Understanding Accounting Ethics

1
Understanding Accounting Ethics

• Chapter 6
• Rules Are Not Enough

2
A fact pattern for a consideration of an
accountants independence

• Alison, Bill, and Cathy are members of Accurate
  Accounting, LLP, and are engaged to audit Classic
  Car Company of New England.
• Alison has a relative who has at various times
  invested in Classic Car Company.
• Bill has a relative who is an employee of Classic
  Car Company.
• For part of her work on the engagement, Cathy
  uses the services of a consulting company, which
  employs a relative of an employee of Classic Car
  Company.

3
Alisons independence would be regarded as
impaired

• If the investment of Alisons relative were
  material to the relative and
• If the relative had invested during the time of
  the engagement or when Accurate Accounting
  expressed its opinion and
• If Alison knew of the relatives investment and
• If the relative were Alisons spouse or
  dependent.

4
Bills independence would be regarded as impaired

• If the relative had a position at Classic Car
  that was audit sensitive and
• If the relative were Bills spouse or dependent.

5
Cathys independence would be regarded as impaired

• If Cathy had relied upon the consulting company
  for a significant part of the engagement and
• If the relative of the employee of the consulting
  company, who works for Classic Car, were a spouse
  or dependent and
• If that relative who works for Classic Car had
  significant influence in that company or were
  involved in audit-sensitive work in that company.

6
Rules are not enough.

• These rules about independence are detailed and
  complex.
• One would think they are sufficient to settle
  questions of an accountants independence.
• But they are not.

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Six reasons why rules are not enough

• Rules give only necessary, not sufficient
  conditions.
• Rules contain terms that require interpretation.
• We must appeal to idealizations in order to apply
  a rule.
• Rules cannot supply the motivation for following
  a rule.
• Rules on their own are unmanageable.
• Due diligence is needed for checking that we have
  indeed followed a rule.

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1. Rules give only necessary, not sufficient
conditions.

• Necessary condition what is necessary for
  something.
• synonyms sine qua non requirement that
  without which not
• example electricity is a necessary condition for
  the operation of a washing machine
• Sufficient condition what suffices for
  something.
• synonym guarantee
• example electricity plus a functioning washing
  machine with its power on constitute a sufficient
  condition for the operation of a washing machine

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I followed all the relevant rules, therefore I
acted properly. NO.

• Members must be aware that it is impossible to
  enumerate all circumstances wherein the
  appearance of a members independence might be
  questioned by a third party. For example, a
  members relationship with a cohabitant may be
  equivalent to that of a spouse.

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2. Rules contain terms that require interpretation

• Cathys independence would be regarded as
  impaired
• If Cathy had relied upon the consulting company
  for a significant part of the engagement and
• If the relative of the employee of the consulting
  company, who works for Classic Car, were a spouse
  or dependent and
• If that relative who works for Classic Car had
  significant influence in that company or were
  involved in audit-sensitive work in that company.

11
A vicious regress

• If we supply further rules in order to explain
  those terms that require interpretation, these
  additional rules will also contain terms that
  require interpretation.
• For example
• In general, a persons activities would be
  considered audit-sensitive if such activities are
  normally an element of or subject to significant
  internal accounting controls.

We cannot indefinitely clarify rules with rules.
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3. We must appeal to idealizations in order to
apply a rule ( e.g. ideally reasonable person)

• In addition, in situations involving assessment
  of the association of any relative or dependent
  person with a client, members must consider
  whether the strength of personal and business
  relationships between the member and the relative
  or dependent person, in conjunction with the
  specified association with the client, would lead
  a reasonable person aware of all the facts, who
  took into consideration normal strength of
  character and normal behavior under such
  circumstances, to conclude that the situation
  poses an unacceptable threat to the members
  objectivity and appearance of independence.

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4. Rules cannot supply the motivation for
following a rule

• It is self-defeating to attempt to capture, in a
  rule, the motivation for following a rule, e.g.
• A member should refuse an engagement with an
  enterprise if his or her spouse does
  audit-sensitive work for the enterpriseand a
  member must be committed to following this rule!
• Members are to follow all of the rules in this
  Code.

To follow a rule presupposes a commitment which
cannot be captured in rules.
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above and beyond the requirements of laws and
regulations

• The AICPA Code of Professional Conduct
  acknowledges at the start that a practitioners
  commitment to the code, and to any rules, must be
  based on something higher than any rule
• Membership in the American Institute of
  Certified Public Accountants is voluntary. By
  accepting membership, a certified public
  accountant assumes an obligation of
  self-discipline.

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5. Rules on their own are unmanageable.

• We unify cases, relative to a rule.
• We unify rules, relative to a principle.

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6. Due diligence is needed for checking that we
have indeed followed a rule.

• We must know when to check that we have indeed
  conformed to a rule.
• if the accountant becomes aware that
  information coming to his attention is incorrect,
  incomplete, or otherwise unsatisfactory, he
  should perform the additional procedures he deems
  necessary to achieve limited assurance that there
  are no material modifications that should be made
  to the financial statements in order for the
  statements to be in conformity with generally
  accepted accounting principles (AR 100.30).

In professional conduct, this is called due
diligence.
17
Culpable ignorance and due diligence are related.

• Culpable ignorance when you fail to know
  something that you should have known.
• Due diligence taking the pains to learn
  something that you should know.
• Thus culpable ignorance is the result of failing
  to exercise due diligence.

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External and internal principles.

• An external principle a high-level
  generalization or rule.
• e.g. Independence regarded as a rule An
  accountant should act in such a way that an
  impartial and objective observer, aware of all
  the relevant facts, would judge that, given
  ordinary human character, his or her judgment is
  not liable to be deflected.
• An internal principle a commitment to an
  ordering of goods
• e.g. An accountant actually values the truth (a
  true representation of the financial condition of
  a company) over money (the business that might be
  lost if a true representation of a company is
  given).

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Even external and internal principles are not
enough!

• A practitioner additionally needs good
  character.
• Good character emotions, dispositions, and
  habits which enable us successfully to abide by
  our reasonable commitments.

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An example of bad character greed.

• Some signs of greed
• loving wealth as an end, not as an instrument for
  anything else (The love of money is the source
  of all evil.)
• taking increasing wealth as an ultimate goal to
  get as much wealth as possible (morebetter
  lessworse)
• being addicted to money

Someone afflicted with greed will find it
difficult or impossible to be independent,
however committed he might be to principles.
21
Rules in the service of principles, or rules as
trumping principles?

• Rules are meant to safeguard and to express
  principles Rules in the service of principles.
  (Substance over form.)
• Rules are misused, when they are followed to the
  neglect of the relevant principle Rules as
  trumping principles. (Form over substance.)

22
Operating or a capital lease?

• E.g. Should a lease be treated as an operating or
  a capital lease?
• The matter needs to be decided with a view to the
  relevant principles
• Transparency The accounting treatment of a
  transaction should fairly represent that
  transaction.
• Substance Over Form When the burdens and
  benefits of ownership are assumed by the lessee,
  then, although the transaction has the form of a
  lease, in substance it is equivalent to a
  mortgage arrangement.

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FASB rules

• Rule 1. If ownership is transferred at the end
  of the lease, then the lease should be treated as
  a capital lease.
• Rule 2. If the lessee has an option to buy the
  property at a bargain price (below market value),
  thus effectively guaranteeing purchase, then the
  lease should be treated as a capital lease.
• Rule 3. If the length of the lease is for at
  least 75 of the total useful life of the
  property, then the lease should be treated as a
  capital lease.
• Rule 4. If the lease payments equal at least 90
  of the value of the property, then the lease
  should be treated as a capital lease.

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The reality of accounting practice

• Often latitude in how one estimates fair value
  and income stream.
• Thus, a practitioner has to choose between rules
  in the service of principles or rules as
  trumping principles.
• Rules as trumping principles e.g. the only
  question the practitioner considers is whether
  the numbers could reasonably be manipulated to
  justify whatever accounting treatment was desired
  by the client.

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Millers GAAP Guide goes right

• Millers Comprehensive GAAP Guide first gets it
  right
• Some lease agreements are such that an asset
  and a related liability should be reported on the
  balance sheet of an enterprise. The distinction
  is one of substance over form (basic principle)
  when the transaction actually transfers
  substantially all the benefits and risks inherent
  in the ownership of the property.

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But then gets it wrong

• Established in GAAP are criteria to determine
  whether a lease transaction is in substance a
  transfer of the incidents of ownership. If, at
  its inception, a lease meets one or more of the
  following four criteria, the lease should be
  classified as a transfer of ownership
• But the rules are not criteria to
  determine!

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The wisdom of the ancients (Aristotle)

• Every law is general, but as regards some
  matters it is not possible to speak in a general
  way with complete correctness. In those matters
  about which one needs to speak in a general way,
  but as regards which it is not possible to do so
  with complete correctness, the law is satisfied
  with speaking about what happens for the most
  partand when it does so, it is not ignorant of
  the fact that it is going astray.

28
A case in which rules were not enough U.S. v.
Simon

• Advances to Repayments by Receivable at
• Year Valley Valley Year-End
• 1958 3,356,239 2,583,172 0
• 1959 4,586,000 3,510,451 384,402
• 1960 2,511,000 2,670,500 397,996
• 1961 2,390,674 1,520,000 848,006
• 1962 4,708,000 1,986,500 3,543,335

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The footnote in the 1962 statement

• 2.The amount receivable from Valley Commercial
  Corp. (an affiliated company of which Mr. Harold
  Roth is an officer, director and stockholder)
  bears interest at 12 a year. Such amount, less
  the balance of the notes payable to that company,
  is secured by the assignment to the Company of
  Valley's equity in certain marketable securities.
  As of February 15, 1963, the amount of such
  equity at current market quotations exceeded the
  net amount receivable.

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How the footnote should have been written

• 2. The amount receivable from Valley Commercial
  Corp. (an affiliated company of which Mr. Harold
  Roth is an officer, director and stockholder),
  which bears interest at 12 a year, was
  uncollectible at September 30, 1962, since Valley
  had loaned approximately the same amount to Mr.
  Roth who was unable to pay. Since that date Mr.
  Roth and others have pledged as security for the
  repayment of his obligation to Valley and its
  obligation to Continental (now 3,900,000,
  against which Continental's liability to Valley
  cannot be offset) securities which, as of
  February 15, 1963, had a market value of
  2,978,000. Approximately 80 of such securities
  are stock and convertible debentures of the
  Company.

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The judgment

• We join defendants' counsel in assuming that
  the mere fact that a company has made advances to
  an affiliate does not ordinarily impose a duty on
  an accountant to investigate what the affiliate
  has done with them or even to disclose that the
  affiliate has made a loan to a common officer if
  this has come to his attention. But it simply
  cannot be true that an accountant is under no
  duty to disclose what he knows when he has reason
  to believe that, to a material extent, a
  corporation is being operated not to carry out
  its business in the interest of all the
  stockholders but for the private benefit of its
  president. For a court to say that all this is
  immaterial as a matter of law if only such loans
  are thought to be collectible would be to say
  that independent accountants have no
  responsibility to reveal known dishonesty by a
  high corporate officer.

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Continued.

• If certification does not at least imply that
  the corporation has not been looted by insiders
  so far as the accountants know, or, if it has
  been, that the diversion has been made good
  beyond peradventure (or adequately reserved
  against) and effective steps taken to prevent a
  recurrence, it would mean nothing, and the
  reliance placed on it by the public would be a
  snare and a delusion. Generally accepted
  accounting principles instruct an accountant what
  to do in the usual case where he has no reason to
  doubt that the affairs of the corporation are
  being honestly conducted. Once he has reason to
  believe that this basic assumption is false, an
  entirely different situation confronts him.