand the corporate culture at DigitPrint.
Virtue Considerations Wonderful is expected to reason through the ethical dilemma and make a decision that is consistent with virtue considerations. The virtue of integrity requires Wonderful to have the courage to withstand the pressure imposed by Doolittle and not subordinate his judgment to hers. Integrity is the virtue that enables Wonderful to act in this way. While he has a loyalty obligation to his employer, it should not override his obligation to the venture capitalists, who expect to receive truthful financial information. A lie by omission is dishonest and inconsistent with the standards of behavior (virtues) in the accounting profession.
What Should Wonderful Do? Wonderful should inform Doolittle that he will take his concerns to Higgins. That may force Doolittle’s hand and cause her to back off from pressuring Wonderful. As presi- dent of the company, Higgins has a right to know about the situation. After all, he hired Doolittle because of her expertise and, presumably, based on certain ethical expectations. Higgins may decide to disclose the matter immediately and cut his losses because this is the right thing to do. On the other hand, if Higgins persists in covering up the matter, then, after seeking outside/legal advice, Wonderful must decide whether to go outside the company. His conscience may move him in this direction. However, the confidentiality standard requires that he not do so unless legally required.
A Message for Students As you can tell from the DigitPrint case, ethical matters in accounting are not easy to resolve. On one hand, the accountant feels an ethical obligation to his employer or the client. On the other hand, the profession has strong codes of ethics that require accoun- tants and auditors to place the public interest ahead of all other interests. Accounting
min622IX_ch01_001-053.indd 32min622IX_ch01_001-053.indd 32 09/08/13 4:46 PM09/08/13 4:46 PM
Chapter 1 Ethical Reasoning: Implications for Accounting 33
professionals should analyze conflicting situations and evaluate the ethics by considering professional standards and the moral principles discussed in this chapter. A decision should be made after careful consideration of these factors and by applying logical reasoning to resolve the dilemma. Keep in mind that you may be in a position during your career where you feel pressured to remain silent about financial wrongdoing. You might rationalize that you didn’t commit the unethical act, so your hands are clean. That’s not good enough, though, as your ethical obligation to the public and the profession is to do whatever it takes to prevent a fraud from occurring and, if it does, take the necessary steps to correct the matter. Betty Vinson learned this lesson the hard way. We hope that you will internalize the importance of acting ethically and in accordance with the ethical values of the accounting profession, and look at the bigger picture when pressured by a superior to go along with financial wrongdoing. The road is littered with CFO/CPAs who masterminded (or at least directed) financial frauds at companies such as Enron, WorldCom, and Tyco. The result of their trials was a jail sentence for Andy Fastow of 10 years, Scott Sullivan of 5 years, and Mark Swartz of 8 1/3 to 25 years. Most important is they lost their livelihood, as well as the respect of the community. A reputation for trust takes a long time to build, but it can be destroyed in no time at all.
Scope and Organization of the Text
The overriding philosophy of this text is that the ethical obligations of accountants and auditors are best understood in the context of professional responsibilities, including one’s role in the corporate governance system, the requirements of financial reporting, the audit function, obligations to prevent and detect fraud, and legal liabilities. Given the rapid pace of globalization in the business world, we also believe that today’s accounting students should gain an appreciation for ethical issues related to international financial reporting and global ethics standards.
Accounting professionals serve as internal accountants and auditors, external auditors, tax preparers and advisers, and consultants to their clients in a variety of advisory services. The ethics standards of the accounting profession, as defined by the AICPA Code of Professional Conduct and IMA’s Statement of Ethical Professional Practice, provide the foundation for ethical decision making in the performance of professional responsibilities. These are discussed throughout this book. We also look at the Institute of Internal Auditors Code of Ethics (Chapter 3), and the Global Code of Ethics (Chapter 8).
Ethical decision making in accounting is predicated on moral reasoning. In this chapter, we have attempted to introduce the complex philosophical reasoning methods that help to fulfill the ethical obligations of accounting professionals. In Chapter 2, we address theories of moral development and the link to ethical reasoning and professional judgment in accounting. We also introduce a decision-making model that provides a framework for ethical decision making and can be used to help analyze cases presented at the end of each chapter. In Chapter 3, we transition to the culture of an organization and how processes and procedures can help to create and sustain an ethical organization environment, including effective corporate governance systems.
The remainder of this book focuses more directly on accounting ethics. Chapter 4 addresses the rules of professional conduct in the AICPA Code; investigations of the pro- fession leading up to the Sarbanes-Oxley (SOX) Act, which created the Public Accounting Oversight Board; and whistleblowing obligations of accounting professionals under SOX and Dodd-Frank Financial Reform Act, which was signed into law by President Obama on July 21, 2010, in response to the financial meltdown in 2007–2008.
The accounting profession has been investigated by Congress several times over a number of years following disclosures of financial fraud. A common question has been: Where were
min622IX_ch01_001-053.indd 33min622IX_ch01_001-053.indd 33 09/08/13 4:46 PM09/08/13 4:46 PM
34 Chapter 1 Ethical Reasoning: Implications for Accounting
the auditors? In Chapter 5, we review generally accepted auditing standards (GAAS), the basis for the independent audit and expectations for professional accountants and auditors. Students do not need to have completed an Auditing course to understand this discussion. We also address the important topic of financial statement fraud, including the Fraud Triangle, which describes the elements of fraud and so-called red flags that increase fraud risk.
In Chapter 6, we look at legal liability issues and regulatory requirements building on the discussion of laws that define acceptable behavior in accounting including whistleblowing requirements. The techniques used to manipulate earnings and obscure financial statement items are discussed in the context of earnings management in Chapter 7. Finally, in Chapter 8, we address global ethics considerations related to international financial reporting that have become increasingly more important for U.S. and non-U.S. companies. Recent estimates indicate that many U.S. companies earn 50 percent or more of their revenue from overseas operations, including Intel (85 percent), Dow Chemical (67 percent), IBM (64 percent), McDonald’s (66 percent), General Electric (54 percent), and Ford (51 percent). 77
There are 160 discussion questions, 76 cases, and 6 major cases in the end-of-chapter materials at the back of the book. These cases may be used by your instructor to supple- ment chapter material and for individual and group projects, including in-class case presentations. About one-third of the cases in this book have been taken from the files of the Securities and Exchange Commission (SEC) to give a real-life dimension to the text. Many of them deal with well-known examples of financial statement fraud, both nationally and internationally.
This book covers a variety of areas in financial reporting. Most students will have taken the Intermediate Accounting sequence before using this book, so the financial reporting areas relevant to accounting ethics such as financial statement reporting, GAAP, and infor- mative disclosure already will have been covered.
In most of the cases, we have purposefully kept the materials as brief as possible. The reason for the brevity is we hope that students will focus on the ethical issues and not get too bogged down with numerical calculations.