Ethics in Accounting
OBJECTIVE   4
This element provides expanded discussion of ethics and ethical issues as they relate to the accounting and the financial reporting environment.
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:

1.  

In carrying out their responsibilities as professionals, 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.

3.  

To maintain and broaden public confidence, members should perform all professional responsibilities with the highest sense of integrity.

4.  

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.

5.  

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.

6.  

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).

7.  

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.

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:

1.  

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.

2.  

Move toward an ethical resolution by identifying and analyzing the principal elements in the situation. Seek answers to the following questions in this sequence:

a.  

What parties (stakeholders) may be harmed or benefited?

b.  

Whose rights or claims may be violated?

c.  

Which specific interests are in conflict?

d.  

What are my responsibilities and obligations?

The first two steps should help you identify and sort out the facts.

3.  

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?

4.  

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.

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:

  

Should the controller re-classify the notes? Give your reasons.

  

Does the treasurer's position pose an ethical dilemma for the controller? Explain your answer.

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:

  

Should Boudreau lower her estimate?

  

What ethical issue is at stake? Would anyone be harmed by the change in estimate?

  

Is Brickhouse acting ethically?

Solutions to Additional Ethics Cases

Ethics Case 1

  

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.

  

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.

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

  

No, Louise Boudreau, the controller, should not manipulate net income in view of any compensation plan the company may have.

  

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.

  

No, Brickhouse is acting unethically. His action serves only his self-interest and has no clear basis in proper accounting procedures.

Additional Resources

To learn more, explore the following resources:

Professional Organizations

  

American Institute of Certified Public Accountants (AICPA)

  

Association for Investment Management and Research (AIMR)

  

  

Institute of Management Accountants (IMA)

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.




Copyright 2006 John Wiley & Sons, Inc. All rights reserved.