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Ethics in Accounting |
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This element provides expanded discussion of ethics and
ethical issues as they relate to the accounting and the
financial reporting
environment.
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Following the introduction, we discuss the increased emphasis placed on
ethics and integrity by businesses, professional organizations, and professional
service firms. A framework for analysis of ethical issues along with some sample
ethics cases (with suggested solutions) on which to apply the framework is then
provided. These sample cases are similar to the Ethics Cases introduced
throughout Fundamentals of Intermediate
Accounting. Links to additional resources on ethics are also
provided.
Introduction - Growing Ethical Awareness
Ethics and the importance of ethical decision making have taken on
increasing significance because of the pressures placed on business managers by
stockholders, creditors, and other parties affected by financial performance. It
is not surprising therefore that a recent survey of investment management firms
revealed that nearly three-quarters of the respondents felt that unethical
behavior, such as personal trading, insider trading, and fraudulent financial
reporting are areas of high concern. Another survey indicated that nearly half
of over 700 human resource professionals said they feel pressure to compromise
their organizations' standards of ethical business conduct.
What are the factors that have led to the increased concern about ethics?
Globalization of the economy has led to a mixing of cultures and socioeconomic
systems. Increasingly, a company cannot assume that what was considered proper
in its home market would be acceptable in another market. Technology has aided
the globalization trend and made more transparent the effects of corporate
unethical or illegal decision-making. Rising competition has resulted in
increased pressure to cut corners, with companies looking for new ways to gain a
competitive edge. The importance of meeting analyst forecasts for net income and
EPS has dramatically increased the incentives for companies to manipulate their
earnings to meet the forecasts. Finally, rising public expectations of ethical
corporate behavior and the ability to use the legal system to be compensated for
unethical or illegal corporate actions have increased the risk of personal and
organizational liability.
Expectations of high standards of ethical corporate behavior are rising, as
companies face legal and economic penalties for pursuing unethical and illegal
activities. Indeed some companies have made ethical leadership in the market a
central part of their corporate strategy. They believe that ethical behavior is not just the right thing to do, it
is also good business.
Responses by Corporations and the Professions
Response by Corporate America
Many large corporations have responded to the rising public concern about
ethics, ethical decision-making, and standards of integrity by examining their
own corporate cultures. These companies have made ethics and ethical behavior by
its employees a key element of their corporate strategies. Companies that follow
the practices recommended for effective ethics programs, develop formal written
ethics standards, assign responsibility for the ethics program to an ethics
director who reports to top management, communicate ethics standards, and set up
procedures to detect violations. These steps help ensure achievement of the
corporate ethics objectives and make clear to employees the importance of
following proper ethical principles.
Response by the Professions
The importance of ethics and standards of integrity are especially
important to members of the profession. Students must recognize that ethics and
integrity are central to the value they bring to the clients they serve. Clients
rely on accountants to perform their jobs with the highest degree of accuracy
and ethical integrity. In a broader context, the stability of the free-market
system, including the stock and bond markets depends, in large part, on reliance
that the investing public and society as a whole places on accurate and fair
reporting, which is confirmed through the independent audit process.
Trust and confidence in ethical behavior by accounting professionals and in
the profession more generally is central to the laws in the U.S., which require
that companies listing their securities on U.S. exchanges must have their
financial reports audited by a CPA. In a recent speech, Isaac C. Hunt,
commissioner of the Securities and Exchange Commission, highlighted the
importance of accountants and auditors in ensuring the credibility of the
financial reporting process. The CPA has value in this role only if he or she is
independent in fact and in appearance and objective in his or her evaluation of
the financial reports. If the market does not trust the CPA to follow high
ethical standards, the role of the CPA is significantly diminished.
Evidence of the importance of high ethical standards for accounting and
other professionals is apparent in the securities laws and accounting
regulations in the U.S. The importance of ethical standards is also evident in
the codes of conduct adopted by accounting professional organizations.
The American Institute of Certified Public Accountants (AICPA) is the
premier association of CPA's, providing licensing requirements and continuing
education for its members. The AICPA also develops auditing standards for the
independent audits provided by AICPA members. The AICPA has adopted a
professional code of conduct that highlights the professional characteristics of
a member of the AICPA.
AICPA Principles of Professional Conduct
The six principles of the professional code of conduct are listed
below:
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In carrying out their responsibilities as professionals,
members should exercise sensitive professional and moral judgments
in all their activities.
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2.
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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.
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To maintain and broaden public confidence, members should
perform all professional responsibilities with the highest sense of
integrity.
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4.
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A member should maintain objectivity and be free of conflicts
of interest in discharging professional responsibilities. A member
in public practice should be independent in fact and appearance when
providing auditing and other attestation services.
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5.
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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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6.
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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 (AICPA Principles of Professional
Conduct, Section 52-57).
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7.
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These principles reinforce the profession's recognition of its
responsibilities to the audit client, outsiders that might use the
financial statements and to colleagues in the workplace. These
general principles are designed to serve as a guide for professional
behavior and express the basic understanding of ethical and
professional conduct. They require professional behavior even at the
cost of personal disadvantage.
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A variety of accounting organizations also have adopted codes of ethics and
conduct for their members that focus on many of the same precepts contained in
the
AICPA
code.
Rule-Based Knowledge: The Foundation of Accounting
Education
Given the contemporary concern for ethics in business and among various
professions, corporate and legal responses indicate that preparation for ethical
decision-making should have a prominent place early in the education of
accountants. It must first be remembered, however that the foundation of
accounting education is rule-based knowledge furthered by "hands on" practice of
preparing financial statements in accordance with established professional
standards and guidelines.
Rule-based knowledge is the essential foundation for accounting practice. As the
educational process continues, the accounting student builds on this foundation.
The initial stages of accounting education place a premium on learning of key
concepts, principles, and procedures. In this way, you are introduced to the
conceptual framework of the accounting process. Future refinement and
elaboration of accounting skills will build on the knowledge base that is
provided by the discipline of memory work. Accounting knowledge is further
developed as you use the rules and your own judgment to prepare financial
statements.
For example, through the practice of preparing financial statements, you
learn to focus on relevant features of economic activity and to report them as
the particular rules of the profession indicate. The ongoing preparation of
financial statements challenges you (1) to develop the intellectual skills of
determining how specific principles work in reporting particular economic
situations; and (2) to demonstrate consistent grasp of the general principles
that underlie the current practice of accounting.
Familiarity with both the specific and the general principles of GAAP is
gained to a great extent through memorization and the accumulated experience of
solving fact-centered "problems." The student learns through frequent
application of the rules. You gain mastery of many details of business
transactions as you prepare financial reports in accordance with GAAP standards.
In this hands-on practice of preparing financial statements, students work
to develop habits of clear thinking and rational analysis. They increase their
ability to make professional judgments by engaging in problem-solving exercises
to gain "hands on" experience in rational decision-making. Through numerous
exercises and problems, accounting educators and curriculum materials direct the
student toward examples of business activities. These problems illustrate
routine financial transactions and structured business circumstances that will
commonly be met in "the real world." These problems are structured to permit
straight-forward application of rules as students identify, organize, and report
financial information.
By working through classroom problems and textbook exercises, students are
engaged in the accounting process. You review the broad principles of
accounting. You learn to identify and communicate financial information by using
the particular rules of GAAP. Success in these early stages of accounting
education is marked by the ability to bring memorized information to bear
directly on many different types of standardized examples.
The Accounting Profession and Ethics
In addition to knowledge of rule-based techniques of preparing financial
statements and methods of reviewing financial reporting practices of companies
and clients, accountants "should know and understand the ethics of the
profession and be able to make value-based judgments. They should be prepared to
address issues with integrity, objectivity, competence and concern for the
public good." (AECC, 1990)
As accounting students learn their craft through rule-memorization,
textbook problem-solving, and the "hands on" experience of encountering new
business situations, they are building a foundation of technical information and
work habits that might be labeled "accounting knowledge." The accounting
knowledge base and the development of communication skills are key aspects of
accounting, but an additional, special self-discipline marks full identity as a
professional accountant. This discipline is the expectation that the
professional accountant makes ethical decisions and exercise moral judgment in
the performance of professional duties.
As noted, in recent years, "ethics scandals" in business and among the
professions have been highly publicized in the United States. A reform
commission in accounting, the Accounting Education Change Commission's (AECC)
has responded to the current climate of concern by encouraging ethics education
in the undergraduate accounting curriculum. Most importantly, the reform agenda
expresses the insight that the accountants' professional identity consists of
more than technical competence and interpersonal and communication skills.
Professional status depends on the integration of your knowledge and skills with
the habitual exercise of moral judgment.
In a word, professional identity involves your adoption and practice of a code
of ethical behavior. It also depends on the formation of habits so that you can
make rational ethical judgments in preparing financial statements and giving
business recommendations. Looked at from this perspective, accounting education
shapes your character as a responsible
professional, calling for a blend of technical knowledge, problem-solving
expertise, and communication skills in disciplined service to the ideal of
creating clear, reliable, and fair financial statements.
Education for your entry into the accounting profession is, in part, a
process of learning to recognize, select, and implement appropriate authoritative procedures in reporting financial
information. These rules (GAAP) are developed and published by the Financial
Accounting Standards Board (FASB). Full status as a professional requires
familiarity with GAAP and consistent practice of these standards. As traditional
teaching methods demonstrate, the discipline of memorization and the frequent
practice of problem-solving skills will train you to identify the accounting issues that are posed by many
business transactions. Accounting issues included ethical, as well as technical,
requirements.
In addition to the GAAP standards which govern the techniques and formulae
for reporting specific information, the professional is guided by codes of
conduct that are created by professional societies. These summary statements are
intended to outline the accountants' proper working relationships to firm,
client, and the broad public interest. Several codes of conduct govern
accounting practice in the United States, including those published by the
American Institute of Certified Public Accountants (AICPA), the Institute of
Management Accountants (IMA), and the Institute of Internal Auditors (IIA).
These professional codes acknowledge that accountants will face moral issues in the performance of their
duties. These moral problems are sometimes presented in the complex financial
transactions, sometimes posed by disagreements between accountant and client
over how financial statements are to be prepared in these ambiguous
circumstances. Whatever the origin of the moral issues, GAAP and the
professional codes call for moral action in the performance of the accountant's
duties.
The AECC's recommendation of ethics education in the undergraduate
accounting program expresses the view that accounting students need to recognize
and resolve these moral issues as they learn to prepare financial statements.
This is a fitting educational response to the climate of contemporary concern
regarding ethics.
A Model for Ethical Decision Making
To respond to the AECC's call for reform in undergraduate accounting
education, accounting education needs to explore the moral dilemmas posed by
certain financial transactions and by disputes over how to report particular
business decisions. The following section presents a decision-making model to
help you identify the moral aspects of
financial transactions and the ethical problems that emerge as you work to represent fairly the financial
position of the firms with which you deal.
Recognition of the ethical dilemma is the first step in deciding how to
resolve the dilemma. When GAAP procedures do not tell you how to resolve the
accounting issue (either because there are several conflicting rules or because
there are no GAAP rules), the accountant faces a moral dilemma. In such
circumstances, you must be alert to pressures on the reporting process that may
be due to the self-interested behavior of the stakeholders (a stakeholder is a
party that is affected by the financial transaction or its disclosure in the
financial statement). In all cases, you can prepare a financial statement that
reports the financial position of the firm fairly only by resolving the moral
dilemma through an orderly process of inquiry and rational analysis.
Here are some specific steps that you can follow that will help you make
decisions involving ethical dilemmas:
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1.
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Recognize an ethical situation or ethical dilemma. The first
step is to know when you have a problem. Being sensitive to and
aware of the effects (the potential harm or benefit) on ones'
actions on the individuals involved in the decision process is the
first step in resolving ethical dilemmas.
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2.
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Move toward an ethical resolution by identifying and analyzing
the principal elements in the situation. Seek answers to the
following questions in this sequence:
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What parties (stakeholders) may be harmed or
benefited?
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b.
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Whose rights or claims may be violated?
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c.
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Which specific interests are in
conflict?
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d.
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What are my responsibilities and
obligations?
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The first two steps should
help you identify and sort out the facts.
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3.
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Identify the alternatives and weigh the impact of each
alternative on various stakeholders. For instance, in financial
accounting, which alternative methods are available to report the
transaction, situation or event? What is the effect of each
alternative on the various stakeholders? Which stakeholders are
harmed or benefited most?
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4.
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Select the best or most ethical alternatives, considering all
the circumstances and the consequences.
Steps 3 and 4 will help you
resolve the ethical dilemma.
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Some ethical issues lead to one right answer. Other ethical issues involve
more than one right answer; these require an evaluation of each and a selection
of the best or most ethical alternative. Note that the process of posing
questions is intended to identify all the significant facts of the business
situation, including the interests of the immediate parties (sometime referred
to as the stakeholders), and to review the GAAP principles that may be relevant
for resolving the situation.
Instead of focusing only on shareholders and maximizing shareholder wealth,
the accountant is encouraged to consider both the moral and social implications
of their decisions in terms of how the decisions affect all stakeholders of the
company. This broader set of interested parties includes shareholders,
debtholders, as well as employees, suppliers, customers, the local community,
and any other party that might be affected by the decision. Why worry about
these additional stakeholders? For one reason, it will help you develop a more
complete analysis of the decision, not just the impact on the immediate
parties.
In the ethical cases that are presented in the toolkit and the accompanying
textbook, you will be asked to explain why you considered specific facts to be
important and why particular GAAP principles were relevant for reporting the
transaction. The practice of giving reasons and explaining how you arrived at
your conclusions should help you develop the discipline of a step-by-step
process of decision-making. In resolving the moral dilemmas that you encounter,
the student should always be able to answer the following question:
"Does the information disclosed to outsiders communicate the underlying
economic reality of the transaction?"
Additional Ethics Cases
Ethics Case 1
Health Corporation has several current notes receivable on its year-end
balance sheet. While collection seems certain, it may be delayed beyond one
year. Because of this, the controller wants to re-classify these notes as
non-current. Health's treasurer also thinks that collection will be delayed but
does not favor re-classification because this will reduce the current ratio from
1.5:1 to .8:1. This reduction in current ratio is detrimental to company
prospects for securing a major loan.
Instructions
Answer the following questions:
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Should the controller re-classify the notes? Give your
reasons.
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Does the treasurer's position pose an ethical dilemma for the
controller? Explain your answer.
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Ethics Case 2
The WGN Company has a bonus arrangement, which grants the financial vice
president and other executives a $15,000 bonus if the net income exceeds the
previous year's by $1,000,000. Noting that the current financial statements
report an increase of $950,000 in the net income, Vice President Jack Brickhouse
asks Louise Boudreau, the controller, to reduce the estimate of warranty expense
to $60,000. The present estimate of warranty expense is $500,000 and is known by
both Brickhouse and Boudreau to be a fairly "soft" amount.
Instructions
Answer the following questions:
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Should Boudreau lower her estimate?
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What ethical issue is at stake? Would anyone be harmed by the
change in estimate?
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Is Brickhouse acting ethically?
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Solutions to Additional Ethics Cases
Ethics Case 1
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Yes, the controller should re-classify the notes from current
notes receivable to noncurrent notes receivable. Because current
assets are defined as assets that will generate cash within one
year, notes which cannot be collected within one year should be
classified as noncurrent investments.
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If the notes are not classified, the current ratio will remain
high enough to secure the major loan. Health Corporation benefits,
but the lending agency may be misled about the financial state of
the company and its potential to meet the conditions of its loan.
Because both the controller and the treasurer recognize that delay
of the collection has an impact on the conflicting economic
interests of Health and its lending agency, the decision to
re-classify has ethical dimensions.
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If the treasurer insists that the notes not be re-classified, the
controller will have to decide whether to accept the treasurer's decision, speak
with higher-level executives at Health, or take some other action.
Ethics Case 2
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No, Louise Boudreau, the controller, should not manipulate net
income in view of any compensation plan the company may
have.
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The economic interests of the management and the potential for
their bonus plans conflict with the stockholder's interest that
financial statements clearly and accurately reflect net income. If
the warranty expense is reduced and the original estimate turns out
to be accurate, the stockholders are harmed because the company pays
a bonus the managers did not earn.
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No, Brickhouse is acting unethically. His action serves only
his self-interest and has no clear basis in proper accounting
procedures.
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Additional Resources
To learn more, explore the following resources:
Professional Organizations
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American Institute of Certified Public Accountants
(AICPA)
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Association for Investment Management and Research
(AIMR)
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Institute of Management Accountants (IMA)
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Professional Services
Firms
Accountants as Gatekeepers-Adding Security and Value to the
Financial Reporting System - Remarks by Securities and Exchange Commissioner
Isaac C. Hunt, Jr.
Remarks by Commissioner Isaac C. Hunt, Jr. U.S. Securities
& Exchange Commission Federation of Schools of Accountancy Arlington,
Virginia October 26, 2001
As a former law school professor and dean, it is a particular pleasure and
an honor to address the Federation of Schools of Accountancy. The people in this
room are on the front lines, continuously advancing accounting programs to meet
the changing needs of today's business and accounting environments.
Before I begin speaking about what the SEC views as the importance of
accurate financial reporting and auditing, I am obligated to state that the
views that I express here today are my own and do not necessarily reflect the
views of the Commission, other Commissioners, or the Commission's
staff.
At the present time, all of us involved in designing and supervising our
financial reporting system - the accounting profession, the standard setters,
the regulators - are under pressure to improve that system by seeing to it that
the information it provides is timelier and more useful, both to the
sophisticated experts and to ordinary investors. You, in the accounting and
teaching professions, and we, the SEC, are challenged to meet the demands placed
on our system by the constant advancements in communications, information
systems, and the globalization of the financial markets. Let's today begin a
dialog about how we can work together to face these challenges.
Let me start by reminding everyone about the philosophy that shapes the
SEC's approach to regulatory issues. As most of you know, the SEC was
established in the wake of the 1929 market crash and ensuing Depression. The SEC
is a market regulator. That is, the SEC does not regulate by passing on the
merits of securities offerings. Rather, SEC regulation aims to maintain fair and
orderly markets and to protect investors primarily by requiring securities issuers to make full and fair
disclosure of all material information, so that investors have a basis
for making informed decisions. Therefore, the quality and credibility of
disclosure documents filed with the SEC by public companies is at the heart of
this approach.
As we enter this new century, many of the worlds' capital markets,
particularly in advanced economies are probably more liquid and efficient than
at any other time in history. However, as we saw in the 1997-1998 Asian market
crises and again beginning in March 2000, investors flee when markets are viewed
as risky. Markets are only viewed as safe and stable if investors trust and understand the underlying financial
reporting structure. Based on these and other instances of investor wariness,
past evidence suggests that the stability of markets is based, in large part, on
the veracity of the information underlying the market.
Therefore, the topic that I will focus on today is the importance of
improving the quality of the financial reporting process. Specifically, I would
like to address the important issues of managed
earnings and "pro forma"
financials. In addition, I'd like to urge my fellow educators in this
room to focus on the critical importance of improving guidance on valuation methodologies and models in
accounting curricula.
The Financial Reporting Process
While the financial statements and supporting disclosure documents are
management's ultimate responsibility, accountants within a company should do all
that they can to ensure those statements and supporting documents are accurate,
complete, and provide a reliable picture of the company.
Why is this so critical? Because the capital formation process hinges on
the willingness of investors to make investments in the securities of public
companies. Investors commit their personal funds to companies relying, at least
in part, on management's representations and the auditor's opinion that a
company's financial statements fairly reflect the financial position, results of
operations, and cash flows of a company.
The federal securities laws, to a significant extent, make accountants the
"gatekeepers" to the public securities markets. The Commission and its staff
have always understood and supported this proposition. These laws require, or
permit the Commission to require, that independent public accountants certify
financial information filed with the SEC. As we all know, without an opinion
from an independent auditor, a company cannot satisfy the statutory and
regulatory requirements for audited financial statements and cannot sell its
securities in the U.S. markets.
In the fiscal year ending September 30, 2001, over 14,000 registrants filed
annual reports with the Commission. While the Commission staff reviews filings,
the staff is not able to review in detail all financial statements filed with
the Commission. Therefore, the Commission must rely heavily on the accounting profession
to be primarily responsible for the large volume of financial information that
under girds the Commission's full disclosure system.
Moreover, Congress, in creating a system in which investors and the
Commission must rely on the accounting profession, granted the accounting
profession an important public trust. The system Congress envisioned is
predicated upon accountants working within corporations, as well as the
independent auditors, adhering to strong ethical standards to ensure that
financial statements conform to US GAAP. Congress did not make this grant
without considering the alternatives. As part of its deliberations, Congress
considered creating a corps of government auditors to review and audit
companies' financial statements, and even considered federal licensing of
accountants. Instead, Congress chose to entrust the accounting profession with
the responsibility for auditing the financial statements of companies registered
with the Commission.
This trust in management accountants and independent auditors forms the
foundation of the financial reporting process. The resulting disclosure provided by these financial
professionals forms the bedrock of our financial markets.
Current Trends
Managed Earnings
Unfortunately, the Commission has recently noticed certain worrisome trends
relating to the integrity of financial information. Current market conditions
have increased the pressure on companies to meet past or projected earnings
levels. As a result, some managers have engaged in manipulation or "smoke and
mirrors" to enhance their companies' earnings and, in turn, the companies' share
prices. When such chicanery is discovered, the resulting and inevitable
restatements of earnings have caused investors to lose billions of dollars, and
confidence in the market.
Pro Forma Information (or "Our Business as
We'd Like it to Be")
Additionally, recent years have seen an increasing use of "pro forma"
earnings, essentially unaudited financial statements or statements not in
conformity with GAAP. The growing use of pro forma earnings has undoubtedly been
fueled by management's desire to paint a rosier picture than GAAP might
otherwise allow. Investors who are overwhelmed by the sheer volume of filing
information might not understand the difference between pro forma earnings and
audited financial statements or may not fully comprehend the importance of
audited financial statements.
Even more disturbing is that pro forma earnings may be "materially
misleading" to reasonable investors, violating the federal securities
laws.
The best use of pro forma statements is a limited one. As you may know, the
Financial Executives International ("FEI") recently provided guidelines for the
presentation of pro forma earnings. These FEI guidelines state "pro forma
results should always be accompanied by clearly described reconciliation to GAAP
results."
While we might all enjoy reading about an idealized version of things on
occasion, I think that we'd all agree it's best to leave that kind of writing to
authors of fiction and reserve the drafting of financial statements to financial
professionals. When dealing with financial statements, pragmatism or reality
over fantasy is preferred.
Valuation
In today's dynamic economy, investors have become increasingly interested
in the fair value of a company's assets
and liabilities, as well as historical cost information provided in financial
statements. Further, many existing and proposed accounting standards require
companies to measure more assets and liabilities at fair value. As a result,
there is an increasing need to improve the quality and comparability of fair
value measures and the auditing of those measurements.
The Commission has urged the American Institute of Certified Public
Accountants ("AICPA") to take a more proactive leadership role, by developing
detailed, broad-based guidance on valuation models and methodologies. Efforts to
educate accounting professionals are important as well. Preparers, auditors, and
even investors need to become more educated on fair value estimates - how they
are calculated, what they mean and when they are used. In addition, educational
curricula need to be modified to more effectively teach valuation techniques,
the meaning of value, and how financial instruments work.
The Commission believes that the AICPA and the Federation of Schools of
Accountancy are best poised to adopt models and methodologies that will equip
accountants with the knowledge and skill to effectuate these kind of valuation
techniques.
It is critical that accountants and
accounting professors continue to monitor and update current financial
disclosure trends to ensure accurate and meaningful disclosure from public
companies. Only then will investors have the information necessary to make
informed investment decisions. Continuing accurate reporting is, in turn,
essential to maintaining the sanctity and integrity of today's markets.
Conclusion
In conclusion, I wish to stress the
tremendous challenge facing both the SEC and the accounting professionals: the
challenge is to maintain high-quality financial reporting, and a strong capital
market.
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| Copyright © 2006 John Wiley & Sons,
Inc. All rights reserved.
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