ACCOUNTING ETHICS – Flashcards
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to preserve the integrity of his reports, the accountant must insist upon ABSOLUTE INDEPENDENCE OF JUDGEMENT AND ACTION. The necessity of preserving this position of independence indicates certain standards of conduct.
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If the confidence of the public in the integrity of accountants' reports is shaken, their value is gone. Authur Anderson in a 1932 Lecture on Business Ethics.
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What went wrong with his company is a story told many times from many perspectives. From our perspective, there are two main reasons. One is on the individual level. Accountants, at least in the Houston offices of Andersen, did not do what they were supposed to do.
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They made the common mistake of many auditors who think their main obligation is to please the client who hires them. Rather, as well will try to show, accounting has a public purpose. It needs to serve the public good first. We will discuss this purpose at length in the book.
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The second reason is that Arthur Andersen succumbed to the systematic temptations that regularly beset the accounting firms, particularly the large firms. Firms, or the human beings who run them, are susceptible to the pressures of incentives; we get what we reward.
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As an auditor, Arthur Andersen had a clear mission-- to attest that the financial statements it was auditing reflected what was really going on in the company. However, Andersen eschewed that mission in favor of fees.
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An auditor's responsibilities are clear. If, however, consulting brings in more profit than auditing does, there will be pressure to do even more consulting. Some might say, if that results in soft auditing, so be it.
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It's simply human nature to follow pursuits that enhance our income stream. But how can we reconcile giving in so such pressure with accounting ethics?
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Ethics is an overarching concern in all areas of life; it is involved in all human activity. Human activity is an activity for which an individual is responsible, one that helps or harms the individual or others, and one that is deemed to be either just or unjust, right or wrong.
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In this book, we will examine the ethical dimensions of the human activity of accounting. To understand it fully, we must first consider where and how the activity of accounting fits into the larger scheme of human activities.
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We will look into how accounting is both an essential practice and a vital profession. It is an essential practice. because today's economically developed system could not exist without accounting.Business and the financial market,
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as we know it, would grind to a halt if there were no way to account for the existence and disposition of the world's wealth and goods. For markets to function efficiently, it is necessary to have transactions based on accurate portraits of the financial worth of any entity being traded.
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Those portraits are painted by accountants. Power relationships, property rights, ownership claims, valuations, receivables, and debts are all social constructs that define who owns what and owes what to whom.
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All of these constructs are identified and tracked by accountants and bookkeepers.
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Determining, examining, and evaluating the purposes of activities or practices is one of the major tasks of ethics. This approach to ethics is a functional one, as it involves an evaluation of a function or purpose. For example, if we take a functional approach to a knife, we see that
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a knife has a basic purpose or function-- to cut. It is considered a good knife, with respect to its basic function, if it cuts well; if it is a dull knife that does not cut sharply, it is considered a poor knife But we can also analyze whether the function itself is a worthwhile activity.
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Whether cutting is worthwhile depends on what is being cut and why--that is, the purpose for which the activity is engaged.
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Every activity is done either for its own sake, in which case it is intrinsically worthwhile, or for the sake of something else, in which case it is instrumentally worthwhile.
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Cutting is an activity for the sake of something else, and it is judged as worthwhile or not depending on the purpose for which it is performed. A good knife can be used to cut up food, or it can be used to kill human beings.
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Providing accurate financial pictures of business activities-- the primary activity of an accountant-- is an instrumental activity, because it offers an indispensable service to those who need that information to engage in financial decision making.While instrumental activities
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can provide great benefits to human beings [and thus be viewed as noble], they can also bring about great harm. Accounting and the skills of the accountant can be utilized to do great harm to society if the purpose for which the information is used are harmful or illegal.
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For example, an accountant for organized crime or an accountant for the Nazi Party is providing a useful service for his clients, but the clients corrupt that service by exploiting it for evil purposes or ends.
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Hence, we judge the purpose of accounting, which is to provide information of economic affairs, as laudable. Having done so, though, we still need to judge the skilled accountant from the perspective of the use to which his or her accounting skills are put.
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If it is a noble purpose--to keep a worthwhile business or social entity functioning well--it will be lauded. if it is a malicious purpose-- to cheat the public out of legitimate tax dollars--it will be condemned.
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With those goals in mind, we begin the book by briefly explaining the history, nature, and purpose of accounting. Because it is the invention of human beings and, consequently, the result of human conventions, it will be helpful to review how accounting has evolved.
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Financial activities are necessary for survival in our present world, and when accounting helps to facilitate these activities, it is usually beneficial.
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Yet, accounting can be misused to benefit some at the expense of others, to deceive and to defraud others. At such times, the accounting itself might be performed well, but the accountant's practice and skills are denigrated by their unethical use.
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Next, we will turn our attention to this question: What is ethics? we will explore current ethical theories to see how they can be applied to accounting today, focusing on both the ethics of purpose and the ethics of relationships. Ethics is more than simply the pursuit of good; it is also
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about fidelity to ethically acceptable relationships. A crucial relationship is that of a professional toward his or her clients. Because accounting is a skill that demands expertise, and because accountants have clients who depend on that expertise, accounting can be included among the professions.
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We will demonstrate why that invests accounting with an ethical dimension. we will also look at the characteristics of professionalism and the concept of agency inherent in any profession.
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We will show that being a professional obligates the accountant to act in the best interests of various constituencies, from the client to the company to the general public.
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In October 2001 Enron began to collapse as a company. October 16, 2001, Enron took a $1.01 billion charge related to write-downs of investments. Of this, $35 million was attributed to partnerships run by CFO Andrew Fastow.
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According to THE WALL STREET JOURNAL, Enron disclosed that it shrank shareholder equity by $1.2 billion as a result of several transactions, including ones undertaken with Mr. Fastow's investment vehicle. Arthur Andersen was Enron's auditing firm.
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On June 15, 2002, Andersen was convicted of obstruction of justice for shredding documents related to its audit of Enron, resulting in the Enron scandal. The United States Securities and Exchange Commission [SEC] does not allow convicted felons to audit public companies.
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The accounting firm agreed to surrender its CPA licenses and its right to practice before the SEC on August 31, 2002, putting Arthur Andersen out of business in the United States. These two companies will be tied together in financial history as an illustration of scandalous ethical behavior.
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Although the Enron/ Arthur Andersen collapse in 2001-2002 was a watershed moment in the history of accounting, the problems, practices, conflicts, and issues that led to the collapse were not new and have still not been overcome.
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Even before Enron, there were problems and shoddy practices. In an article from THE WASHINGTON POST in 1998, then SEC chairman Arthur Levitt, Jr, called attention to what he dubbed a "numbers game" in which companies manipulate accounting data to produce desired results.
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These results range from "making one's numbers"-- meeting Wall Street projections--to smoothing out quarterly results to produce a steady run of increases.
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According to Levitt, "This process has evolved over the years into what can best be characterized as a game among market participants."
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Accounting is a technique, and its practice is an art or craft developed to help people monitor their economic transactions.Accounting gives people a financial picture of their affairs.
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Its original-- and enduring-- fundamental purpose is to provide information about the economic dealings of a person or organization. Initially, only the person or organization needed the information. Then the government needed the information.
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As the economy became more complex and regulated, the number of those who needed the information--the number of users of economic statements--increased.
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The extent of the importance of the information to the user increases the ethical factors governing the development and disbursement of that information. Some people have a right to the information; others do not.
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The accountant provides information that can be used in a number of ways. An organization's managers use it to help them plan and control the organization's operations. Owners, managers, and/or legislative bodies use it to help them appraise an organization's performance and
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make decisions about its future. Owners, managers, lenders, suppliers, employees, and others use it to help to decide how much time and/or money to devote to the organization. Finally, government uses it to determine how much tax the organization must pay.
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Hence, the accountant's role is to furnish various entities that have a legitimate right to know about an organization's affairs with useful information about those economic affairs.
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Useful information is owed to those various entities, and the accountant has an obligation to provide as true a picture of those affairs as possible.
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Thus, accountants issue financial statements that a range of constituencies--from company management, to tax agencies, to potential investors-- need to access. Those statements, which are expected to give a reliable and useful picture of the organization's financial affairs,
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are made within the guidelines developed by the profession itself. The accounting practice rests on what the Financial Accounting Standards Board [FASB] of the Financial Accounting Foundation calls a conceptual framework:
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The conceptual framework is a coherent system of interrelated objectives and fundamentals that is expected to lead consistent standards and that prescribes the nature, function, and limits of financial accounting and reporting. It is expected to serve the public interest [italics added] by providing
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structure and direction to financial accounting and reporting to facilitate the provision of evenhanded financial and related information that helps promote the efficient allocation of scarce resources in the economy and society, including assisting capital and other markets to function efficiently.
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The balance sheet has three elements 1. asset-- the tangible asset and intangible items owned by the company; 2. liabilities-- the organization's debts, involving money or services owed to others; and
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3. owner's equity-- funds provided by the organization's owners and the accumulated income or loss generated over years. The total assets, of course, equal the total liabilities plus the owners' equity.
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Owners' equity [net assets] equals the total assets minus the total liability [net assets]. To put it another way, total assets equals liabilities plus owners' equity.
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This view of the equation indicates how assets were financed: by borrowing money [liability] or by using the owner's money [owner's equity].
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For example, T.Rowe Price's manager, Richard P.Howard, says that many accountants' way of looking at companies is out of sync with modern markets, which focus on a company's earnings rather than its asset value:
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"One of the problems that accountants have is that they're still working on the theory that the balance sheet [the statement of assets and liabilities] is sacrosanct. So they err on the side of writing down assets. They think that they're being conservative, but that's wrong."
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Assets and liabilities can be classified as either current or noncurrent. Noncurrent assets are noncurrent receivables and fixed assets such as land, buildings, and long-term investments.
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Current assets include cash, amounts receivable, inventories, and other assets expected to be consumed or readily converted into cash in the next operating cycle.
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The owners' equity is divided between common or preferred stock, paid-in capital, and retained earnings, where common stock is the set dollar per share, paid-in capital is the premium paid for the stock [shares],
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and retained earnings is the amount earned/lost in the past and dividends distributed to owners. But what is "expected" to be consumed or converted into cash? such items can be manipulated or at the least reported in any number of ways to determine what the owner's equity is.
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The income statement shows net income [profit] when revenues exceed expenses and net loss when expenses exceed revenues. The statement of changes in retained earnings explains the changes in those earnings over a reporting period:
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assets minus liabilities equal paid-in capital and retained earnings. The statement of changes in financial position identifies existing relations and reveals operations that do or do not generate enough funds to cover an organization's dividends and capital investment requirement.
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Because, as we noted, preparation of these statements allows great leeway in what to take account of and what not, as well as where to put things in presenting the statements, opportunities bound to paint different pictures of an organization's financial affairs.
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It takes little imagination to envision a manager who, for fear of his job and wanting to impress his board, puts pressure on the managerial accounting to "cook the books" so that retained earnings look much more substantial than they are.
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But cooking the books and "creative accounting," as the terms suggest, clearly have an unethical element and are activities that must be examined under the ethics of truth telling and disclosure.
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More recently, "aggressive accounting" and "pro-forma accounting" are euphemisms, at least in some cases, for presenting pictures of a company's financial situation that, while not deceptive, are less than candid.
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Accounting is developing information that is going to be used. If the used of the information is benign and the information is truthful, no ethical problems arise. But if the information persuades people to act in one way or other, and their action either benefits or harms the
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persons giving or getting the information, this information giving takes on ethical importance. Depending on the use, giving out information can be very much like selling. For example, the CEO is "selling" the board or the stockholders on the soundness of the company's financial situation.
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His bonus might be tied to how rosy a picture he paints. The worth of the CEO's stock options rests on the financial picture.
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He may sell the Internal Revenue Service [IRS] a different picture of the company, and sell still a different picture to potential investors or lenders. Because accounting entails presenting the product to be sold, it enters into and influences market transactions.
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in the ideal market transaction, two people decide to exchange goods because they hope the exchange will make both better off. In a market exchange, nothing new has been produced, but the exchange is beneficial to both people. Ideally, there is perfect information about the worth of
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what is being given and received in return. Such a trade, freely entered into with full information, should maximize satisfaction on both sides. That is the genius of the market and the defense of our free market system-- freedom of exchange that leads to the overall improvement of the traders' lot.
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If, however, one of the parties is misled into believing a product is what it is not, because the product is misrepresented, that misrepresentation undermines the effect of both sides being better off.
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Deception usually leads to the deceived party's getting something different and less valuable from what he or she expected. The deceived party most likely would not have freely entered into the exchange had that party known the full truth about it.
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The bank would not have made the loan, the public offering of stock would not have been so successful, the CEO's bonus would not have been so large, if the true picture of the company had been available.
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It is important to note that lying is not synonymous with saying something false. Sometimes people simply make a mistake or inadvertently misspeak. In that case, they say something false, but their action can hardly be constructed as lying.
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Telling a lie involves more than simply getting things wrong and not telling the truth. The essence of lying is found in its purpose, which is to alter another's behavior.
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Lying involves deliberately misrepresenting something to another person to get that person to act in a certain way, a way the liar suspects the person would not act if that person knew the truth.
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We can characterize lying, therefore, as an attempt by one person-- usually through spoken or written words that are untrue [lying can also be accomplished with gestures or looks]-- to get another person to act in a way that person would probably not act if he or she knew the truth.
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Misrepresentation or lying can thus be defined as a deceptive activity meant to evoke a certain response that would not have occurred if the truth were told. Simply put, we lie and deceive others to get our way.
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For example, if Enron officials misrepresented the company's financial health in order to persuade their employees to hold on to their stock so the value of the stock would not drop, the officials lied.
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In order to keep their own stock options at an inflated price the officials deceived the employees, who if they had known the truth probably would have sold their shares, thus deflating the value of the stock even more.
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if we apply the notion of lying to an activity in which we paint a false picture of an organization's affairs to change a prospective investor's view of the company's financial health, we misrepresent the state of the organization to get the investor to
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do what we think he wouldn't do if the investor had a true picture. Viewed from this perspective, a deceptive sale is an activity whose goal is to induce the buyer to do what the seller thinks the buyer probably won't do if the buyer knew the truth.
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From an economic point of view, such behavior violates the ideal market principle of free exchange based on perfect information. But more important, from a moral point of view, in getting the buyer to do other than the
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buyer would, the seller takes away the buyer's real choice in the situation and thereby uses the buyer for the deceiver's own ends. Such use, as we will see in the next chapter, is unjust and immoral and often called exploration or manipulation.
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Does failure to disclose fit these considerations? Some would say that not disclosing isn't lying; it's just not telling. But that misses the point. Any action of
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deliberately withholding information, or coloring information to get others to act contrary to the way they would if they had true information, has the same deceptive structure and consequence as an overt lie. It doesn't allow an informed choice.
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But how much must the accountant disclose? Must the accountant disclose everything? It is an accepted principle of effective salesmanship [not to be confused with ethical salesmanship] not to say anything negative
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about the product the salesperson is selling and certainly not to disclose shortcomings unnecessarily. A manager selling the worth of his company to a bank where he hopes to obtain a loan is in much the same situation. How many of the company's "warts" must the manager expose the bank?
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What is the accountant's obligation in this situation? there are pictures, and there are pictures. Is the obligation in business more stringent that the obligation in private affairs?
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As an example, if you are selling your home, is it necessary to point out all the little defects that only you know? There are, after all, laws that require disclosure of some things. Are you ethically obliged to go beyond the law?
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if you do, and disclose every small defect, you might succeed in discouraging every prospect from buying your home. Job applicants, as another example, need to sell themselves. Should they point out their flaws to their potential employers? No job counselor is likely to suggest that.
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Some might argue that if a person doesn't benefit from a nondisclosure, as in some social occasions, it is not lying. For example, when your friends ask how you are, you don't have to disclose that you feel miserable. They probably don't want to hear it.
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Or when your coworker asks you if she looks okay, you don't have to say, "You look terrible, like you just crawled out of bed." That kind of social nondisclosure is acceptable because you are not trying to change another's behavior to benefit personally from it.
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Hence, if you shade the truth for some reason other than manipulating the behavior of the person to whom you are talking, it may not be wrong. This is what we call a "white lie."
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The most common measurement principles are generally accepted accounting principles. Those principles are supervised by the Financial Accounting Standards Board, not the SEC,
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which does have the statutory authority to set financial accounting and reporting standards for publicly held companies under the Securities Exchange Act of 1934. Throughout its history, SEC's policy has been to rely on the private sector to set standards.
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In the United States, much of this is now under review, given some of the shortcomings of the regulatory system that surfaced during the Enron/Andersen investigations, and self-regulation has been superseded by the Public Company Accounting Oversight Board.
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So what is asset value? Asset value is the value to owners or what a buyer would be willing to pay the owners, which can be determined by what the company expects to be able to do with the asset.
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Asset value depends on three factors: the amount of anticipated future cash flows, the timing, and the interest rate.
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Asset value can also be determined by the amount the company could obtain by selling its assets. This determination, however, is rarely used because
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continued ownership of an asset implies that its present value to the owner is greater than its market value, which its apparent value to outsiders. [such a formulation enters into values beyond monetary, even including possible ethical values.]
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In addition to asset value, there is asset cost. Most assets are measured at cost because it is difficult to verify forecasts upon which a generalized value system would have to be based.
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the historical cost of an asset equals the sum of all the expenditures the company made to acquire it. This, obviously, is sometimes difficult to determine.
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Consequently, with so much latitude in establishing the value of an organization's assets, the financial and economic picture can be skewed in any number of ways. Thus, it is important from an ethical standpoint to determine:
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1. Who the financial picture is being created for an for what purposes; 2. who has the right to the picture and for what purposes; and 3 what is to be done when different pictures benefit different parties at the expense of other parties entitled to those pictures.
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Finally, to complete our discussion of the financial statement, we need to highlight some of the chief concepts and techniques that accountants utilize:
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*Net income. Net income indicates the change in a company's wealth, during a period of time, from all sources other than the injection or withdrawal of investment funds.
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Transactions approach. This approach recognizes as income only those increases in wealth [that can be substantiated] from data pertaining to actual transactions that have taken place with persons outside the company.
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The approach does not recognize, for example, the wealth that a service company gains by hiring a dynamic new employee who will produce salable commodities.
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Recognition of income. This involves revenue estimates and expense estimates. The accountant needs to estimate the percentage of gross sales, recognizing that for some goods payment will never be received.
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Expense estimates are based on historical cost of resources consumed. Thus, net income equals the difference between value received from the use of resources and the cost of the resources consumed in the process.
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Historical cost less depreciation. To determine the value of assets, it is necessary to depreciate some items. There are several depreciation formulas, including but not limited to the modified accelerated cost recovery system,
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accelerated cost recovery system, straightline method, double declining balance method, and sum of the year's digits method. which of these an accountant uses will certainly affect the picture of the company's financial affairs.
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Cost of goods sold formulas. To determine the cost of goods sold, the accountant can use one of several measurement methods:
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a. FIFO [first in, first out]. In FIFO, the cost of goods sold is equal to the total cost of various batches of goods available, starting with the oldest batch in the inventory.
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b. LIFO [last in, first out]. The opposite of FIFO, LIFO means that the most recently purchased items are recorded as sold first.
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c. Average cost. In this method, it is assumed that the cost of inventory is based on the average cost of the goods available for sale during the reporting period. Average cost is determined by dividing the total cost of goods available for sale by the total units available for sale.
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Auditing. The most important role is the role of the independent accountant [auditor]. The auditor's function is to determine that the organization's estimates are based on formulas that seem reasonable in the light of whatever evidence is available and to see that those
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formulas are applied consistently from year to year--thus, to ensure reasonable application ans consistent application. The role of the auditor is not to determine whether the formulas are justifiable. That, at least in the United States, is FASB's job.
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Managerial accounting. A second role for accountants is managerial accounting. Businesses need controllers and internal auditors. For example, they need in-house accountants whose role is to give the most accurate picture of the organization's economic state so that the company can rate picture of
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the organization's economic state so that the company can flourish. the accountant's main responsibility is to the company, but if the company's board, managers, and shareholders are at cross-purposes, the accountant is conflicted. These conflicts form the grounds for many ethical problems.
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Tax accounting. A third role for accountant is the determination of tax liabilities for clients, either individual or corporate.
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Financial Planning. More and more accountants are engaging in a fourth kind of activity, which springs from their knowledge of tax law and financial investment markets-- financial planning.
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Some might argue this is not a role of an accountant as such, but rather a role the accountant may be well qualified to assume, given his or her areas of expertise.
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Consulting. Finally, there is the area of consulting. Because an accountant is exceeding familiar with the financial status of the companies he/she serves, the accountant can become a valuable company consultant
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in money management, income distribution, and accounting and auditing functions. Here, too, some might argue that this is not the accountant's role, but rather one he or she can assume based on the accountant's expertise.
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Long before the Enron/ Andersen debacle, Rick Telberg made this pessimistic observation in Accounting Today: "In fact we are probably past the time when independence mattered. CPA firms long ago became more like insurance companies -- complete with their
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focus on assurances and risk-managed audits-- than attestors. Auditors are backed by malpractice insurance in the same way that an insurance company is backed by a re-insurer, so they have become less like judges of financial statements than underwriters weighing probabilities."
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Some in the profession have even argued that auditors should function less like ultimate arbiters of fact and financial reality, and be allowed, instead, to function more like investment bankers, and provide only "due diligence."
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So that CPAs, who once valued fairness and truthfulness in financial reporting, would then promise little more than nods and winks, all beyond the reach of meaningful oversight.
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That danger in Telberg's scenario is that if every auditor or attestor acted in that way, audits and attestations would be worthless.
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There would still be a use for accountants as tax prepares and financial reporters, but the audit function--the heart of the accounting profession-- would be excised from the practice, rendered virtually useless by its misuse.
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if we take the stand that the function of the accountant is to do what is required for a company to flourish monetarily, that would not be ethics. Society need audited reports. It need truthful reports.
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If the delivery of these reports is not profitable, then accounting firms committed to maximizing their own profit will eschew the audit function. That will leave an enormous accounting job still to be done. Someone will step into the gap and perform the service.
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That person will then be subject to the same ethical requirements as the professional auditor of today. The names may change, but the function will remain.
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Beginning in the 1920s, accounting standards were given by a period of industrial growth with a corresponding surge in stock prices.
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"Accounting standards were developed privately, often poorly designed and unregulated. As a result, they were subject to manipulation with accurate financial reporting easily compromised to drive stock prices, meet loan covenants, or attract new investors."
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The Securities Acts of 1933 and 1934 were Congress's response to the Depression, which to some extent resulted from manipulation and fraud in the securities markets. Parts of acts' purpose was to promote ethical behavior through legislation and regulation. Congress established the Securities and
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Exchange Commission, regulated securities trading, mandated common accounting standards, and required CPA firm audits of publicly traded companies. "The Acts signified a landmark change in corporate accountability and provide the foundation for growth of the CPA profession as external auditors."
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The American Institute of Certified Public Accountants [AICPA] in 1963 published Opinion #12 on Independence that stipulated, "..... normal professional or social relationships would not suggest a conflict of interest in the mind of a reasonable observer."
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This opinion, with some caveats, allowed combining auditing and management consulting. The AICPA also determined, at that time, that the fees from management services would not have an impact on the audit because most management fees were not recurring.
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The popular belief was that doing both consulting and auditing would be beneficial to the companies.
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"The result [to place to much emphasis on the appearance of independence, rather than independence in fact] might be to deprive clients of valuable creative
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contributions to improved management which their auditor, through their familiarly with the client's business, acquired in the course of an audit, are in a better position than anyone else to make."
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The U.S. Senate's Subcommittee on Reports, Accounting and Management launched the Metcalf Committee in 1977 to investigate the accounting profession. It recommended that the profession improve its procedures for assuring Independence in view of the public's needs and expectations.
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It also recommended as best policy to require that independent auditors of public owned companies perform only services directly related to accounting.
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It suggested that only certain management advisory services are appropriate to public audit clients, such as certain computer and system analysis necessary to improve internal control procedures.
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The committee cautioned that other services should not be provided to audit clients, such as executive recruitment, marketing analysis, plant layout, product analysis, and actuarial services.
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In 1977, the American Institute of Certified Public Accountants created a division for CPA firms, composed of a SEC Practice Section [SECPS] and a Private Companies Practice Section.
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The SECPS adopted criteria for the scope to a public audit client: psychological testing, public opinion polls, mergers and acquisitions, assistance for a finder's fee, executive recruitment, and actuarial services to insurance companies.
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Members were required to report to the audit committee of each SEC client the amounts and nature of management advisory services performed on an annual basis.
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To oversee the activities of the SECPS, the AICPA established the Public Oversight Board [POB]. The POB was charged with establishing and enforcing quality-control standards for public accounting firms and instituting a peer review process.
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The SEC, in 1978, required to disclose any nonaudit services when the fees paid to the auditor were at least 3 percent of the audit fees paid. In the same year, the AICPA rescinded its ban on advertising and other forms of clients solicitation.
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In 1979, the POB recommended that no rules should be imposed to prohibit certain services. It would be better, the POB said, to rely on the public disclosures of nonaudit services required by the SEC.
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In 1982, the SEC concluded that the required disclosure of fees for nonaudit service was not useful to investors in making decisions, and the 1978 disclosure requirement was repealed.
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The Sarbanes-Oxley Act was designed primarily to regulate corporate conduct in an attempt to promote ethical behavior and prevent fraudulent financial reporting. The legislation applies to a company's board of
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directors, audit committee, CEO, CFO, and all other management personnel who have influence over the accuracy and adequacy of external financial reports. The Sarbanes-Oxley Act has changed the basic structure of the public accounting profession in the United States.
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The first section of the act created the Public Company Accounting Oversight Board [PCAOB], imposing external independent regulation on the profession and ending self-regulation under the AICPA.
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The PCAOB now sets the auditing standards and conducts inspections of CPA firms. It is also responsible for disciplinary actions against CPAs and for setting the ethical tone for the profession.
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Section 301 of SOX addresses the responsibilities of the board of directors' audit committee. These responsibilities increased significantly. Under SOX, audit committees are directly responsible for appointment and compensation of the external
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auditor and must approve all nonaudit services provided by the external auditor. The audit committee members must be independent, which means that they may not receive fees from the company other than for board service and may not be affiliated in other ways.
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Section 302 affects senior management. Both the CEO and the CFO must personally sign and certify that the company's financial report does not contain any known untrue material statements or omit a material fact.
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They must admit that they are responsible for establishing and maintaining internal controls. CEOs and CFOs are subject to a $5 million fine or a 20-year prison term, without an option for parole,for violation of the certification regulation, which falls under federal court jurisdiction.
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Sections 303, 304, and 306 promote ethical conduct by the board of directors, corporate executives, and key employees. It is unlawful for an officer or director to take any action to influence or mislead the external auditor.
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CEOs and CFOs must forfeit bonuses and profits when earnings are restated due to fraud. Executives are prohibited from selling stock during blackout periods and are prevented from receiving company loans unavailable to outsiders.
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The Sarbanes-Oxley Act takes a much stronger position on incarceration than previous attempts to legislate morality in business. it contains maximum prison terms for securities fraud, mail and wire fraud, and for destroying altering or fabricating records in federal investigations.
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Finally, it requires the preservation of key financial audit documents and email for 5 years with a penalty for destroying any such documentation. All of these charges fall under federal jurisdiction.
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The Sarbanes-Oxley Act takes a much stronger position on incarceration than previous attempts to legislate morality in business. It contains maximum prison term for securities fraud, mail and wire fraud, and for destroying, altering or fabricating records in federal investigations.
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Finally, it requires the preservation of key financial audit documents and email for 5 years with a penalty for destroying any such documentation. All of these charges fall under federal jurisdiction.
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Section 406 of SOX requires public corporations to have a code of ethics for senior executives or to state in their annual report that they do not have such a code and the reasons why they do not.
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The SEC provides the following guidance for the code: it should promote honest and ethical conduct, full and fair disclosure, compliance with the laws, internal reporting for violations, and accountability for adherence to the code.
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Section 201 is a direct response to the conflict of interest arising from the consulting and external audit services provided to Enron by Andersen.
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It prohibits most of the other professional services that auditors historically performed for their audit clients, and the board of directors' approval is required for any additional service the external auditor provides that is not specifically prohibited by SOX.
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The WorldCom scandal immediately followed the Enron/Andersen scandal. WorldCom started its questionable practices when the company did not meet earnings expectations. Its fraudulent accounting led to a $9 billion restatement that was the largest in the history of the United States.
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"Accounting managers were given promotions, raises and made to feel responsible for a likely collapse of the stock price if they did not manipulate the books."
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Moreover, cooking the books didn't stop with the demise of Enron, Andersen and WorldCom-or even with the passage of the Sarbanes-Oxley Act.
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Since then, there have been other scandals, the most notorious of which is HealthSouth, where recent estimates indicate that accounting fraud may have manufactured $4 billion of false earning [2004].
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Reports say that the accountants focused on changing the contractual adjustments account- The difference between the gross billings and what the health care providers will pay-to increase revenues.
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This serves to increase net revenue; adjustments are made in the balance by falsifying fixed-asset accounts.
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The words "ethics" and "morals" have a number of meanings. Webster's Collegiate Dictionary gives four basic meanings of the word "ethics:"
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1. the discipline dealing with what is good and bad and what moral duty and obligation. 2. A set of moral principles or values 3. A theory or system of moral values 4. The principles of conduct governing an individual or group.
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Ethics, in all its forms, is concerned with right or wrong, good or bad, it is either a set of principles held by an individual or group or the discipline that studies those ethical principles. The tasks of that discipline is the analysis and evaluation of human actions and practices.
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For example, according to some people or groups, assisted suicide is ethically acceptable. The discipline of ethics examines what "assisted suicide" means [analysis] and what reasons can be given in support of or against the practice [evaluation].
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To begin, we will look at the structure of an ethical belief. Every ethical belief contains two elements. it has what logicians call a subject and a predicate. A subject is what the belief is about. Usual subjects in ethics are actions or practices such as
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capital punishment, adultery, lying, and so forth. A predicate is what is said about the subject. "Wrong" of course, is an ethical predicate. So are such terms as "unfair," "unjust", "bad" "should be done," "the right thing to do," and so on.
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Hence, for the person who believes that assisted suicide is wrong, "assisted suicide" is the subject of the belief and "wrong" is the ethical predicate. In the judgement [judgement here simply means the expression of our beliefs]
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"Cooking the books is wrong," "cooking the books" is an action or practice. The subject of an ethical belief is usually an action or practice, but sometimes is a system or institution.
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Human actions are the primary subject matter of our ethical judgements. By human action, we mean behavior or activity that is deliberate-that is, an action about which a person deliberates and freely chooses to perform.
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People deliberate about actions over which they have control and consequently are held responsible for those actions. We don't hold animals responsible for their actions, because their is no evidence that they do things "deliberately" in the same way that humans can and do.
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Why should an accountant get involved in this study of ethics? Surely, every accountant already has a set of moral beliefs that he or she follows. Even so, there are several reasons for studying ethics:
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1. First, some moral beliefs an individual holds may not suffice because they are simple beliefs about complex issues. The study of ethics can help the individual sort out these complex issues by seeing what principles operate in those cases.
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Second, in some situations, because of conflicting ethical principles, it may be difficult to determine what to do. In these cases, ethical reasoning can provide insights into how to adjudicate between conflicting principles an can show why certain course of action are more desirable than others.
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The study of ethics can help develop ethical reasoning skills. Third, individuals may hold some inadequate beliefs or cling to inadequate values. Subjecting those beliefs or values to critical ethical analysis may show their inadequacy. let's look at a few examples:
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a. At one time, you probably thought certain things were wrong that you now thing are okay, and you thought certain things were okay that now seem wrong. In short, you changed your mind about some of your ethical beliefs.
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Sometime ago, for example, many managers believed that it was acceptable to fire someone for little or no justifiable reason. After ethical reflection and examination--which encourages us to become more knowledgeable and conscientious in moral matters--that practice now seems questionable.
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Although managers have an obligation to stockholders not to retain unneeded employees, don't the managers have some obligation to those who are fired?
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b. In the pat, the principle CAVEAT EMPTOR-- "Let the buyer beware"-- was an acceptable practice.
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Now, it is generally believed, in many cases, that the manufacturer has the obligation to inform the buyer of potentially harmful defects. Caveat emptor has become CAVEAT VENDOR--"Let the seller beware."
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c. Years ago, accountant thought it unacceptable to advertise. Today, it is a justifiable practice.It also used to be an accepted belief that an accounting firm fulfills the letter of the law simply by following generally accepted accounting principles [GAAP].
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Upon ethical reflection, however, does the fir have an ethical obligation to encourage more realistic financial pictures, even if it means going beyond GAAP?
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A fourth and very important reason to study ethics is to understand whether and why opinions are worth holding. Socrates philosophized that the unexamined life is not worth living. Have you examined your life? As an accountant, what are you basic goals?
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Are they compatible with other values that you have? If you need to choose between keeping a job and violating your professional responsibilities, what would you do? when your responsibility to family clashes with your responsibility to your job, how do you resolve the conflict?
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A final reason for studying ethics is to identify the basic ethical principles that can be applied to action. These principles should enable you to determine what should be done and to understand why.When you are faced with a decision about
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what to do in a difficult situation, it is helpful to have a checklist of basic questions or considerations you can apply to help determine what the outcome should be. in engineering, we must learn the principles of construction so that we can apply them to certain activities.
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In accounting, we must learn the principles of accounting so that we can apply them to specific situations. So, too, in ethics, we must learn the principles of ethics, which govern human behavior, so that we can apply them to the difficult ethical situations we face.
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Thereby, we can ensure that we have examined the issue adequately, using all the ethical principles available.
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Thus, a professional code of ethics and/or a job description sets the standards. For example, the AICPA code of ethics clearly mandates certain types of behavior in its seven principles, as follows: 1. in carrying out their responsibilities as professionals,
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members should exercise sensitive professional and moral judgments in all their activities. 2. Members should accept the obligation to act in a way that will serve the public interest, honor the public trust, and demonstrate commitment to professionalism.
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3. To maintain and broaden public confidence, members should perform all professional responsibilities with the highest sense of integrity.
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4. A member should maintain objectivity and be free of conflicts of interest in discharging professional responsibilities. 5. A member in public practice should be independent in fact and appearance when providing auditing and other attestation services.
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6. A member should observe the profession's technical and ethical standards, strive continually to improve competence and the quality of services, and discharge professional responsibility to the best of the member's ability.
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7. A member in public practice should observe the Principles of the Code of Professional Conduct in determining the scope and nature of services to be provided.
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According to the first principle, members should "exercise sensitive professional and moral judgement in all their activities." What is involved in sensitive judgement? What factors lead to making ethical judgments? if we can determine how moral judgments
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are constructed, we can discover ways to justify our moral beliefs--ways to ascertain the right answer [or most adequate answer possible] about what to do in particularly difficult situations. Ethics gives us a powerful tool to a adjudicate ethical conflicts and resolve ethical issues.
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The belief that "people should do their jobs" is probably in your set of moral beliefs, but why is that the right to do? Why should people do their jobs? should they do them under any and every circumstance,
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even when it is not beneficial to them? The second principle stipulates that members should "accept the obligation to act in a way that will serve the public interest, honor the public trust, and demonstrate commitment to professionalism."
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Does that mean that accountants need to place their family's interests below those of the public? if the accountant has obligations both to a client and to a family member,
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does the accountant necessarily have to place the public's interest first? Further, what should the accountant do when the interests of the company-- say, the need for more business-conflict with the needs of the client or the public?
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There are two kinds of reasons to justify our moral beliefs: reasons that validate doing something and those that validate not doing something. it is much harder to take a positive course of action than to prohibit a course of action, because taking a positive action opens up
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an indefinite number of options. It is much clearer to prohibit an action, for if we know that an action will harm another, we need only to avoid it. Often, therefore, we are clear about what we should not do [negative injunctions] but not clear about what we should do [affirmative duties].
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As human beings, we have several levels of need corresponding to several dimensions of human nature. There are material needs that fulfill the bodily dimension-- needs for food, shelter, and clothing. Beyond that, because human beings are social, there are needs relating to
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other people, as in friendship. These are the needs to fulfill the social dimension. Finally, because human beings are potential producers, there is a need for purposeful projects, goals, and actions--in short, meaningful activity. These are the needs that fulfill the active dimension.
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Both egoism and utilitarianism determine whether an action is ethically acceptable according to the action's consequences. Egoism gives priority to the reason, "it benefits me." When there is a conflict between something good for me and society, or a conflict between something good for me
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and its fairness, egoism recommends the self-serving action. Thus, egoist theory maintains that an individual should always act in his or her own best interest. As we mentioned, egoism has its advocates, even though it may seem paradoxical for an ethical theory to give primacy to self-interest.
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Utilitarianism gives priority to concern for everybody's good, including the individual's, which is factored into the total overall good.
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If self-interest conflicts with the overall good, self-interest is set aside. Thus, utilitarianism recommends actions that bring about the greatest good for the greatest number of people.
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Finally, the theory that gives precedence to the issues of fairness, rights, and commitments, and advocates doing the right thing-- no matter what the consequences to self and others-- is called deontological theory.Under this theory, the end does not justify the means.
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Let us summarize. Sometimes in deciding what to do, no conflict arises between reasons. In these situations, what is good for me is also good for society and is fair and just. Then there is every reason to perform the action, which fulfills all three theories' principles.
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In a case where there is conflict, however, disagreement arises about which principle to follow. Which reason takes priority? if we decide always for ourselves, we are egoists. If we consider the benefits to society, we are utilitarians.
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If we are moved by questions of fairness or justice, we are deontologists. The integrity of each of these theories rests on its appeal to a very important reason to choose a course of action.
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To understand this more clearly, it is necessary to explain the difference between selfishness and self-interest. Acting in self-interest is doing what is in one's own best interest--what benefits one. Self-interested pursuits are not bad.
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Psychologists have pointed out the necessity of self-love and self-esteem, and the desirability of an individual's vigorous pursuit of his or her projects and dreams. It is healthy, therefore, to pursue your own interests.
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After all, if you don't, who will? that is why an action that benefits you is a good action, and a good reason for doing something is that it will be good for you.
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The problem arises when the pursuit of one's own interests is at the expense of others. Selfishness is pursuing one's own interest at the expense of another. if you can make a sale only by persuading a customer who can't afford the product to buy it, that is selfish behavior. To justify your action
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by saying that it will help you is to justify it egoistically. Thus, a principle that says, "always do what is in your own interest," is a principle that necessarily, at some time or other, promotes selfishness--that is, achieves one's own interests only at the expense of another.
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Because selfish behavior is unethical behavior and egoism mandates selfishness, we reject egoism as a viable ethical theory. Clearly, it is not acceptable in the accounting profession, where the code ethics mandates the accountant's "obligation to act in a way that will serve the public interest."
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There are additional formal objections to egoism, which we will mention briefly. First, egoism is incompatible with many human activities, such as giving advice. Ask yourself how someone who is always acting in his or her own interest can give you trustworthy advice.
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The incompatibility of egoism with friendship is also easy to show.Would you consider a friend "true" if you knew that he was acting as a "friend" just for what he could get out of the friendship?
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we expect friends to put themselves out for us, and we expect to put ourselves out for our friends. The consistent egoist, then, can be seen to recommend against friendship.
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Egoism is also incompatible with many business activities, such as being an agent or fiduciary for another. There are times when, as an accountant, you will not have the expertise necessary to provide a client with the best service. In such a situation, you may have to
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recommend another professional and lose the business. You do not do this because you are concerned about your long-range self-interest. You do it because you have a responsibility as a professional to act in the client's best interest.
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If egoism is inadequate, then what is its appeal? The appeal seems to derive from the fact that acting out of self interest is such a strong motivating factor.
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Philosopher Thomas Hobbes claimed that if we look deeply into human motivation, we can see that all actions are directed by self-interest. Philosopher and economist Adam Smith also believed self-interest was a primary motivator of human being behavior.
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Consider Holden Caulfield's observation in J.D. Salinger's The Catcher in the Rye: "Even if you did go around saving guys' lives and all, how would you know if you did it because you really wanted to save guys' lives, or whether you did it because what you really wanted to
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do was be a terrific lawyer, with everybody slapping you on the back and congratulating you in a court when the god dam trial was over, the reporters and everybody? How would you know you weren't being a phony? The trouble is, you wouldn't."
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Salinger's Holden Caulfield says he does not know if we are acting in our own interest all the time, but there are some philosophers who think that human beings naturally act in their own interest all the time. If everyone always does look out for their own interests then
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recommendations suggesting any course of action must take that into account. Remember the old maxim, "You'll catch more flies with honey than vinegar"? If someone is naturally disposed one way you better make recommendations that conform to that disposition rather than go against it.
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One example is Adam Smith, who maintains that conjunction of the forces of self-interest, competition, and supply and demand-the doctrine of the "invisible hand"-- guide society, that Smith is not an extreme psychological egoist, since he does not believe self-
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interest is the only motivator: "Howsoever selfish he may be supposed, there are evidently some principles in his nature, which interest him in the fortune of others and render their happiness necessary to him, though he derives nothing from it except the pleasure of seeing it."
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The principal maxim of utilitarianism is best expressed by John Stuart Mill: "Actions are right in proportion as they tend to promote happiness, wrong as they tend to produce the reverse of happiness."
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Mill continues that "the happiness" to which he refers is "not the agent's own greatest happiness, but the greatest amount of happiness all together." The appeal to the happiness of all is Mill's answer to the egoists.
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Utilitarianism has recently been expressed in a slightly different way: "Do that action which will bring about the greatest good for the greatest number of people."
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Utilitarianism is significantly different from egoism because the consequences used to judge an action's worth are not simply the consequences for the agent but also include the consequences for everyone concerned with or affected by the action, including the agent.
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Utilitarianism is in greater accord with moral sensibilities than egoism is, and it reflects what we do when we find reasons to justify an action or practice.
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Doing something to make yourself happy is acceptable unless doing so makes someone else miserable. If you do something that maximizes your own happiness, makes others happy, and leaves precious few people miserable, that action is justifiable.
