Ethical Issues in Accounting

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Ethical Issues inAccounting Finance

• Chapter 6

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Ronald F. Duska andBrenda Shay Duska

• Ethics in Auditing The Auditing Function
• Duska and Duska examine the responsibilities of
  auditors.
• They conclude that the duties of the auditor to
  the public override their duties to those who
  hire them (the corporations).
• As a result, they have a duty to maintain
  independence in fulfilling their duties, even if
  that entails avoiding even the perception of a
  conflict of interest.

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Internal Auditing

• By examining the corporations books and records,
  the independent auditor determines whether the
  financial reports of the corporation have been
  prepared in accordance with generally accepted
  accounting principles.
• The auditor then issues an opinion as to whether
  the financial statements, taken as a whole,
  fairly present the financial position and the
  operations of the corporation for the relevant
  period.
• By certifying the public reports that
  collectively depict a corporations financial
  status, the independent auditor assumes a public
  responsibility transcending any employment
  relationship with the client.

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Kantian Finance

• Applying Kants universalizability principle
  what would happen if everybody misrepresented the
  financial health of their company when it was to
  their advantage to lie?
• Trust in business dealings that required
  information about the financial picture would be
  eroded. Chaos would then ensue since markets
  cannot operate without trust.
• Misrepresentation would be impossible since no
  one would be able to have the requisite levels of
  trust that are required for misrepresentation.
• Because trust is so central to the operation of
  markets even the appearance of impropriety is
  damaging. Only a fool trusts someone who puts
  themselves in positions where they seem likely to
  have their integrity compromised.

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The Auditors Basic Responsibilities

• Proficiency on the part of the auditor
• Independence in fact and in appearance
• Due professional care, which involves a sense of
  professional skepticism
• Adequately planned and properly supervised field
  work
• A sufficient understanding of the internal
  control structure of the audited entity
• Sufficient inspection observation, and inquiries
  to afford a reasonable basis for an opinion
• A report stating whether the financial statements
  are in accord with generally accepted accounting
  principles (gap)
• Identification of circumstances in which the
  principles have not been consistently observed
• Disclosures in the financial statements are to be
  regarded as reasonably adequate unless otherwise
  stated
• A report shall contain either an opinion of the
  statement taken as a whole, or an assertion to
  the effect that an opinion cannot be expressed

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4 Principles ofAuditor Independence

• Freedom from those pressures and other factors
  that compromise, or can reasonably be expected to
  compromise, an auditors ability to make unbiased
  audit decisions.
• Assessing the level of independence risk
  Independence decision makers should assess the
  level of independence risk by considering the
  types and significance of threats to auditor
  independence and the types and effectiveness of
  safeguards.
• Determining the acceptability of the level of
  independence risk After assessing the level of
  risk the auditor needs to determine whether the
  level of independence is at an acceptable
  position on the independence risk continuum.
• Considering benefits and costs Independence
  decision makers should ensure that the benefits
  resulting from reducing independence risk by
  imposing additional safeguards exceed the costs
  of those safeguards.
• Considering interested parties views in
  addressing auditor independence issues
  Independence decision makers should consider the
  views of investors, other users and others with
  an interest in the integrity of financial
  reporting when addressing issues related to
  auditor independence and should resolve those
  issues based on the decision makers judgment
  about how best to meet the goal of auditor
  independence.

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Conclusion

• Even the appearance of a conflict of interest is
  sufficient to undermine the faith needed to
  effectively fill the responsibilities auditors
  have to the public.
• Question
• Is it too strong to argue against even the
  appearance of a conflict?
• Or should they just stick to actual conflicts of
  interest?

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Colin Boyd

• The Structural Origins of Conflicts of Interest
  in the Accounting Profession
• Boyd provides a detailed account of the
  transitions that took place within the major
  accounting firms over the years.
• He picks out several practices that he believes
  largely led to the conflicts of interest that
  resulted in the Enron scandal and others.
• In light of the role those practices had, he
  concludes that it is unlikely that the
  Sarbanes-Oxley Act will be sufficient to prevent
  similar scandals in the future.

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The Big Eight, um Six, no Five

• During the 1950s and 60s, following the national,
  and then international consolidation of
  businesses, accounting firms began to merge
  resulting first in the Big Eight, then the Big
  Six, and finally the Big Five accounting
  firms.
• In 1996 93 of the revenues earned by the top 18
  accounting firms in the U.S. went to the Big Six
• 91 of the employees were Big Six employees
• The revenue of the smallest of the Big Six Firms
  was one and a half times the combined revenue of
  the seventh through eighteenth largest firms.

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Consolidation of Power

• This consolidation of power and ownership in the
  accounting industry coincided with a
  transformation of auditing from being the
  professions most conspicuous and prestigious
  service to its later state as a low profit
  activity within a constellation of other, more
  profitable services.
• Clients began to put pressure on audit prices and
  the traditional, long-term auditor-client
  relationship disappeared.

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Shopping for Opinions

• Eventually this led to the emergence of opinion
  shopping where clients would shop for not only
  audit prices but also attempt to determine the
  degree the firm may be willing to interpret
  accounting standards in order to present the
  clients financial statement in managements
  preferred manner.
• Price pressure led to the need to cut costs. It
  is hard to determine if this was done by reducing
  the number of hours spent on an audit, however,
  it is clear that they did decrease costs by
  utilizing (and hiring) more low-cost junior
  auditors.
• The increasing number of junior auditors who were
  hired by the auditing firms, were then able to be
  moved to clients who needed them for auditing
  within industry and commerce.

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Conflicts of Interest

• The case of Enron revealed that these employee
  transfers from the auditing company to their
  client were taking place on a huge scale
• Horizontal Integration As auditing became
  increasingly unattractive as a money making
  endeavor it began to be used primarily as an
  avenue for the selling of consulting services to
  the client to fix problems identified during the
  auditing process.
• Conflicts of Interest The combination of
  increasing amounts of revenue streaming from the
  selling of consulting services to client
  companies, and the increasing number of previous
  firm employees under the employment of the
  companies those firms audited for, virtually
  guaranteed conflicts of interest. Afraid of
  losing valuable consulting services, firms became
  increasingly less independent in their audits.

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The Sarbanes-Oxley Act

• The Enron scandal prompted the passage of the Act
  in 2002 in order to secure against future
  incidences.
• Section 206 The CEO, Controller, CFO, Chief
  Accounting Officer or person of equivalent
  position cannot have been employed by the
  companys audit firm during the 1-year period
  preceding the audit.
• Prevents conflicts of interest from arising from
  the transfer of employees at the highest levels
  but it does not bar the transfer of employees at
  lower levels.
• Section 203 The lead audit or coordinating
  partner and the reviewing partner must rotate off
  the audit every 5 years.
• This falls short of the full rotation of the
  audit firm itself.

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The Sarbanes-Oxley Act

• Section 201 An auditor may not offer these
  services to a client along with the audit (1)
  bookkeeping or other services related to the
  accounting record or financial statements of the
  audit client (2) financial information systems
  design and implementation (3) appraisal or
  valuation services, fairness opinions, or
  contribution-in-kind reports (4) actuarial
  services (5) internal audit outsourcing
  services (6) management functions or human
  resources (7) broker or dealer, investment
  adviser, or investment banking services (8)
  legal services and expert services unrelated to
  the audit (9) any other service that the Board
  determines, by regulation, is impermissible.
• The concerned services center on operational or
  production conflicts of interest. As several of
  the conflicts picked out in the article arise
  from marketing and sales activities of the
  accounting firms, there is fear the Act may have
  missed the mark.

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John R. Boatright

• Individual Responsibility in the American
  Corporate System Does Sarbanes-Oxley Strike the
  Right Balance?
• Boatright examines several theories of motivation
  and deterrence in corporate responsibility.
• In each case he concludes that liability is more
  effective as a deterrent when it is primarily
  placed on shareholders and the corporation as a
  whole.

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The Sarbanes-Oxley Act on individual
responsibility

• Section 302 requires
• that the chief executive officer and the chief
  financial officer personally certify that he or
  she has reviewed certain reports submitted to the
  SEC
• that to the officers knowledge the reports are
  complete and accurate
• that they fairly represent the financial
  situation of the company
• that effective internal controls have been
  established and evaluated
• and that any deficiencies in the control system
  and any fraud involving management or those
  involved in the control system have been
  disclosed to the auditors and the audit committee
  of the board.

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The Sarbanes-Oxley Act on individual
responsibility

• Section 304 The Forfeiture Provision
• mandates that in the event the corporation is
  forced to restate its earnings due to misconduct
  with regard to financial reporting requirements,
• the CEO and the CFO shall return to the company
  any bonus or incentive compensation,
• and return any profits from the sale of
  securities in the 12-month period following the
  issuance or filing of the report that contains
  the misreported earnings.

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The Sarbanes-Oxley Act on individual
responsibility

• Section 404
• Requires management to assume responsibility for
  establishing and maintaining an adequate system
  of internal control, and
• Requires management to assess the effectiveness
  of this system annually

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White-Collar Crime

• Title IX The White-Collar Crime Penalty
  Enhancement Act of 2002 (WCCPEA)
• Increases the fines and sentences of a number of
  offenses, including fraud and conspiracy.
• It instructs the U.S. Sentencing Commission to
  revise the Federal Sentencing Guidelines to
  reflect these changes and also contains penalties
  for violating the certification provision.
• Since CEOs and CFOs are already liable for
  documents filed by their companies it is not
  clear how these measures will improve individual
  responsibility.

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Individual Responsibility

• Responsibility being answerable or accountable
  for what one has done
• Most importantly, for a failure to perform some
  moral or legal obligation
• As a result, the person now deserves to be blamed
  or punished

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Conditions for Responsibility

• Generally applies to both legal and moral
  responsibility
• Person must act freely i.e., not be coerced
• Person acts from the appropriate state of mind
• Justice requires punishment for the responsible
• No punishment injustice

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Problems of responsibility within modern
corporations

• Fragmented decision-making and action, and the
  diffusion of knowledge in organizations, can make
  it difficult to place responsibility on any
  specific individual or group of individuals.
• Insofar as a corporate officer, such as a CEO is
  an agent of the shareholders, it is difficult to
  determine whether that individual or the
  corporation as a whole should be held responsible
  for wrongdoing.
• Individuals are generally held responsible for
  wrongdoing or facilitating the commission of a
  crime, however, in less serious cases the legal
  principle of respondeat superior has been
  applied, where the principal is responsible for
  the actions of the agent.

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Law and Responsibility

• 3 objectives driving the laws treatment of
  individual responsibility
• To deter actions that cause harm to the public
  deterrence
• To secure compensation for wrongful harms (tort
  law) compensation
• To seek appropriate punishment for criminal
  conduct by means of fines and imprisonment
  retribution

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Striking a Balance

• We ought to temper our moral outrage over the
  individual actions in cases like Enron.
• We must understand the practical effects of
  assigning responsibility in different ways
• Balance individual resp. w/ corp. resp.
• Do this using Agency Theory, Transaction Costs,
  and Behavioral Law

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An Agency Theory, Transaction Cost Perspective

• The main objective of both government and market
  regulation is deterrence.
• Four arguments for corporate liability
• Managers are too poor to pay effective fines
• Higher costs for Managerial Liability
• Less incentive for oversight
• Managers are ineffective police

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Ineffective Managerial Fines

• Managers do not have the resources to pay fines
  that are substantial enough to have a deterrent
  affect
• Optimal Penalty Theory
• Any fine capable of deterring must exceed a
  persons expected return divided by the
  probability of successful prosecution
• If this amount exceeds a persons total assets,
  then the deterrent value of any fine is
  significantly reduced.
• Since corporations are more likely to have
  sufficient resources to pay these fines it is
  better to hold the corporation liable and have
  the corporation police for misconduct.

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Higher Costs

• Since managers are not diversified, if they are
  held liable they would demand compensation in the
  form of higher pay, indemnification, insurance,
  or some combination.
• This will ultimately cost the shareholders.
• Since shareholders are diversified they can carry
  this risk at a lower cost than managers.

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Less Oversight

• As more responsibility is shifted from
  shareholders to managers, the less incentive
  shareholders have to carefully select and monitor
  managers.
• As individual responsibility shifts to
  lower-level employees (doesnt flow up), managers
  and shareholders have incentives to encourage
  misconduct.

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Ineffective Policing

• The separation of ownership and control within
  corporations means that
• often financial controls create stronger
  pressures on lower level employees than internal
  sanctions for wrongdoing,
• meaning that managers may often be less effective
  at policing employees than shareholders who are
  in control of financial mechanisms.

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A Behavioral Law andEconomics Approach

• Managers are not always rational decision makers.
• Managers may not be aware that conduct is
  unethical or illegal, they may be misled, they
  may underestimate the likelihood of detection or
  the severity of consequences, managers are
  vulnerable to bias, they utilize heuristics, etc.
• Solutions to problems of bias and heuristics
  usually center on changing corporate culture.
  Only threats to shareholders are sufficient to
  bring about these kinds of changes.

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Aiding and Abetting

• Should gatekeeper institutions be held liable for
  actions brought against a corporation when they
  failed to fulfill their gatekeeper duties?
• Corporations are more likely to have borne the
  benefits of their impropriety and will have less
  motivation to settle than the firm.
• This means that corporations may have leverage
  with which to coerce the firm in question.
• Firms often do not have control over the uses a
  corporation puts their services to.
• For them to bear liability for actions out of
  their control is unfair.
• Since the activities of monitors and gatekeepers
  is often unclear and it is often difficult to
  determine what constitutes aiding and abetting
  liability deterrence is not particularly
  effective.
• Incentives that increase independence and provide
  oversight are often more effective strategies.

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John R. Boatright

• Ethical Issues in Financial Services
• Boatright examines the moral issues that serve as
  objections against four problematic practices
  within financial services.
• While he agrees that deception, churning, and
  suitability constitute problematic moral wrongs,
  he is not clear on what precisely the moral
  objection to insider trading is.
• He raises questions over the appropriateness of
  anti-insider trading laws.

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Deception

• Ethical treatment of clients requires salespeople
  to explain all of the relevant information
  truthfully in an understandable, non-misleading
  manner.
• Salespeople employ euphemisms to hide the true
  meaning of what they are explaining tax-free
  when its tax-deferred high yield when its
  actually risky commissions are front-end or
  back-end loads, etc.
• Figures of past performance can be carefully
  selected and displayed in a misleading fashion
  essential information may be left out, etc.
• The Securities Act of 1933 requires all
  material information, defined as information
  about which an average prudent investor ought
  reasonably to be informed or to which a
  reasonable person would attach importance in
  determining a course of action in a transaction.
• In general a person is deceived when that person
  is unable to make a rational choice as a result
  of holding a false belief that is created by some
  claim made by another.

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Churning

• Excessive or inappropriate trading for a clients
  account by a broker who has control over the
  account with the intent to generate commissions
  rather than to benefit the client.
• Churning is a breach of the fiduciary duty to
  trade in ways that are in the clients best
  interests.
• Cases of churning require three elements
• The broker must control the account
• The trading must be excessive for the character
  of the account
• The broker must have acted with intent
• The commission system is primarily responsible
  for this practice. However, the SEC has
  concluded that this system is too deeply rooted
  to be significantly changed.

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Suitability

• Brokers have an obligation to recommend only
  suitable securities and financial products.
• The most common causes of unsuitability are
• Unsuitable types of securities i.e.
  recommending stocks when bonds would be more
  appropriate.
• Unsuitable grades of securities i.e. selecting
  lower-rated bonds when higher-rated bonds are
  more appropriate.
• Unsuitable diversification diversification (or
  the lack of) that leaves a portfolio vulnerable
  to market changes.
• Unsuitable trading techniques i.e. using
  margins or options to leverage an account and
  create greater risk.
• Unsuitable liquidity i.e. creating a limited
  partnership which is not very marketable and
  unsuitable for customers that may need to
  liquidate their investment.
• It is difficult to determine unsuitability except
  within the context of a clients entire portfolio.

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Insider Trading

• Trading in the stock of a publicly held
  corporation on the basis of material, nonpublic
  information.
• Insider trading occurs when
• The trader has violated some legal duty to a
  corporation and its shareholders or
• The source of the information has such a legal
  duty and the trader knows that the source is
  violating that duty.
• Arguments against insider trading
• Insider information as property companies make
  investments in acquiring information and the
  competitive value that information has.
• However, its not clear how using this
  information is a violation of property rights
• Insider trading is unfair other traders are
  barred from obtaining insider information no
  matter how diligent they may be in their
  research.
• However, some argue that the stock market would
  be more efficient without laws against insider
  trading. If insider trading was allowed
  information would be registered more quickly with
  less cost.
• Insider trading is a violation of fiduciary
  duties benefiting from the use of information
  garnered while operating as a fiduciary is a
  violation of fiduciary duties.
• However, this says nothing about the moral
  wrongness of insider trading for those who do not
  have a fiduciary relationship with the person
  they receive the information from.

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Robert W. McGee

• Applying Ethics to Insider Trading
• McGee examines the primary arguments for and
  against insider trading.
• Relies primarily on a utilitarian analysis of
  insider trading
• Concludes that there is not sufficient reason to
  believe that insider trading does in fact cause
  harm
• Also, there is significant reason to believe that
  insider trading may in fact be beneficial.

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What is wrong with insider trading?

• Inside information is the information held by the
  board of directors, auditors, and management of a
  corporation and is available to them solely due
  to their role inside the organization.
• This distinguishes inside information from other
  kinds of specialized knowledge (such as that of
  doctors or accountants) in that their knowledge
  is inherently public, even if most of us do not
  possess it.

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Two Answers

• Is it ethical to profit from asymmetric
  information?
• The utilitarian approach if the winners exceed
  the losers or if the result is a positive-sum
  game then profiting from such information is
  ethical.
• The process approach if the process is ethical
  then profiting from such information is ethical
  regardless of whether it is a positive-sum game.

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Who does insider trading harm?

• Fraud intentional deception to cause a person
  to give up property or some lawful right.
• Insider trading does not seem to fit the
  definition of fraud an inside trader has no
  duty to inform potential sellers or buyers of his
  information.
• Who does insider trading harm?
• Sellers who sell their stock to an inside trader
  would have sold to another individual if he had
  not purchased it. In fact they may have received
  a better price.
• If employers are harmed by insider trading they
  should sue the employee, not utilize the
  government.

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What are the benefits of insider trading?

• Insider trading serves as a means of
  communicating market information which makes
  markets more efficient.
• An acquirer in a takeover attempt may benefit
  when arbitragers accumulate shares with the
  intention of selling them shortly, which may
  increase the chances of a takeovers success.
• Sellers who sell to the arbitragers may benefit
  from a higher price (since they would have been
  selling anyway).
• Insider trading has a tendency to increase stock
  prices which is the goal of most corporate
  management.

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Who is harmed by prohibitions on insider trading?

• The market operates less efficiently
• Hostile takeovers will be more difficult and
  since they generally tend to benefit by hostile
  takeovers, shareholders lose out.
• Laws incur compliance and escape costs (i.e.
  legal and accounting fees).
• Taxpayers are adversely affected due to increased
  policing expenses.
• Further, since the risk-to-benefit ratios are so
  high, policing will never be particularly
  effective.

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Leveling the Playing Field

• The market should be fair to all participants
• Meaning that the asymmetry of information should
  be minimized.
• Ricardos theory of comparative advantage
  penalizing those who are better at something or
  subsidizing those who are worse at something
  results in inefficient outcomes and is unfair to
  some groups.
• It reduces efficiency and violates rights.

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Property Rights and Contract Rights

• It is not clear whether insider trading creates
  more good or harm
• However, there is clear concern that enforcement
  of anti-insider trading laws has the potential to
  infringe on individual property and contract
  rights.

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Legal Perspectives

• United States, Petitioner v. James Herman OHagan
• In 1988 OHagan, operating on information he had
  gathered while working as local counsel
  representing Grand Met, regarding the potential
  offer of Pillsbury Company common stock,
  purchased 2,500 options of Pillsbury stock. Upon
  making the offer for Pillsbury the stock rose 21
  and OHagan sold his outstanding shares. The
  court concluded that OHagan was in violation of
  the SEC laws governing insider trading.
• American Institute of Certified Public
  Accountants Code of Professional Conduct
• The code lays out the responsibilities and proper
  practices that govern the American Institute of
  Certified Public Accountants. These policies and
  procedures strive to maintain the independence
  and the reliability of certified public
  accountants.

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Cases

• An Auditors Dilemma
• Alison Lloyd, an internal auditor for Gems Jams,
  stumbles across a misdated invoice. She quickly
  recalls having seen several similar invoices.
  Concerned she goes to Greg Berg, the head of
  purchasing. Berg explains that this is a common
  practice that has been adopted so that the
  company may meet its monthly quotas. Alison
  feels that no one is being harmed by the practice
  but feels that if she does not report the issue
  that she will be in violation of the code of
  ethics governing the Institute of Internal
  Auditors.

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Cases

• Accounting for Enron
• The article discusses in detail the events that
  led up to and followed the Enron scandal. The
  case examines the primary practices that
  ultimately caused the scandal and subsequent
  bankruptcy and the legislation that has since
  been passed in response to it.
• Enron and Employee Investment Risk
• In the midst of the questionable bookkeeping
  practices that ultimately led to the eventual
  Enron scandal, Enron began using company stock as
  the sole unit of deposit for employee 401(k)
  earnings. In the subsequent collapse, employees
  with retirement savings invested in company stock
  had lost all of their savings.

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Cases

• The Conventions of Lying on Wall Street
• The case examines the apparently common practices
  surrounding the purchase of U.S. Treasury notes.
  These questionable practices are so widespread
  that many defend it as the rules of a game that
  everyone understands.
• Martha Stewart Living Omnimedia Inc. An
  Accusation of Insider Trading
• The case examines the events that surrounded
  accusations of insider trading by Martha Stewart.
  Following a message from either her broker or
  his office a trade was executed in her behalf,
  eventually leading to her investigation by the
  SEC.