The case study, requirement:

· Read the question closely; be sure you know what is being asked. Briefly, indicated the facts of the case and write a brief outline of what you want to fit into your 3 pages.

· Identify the dilemma: explain the ethical issue and support for alternative choices. Contrast reasons using prepositions: benefit/consequences of doing or not doing

· Explain the benefits/ consequences in terms of who, when, dollar amount, and certainty positive and negative consequences. Consider long run versus short run consequence.

· Choose one position and explain the reason it is more ethical than the alterbatives refuting your support for the other positions. Where there is a dilemma, explain why ethical support for one choice is better than support for the other choices. Explain why this case is important.

Case also can be found at the attached PDF file page 491.

Please use the knowledge related to the book. No outside resource allowed.


Case 7-8

Diamond Foods

On November 14, 2012, Diamond Foods Inc. disclosed

restated financial statements tied to an accounting scandal

that reduced its earnings during the first three quarters

of 2012 as it took significant charges related to improper

accounting for payments to walnut growers. The restatements

cut Diamond’s earnings by 57 percent for FY2011, to

$29.7 million, and by 46 percent for FY2010, to $23.2 million.

By December 7, 2012, Diamond’s share price had declined

54 percent for the year. A press release issued by the company

explains in great detail the accounting and financial

reporting issues. 1

Diamond Foods, long-time maker of Emerald nuts and

subsequent purchaser of Pop Secret popcorn (2008) and

Kettle potato chips (2010), became the focus of an SEC

investigation after The Wall Street Journal raised questions

about the timing and accounting of Diamond’s payments to

walnut growers. The case focuses on the matching of costs

and revenues. At the heart of the investigation was the question

of whether Diamond senior management adjusted the

accounting for the grower payments on purpose to increase

profits for a given period.

The case arose in September 2011, when Douglas

Barnhill, an accountant who is also a farmer of 75 acres of

California walnut groves, got a mysterious check for nearly

$46,000 from Diamond. Barnhill contacted Eric Heidman,

the company’s director of field operations, on whether the

check was a final payment for his 2010 crop or prepayment

for the 2011 harvest. (Diamond growers are paid in installments,

with the final payment for the prior fall’s crops coming

late the following year.) Though it was September 2011,

Barnhill was still waiting for full payment for the walnuts that

he had sent Diamond in 2010. Heidman told Barnhill that the

payment was for the 2010 crop, part of FY2011, but that it

would be “budgeted into the next year.” The problem is under

accounting rules, you cannot legitimately record in a future

fiscal year an amount for a prior year’s crop. That amount

should have been estimated during 2010 and recorded as an

expense against revenue from the sale of walnuts.

An investigation by the audit committee in February 2012

found payments of $20 million to walnut growers in August

2010 and $60 million in September 2011 that were not

recorded in the correct periods. The $20 million payments

to growers in 2010 caught the eye of Diamond’s auditors,

Deloitte & Touche. However, it is uncertain whether the firm

approved the accounting for the payments. It is an important

determination because corporate officers can defend against

securities fraud charges by arguing they did not have the

requisite intent because they relied on the approval of the


The disclosure of financial restatements in November 2012

and audit committee investigation led to the resignation of former

CEO Michael Mendes, who agreed to pay a $2.74 million

cash clawback and return 6,665 shares to the company.

Mendes’s cash clawback was deducted from his retirement

payout of $5.4 million. Former CFO Steven Neil was fired on

November 19, 2012, and did not receive any severance.

As a result of the audit committee investigation and the

subsequent analysis and procedures performed, the company

identified material weaknesses in three areas: control environment,

walnut grower accounting, and accounts payable

timing recognition. The company announced efforts to remediate

these areas of material weakness, including enhanced

oversight and controls, leadership changes, a revised walnut

cost estimation policy, and improved financial and operation

reporting throughout the organization.

An interesting aspect of the case is the number of red

flags, including unusual timing of payments to growers,

a leap in profit margins, and volatile inventories and cash

flows. Moreover, the company seemed to push hard on every

lever to meet increasingly ambitious earnings targets and

allowed top executives to pull in big bonuses, according to

interviews with former Diamond employees and board members,

rivals, suppliers and consultants, in addition to reviews

of public and nonpublic Diamond records.

Nick Feakins, a forensic accountant, noted the relentless

climb in Diamond’s profit margins, including an increase in

net income as a percent of sales from 1.5 percent in FY2006

to more than 5 percent in FY2011. According to Feakins,

“no competitors were improving like that; even with rising

Asian demand . . . it just doesn’t make sense.” 2 Reuters did a

review of 11 companies listed as comparable organizations in

Diamond’s regulatory filings and found that only one, B&G

Foods, which made multiple acquisitions, added earnings

during the period.

Another red flag was that while net income growth is generally

reflected in operating cash flow increases, at Diamond,

the cash generation was sluggish in FY2010, when earnings

were strong. This raises questions about the quality of earnings.

Also, in September 2010, Mendes had promised EPS

growth of 15 percent to 20 percent per year for the next

five years. In FY2009, FY2010, and FY2011, $2.6 million

of Mendes’s $4.1 million in annual bonus was paid because

Diamond beat its EPS goal, according to regulatory filings.

It was expected that the company would likely face a civil

enforcement action by the SEC for not maintaining accurate

books and records and failing to maintain adequate internal

controls to report the payments properly, both of which are

required for public companies. If the SEC decides to bring

1 Available at

189398&p=irol-newsArticle&id=1758849 .

2 Available at

idUSBRE82I0AQ20120319 .

Chapter 7 Earnings Management and the Quality of Financial Reporting 469

a civil fraud case against any individuals at Diamond Foods,

the Dodd-Frank Act gives it the option of filing either an

administrative case or a civil injunctive action in Federal

District Court. An administrative proceeding is generally

considered a friendlier venue for the SEC.


1. One of the red flags identified in the case was that operating

cash flow increases did not seem to match the level of

increase in net income. Explain the relationship between

these two measures and why it raised questions about the

quality of earnings at Diamond Foods.

2. Why were the actions of Diamond Foods with respect to its

‘accounting for nuts’ unethical?

3. The role of Deloitte & Touche is unclear in the case. We

do not know whether the firm approved the accounting

for the payments to walnut growers and periods used to

record these amounts. Assume that the firm identified

the improper payments and discussed the matter with

management (i.e., CFO and CEO). What levers might

Deloitte use to convince top management to correct the

materially misstated financial statements?


Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright © 2014 by McGraw-Hill Education. All rights reserved. Printed in the United States of America. Previous editions © 2011 and 2008. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of McGraw-Hill Education, including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.

Some ancillaries, including electronic and print components, may not be available to customers outside the United States.

This book is printed on acid-free paper.

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ISBN 978–0–07–786221–3 MHID 0–07–786221–X

Senior Vice President, Products & Markets: Kurt L. Strand Vice President, Content Production & Technology Services: Kimberly Meriwether David Managing Director: Timoth Vertovec Brand Manager: James Heine Marketing Manager: Constantine Karampelas Development Editor: Gail Korosa Director, Content Production: Terri Schiesl Project Manager: Judi David Buyer: Jennifer Pickel Cover Image: Dynamic Graphics/Jupiterimages Compositor: S4Carlisle Publishing Services Typeface: 10/12 Times New Roman Printer: Quad/Graphics

All credits appearing on pages or at the end of the book are considered to be an extension of the copyright page.

Library of Congress Cataloging-in-Publication Data Mintz, Steven M. Ethical obligations and decision making in accounting: text and cases / Steven M. Mintz, DBA, CPA, Professor of Accounting California Polytechnic State University, San Luis Obispo Roselyn E. Morris, PhD, CPA, Professor of Accounting Texas State University-San Marcos. — Third edition. pages cm ISBN 978-0-07-786221-3—ISBN 0-07-786221-X 1. Accountants—Professional ethics—United States— Case studies. I. Morris, Roselyn E. II. Title. HF5616.U5M535 2014 174′.4—dc23


The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does not indicate an endorsement by the authors or McGraw-Hill Education, and McGraw-Hill Education does not guarantee the accuracy of the information presented at these sites.

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“Whatever we learn to do, we learn by doing it.” — Aristotle

We hope this book inspires students to engage in the learning process, to make ethical choices in their lives, and always strive for excellence in whatever they do.


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About the Authors STEVEN M. MINTZ, DBA, CPA, is a professor of accounting in the Orfalea College of Business at the California Polytechnic State University–San Luis Obsipo. Dr. Mintz received his DBA from George Washington University. His first book, titled Cases in Accounting Ethics and Professionalism, was also published by McGraw-Hill. Dr. Mintz develops individual courses in professional accounting ethics for Bisk Education that meet each state’s board of accountancy mandatory requirements for continuing education in ethics. He also writes two popular ethics blogs under the names “ethicssage” and “work- placeethicsadvice.” Dr. Mintz has received the Faculty Excellence Award of the California Society of CPAs and Service Award from the California Board of Accountancy for his work on the Advisory Committee on Accounting Ethics Curriculum.

ROSELYN E. MORRIS, PH.D., CPA, is a professor of accounting in the Accounting Department at the McCoy College of Business, Texas State University–San Marcos. Dr. Morris received her Ph.D. in business administration from the University of Houston. She is a past president of the Accounting Education Foundation and a member of the Qualifications Committee of the Texas Board of Public Accountancy. Dr. Morris has received the Outstanding Educator Award from the Texas Society of CPAs.

Both Professors Mintz and Morris have developed and teach an accounting ethics course at their respective universities.

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Preface Why Did We Write This Book?

The first edition of Ethical Obligations and Decision Making in Accounting: Text and Cases was written in the wake of the bubble and accounting scandals at companies such as Enron and WorldCom. The second edition was written in the wake of the financial meltdown of 2007–2008 that was due to high-risk lending and borrowing practices. The result of these scandals has been an increased call by professional and regulatory bodies for ethics education of accounting students in values, ethics, and attitudes to support pro- fessional and ethical judgments and act in the public interest. We dedicate ourselves to this goal through our book.

Several states now require their accounting students to complete an ethics course prior to certification. Texas was first state to do so, and it requires accounting students in Texas and those moving into the state to complete an ethics course at a Texas uni- versity or in their home institution. California and Colorado require separate account- ing ethics courses; states such as Maryland, New York, and West Virginia also have separate ethics course requirements. This book is written to enable instructors to address the content material that state boards typically expect to be covered in qualify- ing courses.

Ethical Obligations and Decision Making in Accounting was written to guide students through the minefields of ethical conflict in meeting their responsibilities under the pro- fessions’ codes of conduct. Our book is devoted to helping students cultivate the ethical commitment needed to ensure that their work meets the highest standards of integrity, independence, and objectivity. We hope that this book and classroom instruction will work together to provide the tools to help you make ethical judgments and carry through with ethical actions.

Our book blends ethical reasoning, components of behavioral ethics, reflection, and the principles of ethical conduct that embody the values of the accounting profession. We incorporate these elements into a framework to consider the ethical obligations of accountants and auditors and how to make ethical decisions that address the following material:

• The role of moral and cognitive development in ethical reasoning, ethical judgment, and ethical orientation

• Professional codes of conduct in accounting • Ethical corporate governance systems • Fraud detection and prevention • Legal and regulatory obligations of auditors • Whistleblowing obligations of accountants and auditors • Earnings management issues and the quality of financial reporting • Ethical systems, global ethics standards, and corporate governance considerations in

doing business worldwide

Attributes of This Textbook Ethical Obligations and Decision Making in Accounting is designed to provide the instructor with comprehensive coverage of ethical and professional issues encountered by accounting professionals. Our material provides the best flexibility and pedagogical

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viii Preface

effectiveness of any book on the market. To that end, it includes numerous features designed to make both learning and teaching easier, such as:

• Ethical reflections that set the tone for each chapter • 160 discussion questions • 76 cases (10 per Chapters 1–7 and 6 in Chapter 8), about one-third of which are from the

SEC enforcement files • 6 additional major cases that can be used for comprehensive testing, a group project, a

research assignment, or a capstone to the book • Dozens of additional cases and instructional resources, which are available to enrich

student learning • Links to videos for instructors

Pedagogical approach:

• The book is comprehensive enough to serve as a stand-alone text, yet flexible enough to act as a co-text or supplementary text across the accounting curricula or within an auditing or financial accounting course.

• There is sufficient case and supplementary material to allow the instructor to vary the course over at least two to three terms.

• The writing style is pitched specifically to students, making the material easy to follow and absorb.

• Group discussions and role-play opportunities using case studies • Video links to bring case material to life

The Instructor Edition of the Online Learning Center,, offers materials to support the efforts of first-time and seasoned instructors of accounting ethics. A comprehensive Instructor’s Manual provides teaching notes, grading sugges- tions and rubrics, sample syllabi, extra cases and projects, and guidelines for incorporating writing into the accounting ethics course; a Test Bank that provides a variety of multiple- choice, short answer, and essay questions for building quizzes and tests; additional cases that can be assigned, including some that were not carried over from the first and second editions; links to videos to enhance the learning experience and bring case discussions to life; and PowerPoint presentations for every chapter make a convenient and powerful lecture tool.

Changes in This Edition The behavioral approach to ethics leads to understanding and explaining moral behavior in a systematic way. We have expanded our discussion of ethics beyond the traditional philosophical moral reasoning methods that teach students how they should behave when facing ethical dilemmas and now also engage them to understand their own behavior better and compare it to how they would ideally like to behave. We incorporate those discussions in addressing ethical obligations of accountants and auditors under professional codes of conduct and in areas such as whistleblowing considerations under Sarbanes-Oxley (SOX) and the Dodd-Frank Financial Reform Act.

This revision also includes:

• Emphasis on values, ethics, and behaviors in a professional setting • Expanded coverage of professional codes of conduct and failure to maintain indepen-

dence, integrity, objectivity, and professional skepticism • New audit requirements and clarified Statements on Auditing Standards effective in

2014 that collectively better address financial statement fraud and the risk of material misstatements

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Preface ix

• Broadened perspective on earnings management, including the role of earnings expec- tations, the use of accruals, income smoothing, risk assessment and materiality, and financial restatements

• Public interest and ethical considerations in developing international financial report- ing standards, cultural considerations when operating overseas, corporate governance systems, and global bribery

• Restoring public trust and confidence in the accounting profession

This edition of Ethical Obligations and Decision Making in Accounting has dozens of new discussion questions. The material that was replaced to keep the book fresh is avail- able to instructors in the Instructor’s Manual for testing purposes. For the first time, we provide video links to many of the cases in the book in the IM.

In a project of this kind, errors are bound to occur. As authors, we accept full responsi- bility for all errors and omissions. We welcome feedback on the book and suggestions for improvements. The authors have collectively had more than 30 years of experience teach- ing accounting ethics and welcome the opportunity to share our insights with you on how best to use the book and teach ethics to accounting students.


The authors want to express their sincere gratitude to these reviewers for their comments and guidance. Their insights were invaluable in developing this edition of the book.

Russell Calk New Mexico State University Jeffrey Cohen Boston College Dan Hubbard University of Mary Washington

Lorraine Lee University of North Carolina–Wilimington Stephen A. McNett Texas A&M University–Central Texas Barbara Porco Fordham University

We also appreciate the assistance and guidance given us on this project by the staff of Mc-Graw-Hill Education, including Tim Vertovec, Managing Director; James Heine, Executive Brand Manager; Michelle Nolte, Marketing Manager; Lori Bradshaw, develop- ment editor; Judi David, project manager; Jennifer Pickel, buyer; Studio Montage, design coordinator; and Prashanthi Nadipalli, media project manager. We greatly appreciate the role of Shyam Ramasubramony, project manager, and Susan McClung, copyeditor of the book.

Finally, we would like to acknowledge the contributions of our students, who have pro- vided invaluable comments and suggestions on the content and use of these cases.

If you have any questions, comments, or suggestions concerning Ethical Obligations and Decision Making in Accounting, please send them to us at and

Steve Mintz

Rosie Morris

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Case Descriptions

Case # Case Name/Description

1-1 Harvard Cheating Scandal Student cheating at Harvard raises questions about responsibilities of instructors and student personal responsibilities

1-2 Giles and Regas Dating relationship between employees of a CPA firm jeopardizes completion of the audit.

1-3 NYC Subway Death: Bystander Effect or Moral Blindness Real-life situation where onlookers did nothing while a man was pushed to his death off a subway platform.

1-4 Lone Star School District Failure to produce documents to support travel expenditures raises questions about the justifiability of reimbursement claims.

1-5 Reneging on a Promise Ethical dilemma of a student who receives an offer of employment from a firm that he wants to work for, but only after accepting an offer from another firm.

1-6 Capitalization versus Expensing Ethical obligations of a controller when pressured by the CFO to capitalize costs that should be expensed.

1-7 Eating Time Ethical considerations of a new auditor who is asked to cut down on the amount of time that he takes to complete audit work.

1-8 A Faulty Budget Ethical and professional responsibilities of an accountant after discovering an error in his sales budget.

1-9 Cleveland Custom Cabinets Ethical and professional responsibilities of an accountant who is asked to “tweak” overhead to improve reported earnings.

1-10 Telecommunications, Inc. Concerns about the ethics of engineers who accept free travel and lodging from a foreign entity after establishing the criteria for a contract awarded to that entity.

Case # Case Name/Description

2-1 WorldCom Persistence of internal auditor, Cynthia Cooper, to correct accounting fraud and implications for Betty Vinson, a midlevel accountant, who went along with the fraud

2-2 Better Boston Beans Conflict between wanting to do the right thing and a confidentiality obligation to a coworker.

2-3 The Tax Return Tax accountant’s ethical dilemma when asked by her supervisor to ignore reportable lottery winnings.

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2-4 Shifty Industries Depreciation calculations and cash outflow considerations in a tax engagement.

2-5 Blues Brothers Identifying enablers and disablers of ethical action and ways to convince others of one’s point of view.

2-6 Supreme Designs, Inc. Ethical dilemma of an accountant who uncovers questionable payments to his supervisor.

2-7 Milton Manufacturing Company Dilemma for top management on how best to deal with a plant manager who violated company policy but at the same time saved it $1.5 million.

2-8 Juggyfroot Pressure imposed by a CEO on external accountants to change financial statement classification of investments in securities to report a market gain in earnings.

2-9 Phar-Mor SEC investigation of Phar-Mor for overstating inventory and misuse of corporate funds by the COO.

2-10 Gateway Hospital Behavioral ethics considerations in developing a position on unsubstantiated expense reimbursement claims.

Case # Case Name/Description

3-1 The Parable of the Sadhu Classic Harvard case about ethical dissonance and the disconnect between individual and group ethics.

3-2 Amgen Whistleblowing Case Whistleblower’s termination after raising issues about the company’s underreporting of complaints and problems with pharmaceutical drugs.

3-3 United Thermostatic Controls Acceptability of accelerating the recording of revenue to meet financial analysts’ earnings estimates and increase bonus payments.

3-4 Hewlett-Packard Use of false and fraudulent means to obtain confidential information from members of the board of directors.

3-5 IRS Whistleblower and Informing on Tax Cheats Ethics of gathering sensitive information about wrongdoing to qualify for whistleblower payouts.

3-6 Bennie and the Jets Ethical and professional obligations in reporting accounting wrongdoing to higher-ups in the organization.

3-7 Exxon-XTO Merger Alleged breach of fiduciary duties of the board of directors of XTO Energy that arose from ExxonMobil’s takeover of XTO.

3-8 Disclosure of Steve Jobs’s Health as Apple CEO: A Public or Private Matter? Shareholder rights to receive negative information about the health of its CEO.

Case Descriptions xi

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3-9 Bhopal, India: A Tragedy of Massive Proportions Evaluation of the decision-making process before, during, and after the leak of a toxic chemical that killed or injured thousands.

3-10 Accountability of Ex-HP CEO in Conflict of Interest Charges Sexual harassment charges stemming from conflict of interest between CEO/board chair and outside contractor.

Case # Case Name/Description

4-1 America Online (AOL) Internet-based company’s improper capitalization of advertising costs and the use of “round-trip” transactions to inflate revenue and earnings.

4-2 Beauda Medical Center Confidentiality obligation of an auditor to a client after discovering a defect in a product that may be purchased by a second client.

4-3 Family Games, Inc. Ethical dilemma for a controller being asked to backdate a revenue transaction to increase performance bonuses in order to cover the CEO’s personal losses.

4-4 First Community Church Misappropriation of church funds and subsequent cover-up by a member of the board of trustees.

4-5 Lee & Han, LLC Alteration of work papers and ethical obligations of auditors.

4-6 Gee Wiz Ethics of working for employer’s customer on the side and evaluating the customer’s receivable account.

4-7 Family Outreach Questions about validity of expense accounts and ethical obligations of the state auditor.

4-8 HealthSouth Corporation Manipulation of contractual allowances to overstate net revenues, and auditors’ inability to gather the evidence needed to stop the fraud.

4-9 Healthcare Fraud and Accountants’ Ethical Obligations Stakeholder considerations and ethical obligations upon discovering Medicare fraud.

4-10 Independence Violations at PwC Investigation of PwC independence procedures after self-regulatory peer review fails to identify violations.

Case # Case Name/Description

5-1 Computer Associates Audit committee’s role in identifying premature revenue recognized on software contracts.

5-2 ZZZZ Best Fraudster Barry Minkow uses fictitious revenue transactions from nonexistent business to falsify financial statements.

5-3 Imperial Valley Thrift & Loan Role of professional skepticism in evaluating audit evidence on collectability of loans and going concern assessment.

xii Case Descriptions

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5-4 Audit Client Considerations and Risk Assessment Risk assessment procedures prior to deciding whether to submit a competitive bid for an audit engagement.

5-5 Krispy Kreme Doughnuts, Inc. “Round-trip” transactions used to inflate revenues and earnings to meet or exceed financial analysts’ EPS guidance.

5-6 Dunco Industries Role and ethical responsibilities of accounting professionals in assessing the validity of audit evidence.

5-7 First Community Bank Valuation of loan loss impairment and risk assessment.

5-8 Fannie Mae: The Government’s Enron Comprehensive case covers manipulation in four areas to project stable earnings—derivatives, loan fees, loan loss reserves, and marketable securities.

5-9 Royal Ahold N.V. (Ahold) U.S. subsidiary of a Dutch company that used improper accounting for promotional allowances to meet or exceed budgeted earnings targets.

5-10 Groupon Competitive pressures on social media pioneer leads to internal control weakness and financial restatements.

Case # Case Name/Description

6-1 SEC v. Halliburton Company and KBR, Inc. Bribery allegations against Halliburton and the application of the Foreign Corrupt Practices Act (FCPA).

6-2 Con-way Inc. Facilitating payments and internal control requirements under the FCPA.

6-3 Insider Trading and Accounting Professionals Insider trading by accounting professionals and providing tips to friends.

6-4 Anjoorian et al.: Third-Party Liability Application of the foreseeability test, near-privity, and the Restatement approach in deciding negligence claims against the auditor.

6-5 Vertical Pharmaceuticals Inc. et al. v. Deloitte & Touche LLP Fiduciary duties and audit withdrawal considerations when suspecting fraud at a client.

6-6 SEC v. DHB Industries, Inc., n/k/a Point Blank Solutions, Inc. SEC action against independent directors and audit committee members in a securities fraud case.

6-7 Livingston & Haynes, P. C. Evaluation of ordinary negligence, gross negligence, and fraud in a securities violation.

6-8 Kay & Lee LLP Auditor legal liability when foreseen third party relies on financial statements

6-9 Reznor v. J. Artist Management (JAM), Inc. Legal liability of manager of lead singer of Nine Inch Nails based on allegations of mismanagement.

6-10 SEC v. Zurich Financial Services Complex accounting for reinsurance transactions and transfer of economic risk.

Case Descriptions xiii

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Case # Case Name/Description

7-1 Nortel Networks Use of reserves and revenue recognition techniques to manage earnings.

7-2 Solutions Network, Inc. Use of the Fraud Triangle to evaluate management’s actions.

7-3 Cubbies Cable Differences of opinion with management over whether to capitalize or expense cable construction costs.

7-4 Solway, Inc. Use of year-end accruals to manage earnings and whistleblowing considerations.

7-5 Dell Computer Use of “cookie-jar” reserves to smooth net income and meet financial analysts’ earnings projections.

7-6 Sweat Construction Company Pressure on the controller to ignore higher estimated costs on a construction contract to improve earnings and secure needed financing.

7-7 Sunbeam Corporation Use of cookie-jar reserves and “channel stuffing” by a turnaround artist to manage earnings.

7-8 Diamond Foods Link between projecting financial results and earnings management.

7-9 The North Face, Inc. Questions about financial structuring and revenue recognition on barter transactions to achieve desired results.

7-10 Vivendi Universal Improper adjustments to EBITDA and operating free cash flow by a French multinational company to meet ambitious earnings targets and conceal liquidity problems.

Case # Case Name/Description

8-1 SEC v. Siemens Aktiengesellschaft Bribery committed by a German company, using slush funds, off-book accounts, and business consultants and intermediaries to facilitate illegal payments.

8-2 Parmalat: Europe’s Enron Fictitious accounts at Bank of America and the use of nominee entities to transfer debt off the books by an Italian company led to one of Europe’s largest fraud cases.

8-3 Satyam: India’s Enron CEO’s falsification of financial information and misuse of corporate funds for personal purposes.

8-4 Royal Dutch Shell plc Overstatement of estimated recoverable proved oil and gas reserves by Dutch-U.K. company in violation of SEC regulations.

xiv Case Descriptions

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8-5 Autonomy Investigations by U.S. SEC and UK Serious Fraud Office into accounting for an acquisition of a British software maker by Hewlett-Packard (HP).

8-6 Olympus Major corporate scandal in Japan where Olympus committed a $1.7 billion fraud involving concealment of investment losses through fraudulent accounting.

Major Cases

Chapter Coverage Case Name/Description

1 Adelphia Communications Corporation SEC action against Deloitte & Touche for failing to exercise the proper degree of professional skepticism in examining complex related-party transactions and contingencies that were not accounted for in accordance with GAAP.

2 Royal Ahold N.V. (Ahold) Court finding that Deloitte & Touche should not be held liable for the efforts of the client to deprive the auditors of accurate information needed for the audit and masking the true nature of other evidence.

3 MicroStrategy, Inc. SEC action against MicroStrategy for improper revenue recognition of accounting for multiple deliverables contracts and questions about independence of PwC.

4 Cendant Corporation SEC action against Cendant for managing earnings through merger reserve manipulations and improper accounting for membership sales, and questions about the audit of Ernst & Young.

5 Navistar International Confidentiality issues that arise when Navistar management questions the competency of Deloitte & Touche auditors by referring to PCAOB inspection reports and fraud at the company.

6 Waste Management Failure of Andersen auditors to enforce agreement with the board of directors to adopt proposed adjusting journal entries that were required in restated financial statements.

Case Descriptions xv

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1 Ethical Reasoning: Implications for Accounting 1

2 Cognitive Processes and Ethical Decision Making in Accounting 54

3 Creating an Ethical Organization Environment and Effective Corporate Governance Systems 91

4 AICPA Code of Professional Conduct 175

5 Fraud in Financial Statements and Auditor Responsibilities 246

Brief Contents 6 Legal, Regulatory, and Professional

Obligations of Auditors 335

7 Earnings Management and the Quality of Financial Reporting 410

8 International Financial Reporting: Ethics and Corporate Governance Considerations 475



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Table of Contents Chapter 1 Ethical Reasoning: Implications for Accounting 1

Ethics Reflection 1 Integrity: The Basis of Accounting 3 Religious and Philosophical Foundations of Ethics 4 What Is Ethics? 5

Norms, Values, and the Law 6 Ethical Relativism 8 Situation Ethics 8 Cultural Values 10

The Six Pillars of Character 11 Trustworthiness 12 Respect 15 Responsibility 15 Fairness 15 Caring 16 Citizenship 16

Reputation 16 The Public Interest in Accounting 18

Professional Accounting Associations 18 AICPA Code of Conduct 19

Virtue, Character, and CPA Obligations 20 Modern Moral Philosophies 21

Teleology 22 Deontology 25 Justice 27 Virtue Ethics 28

Application of Ethical Reasoning in Accounting 29 DigitPrint Case Study 31

Scope and Organization of the Text 33 Concluding Thoughts 34 Discussion Questions 35 Endnotes 37 Chapter 1 Cases 41

Case 1-1: Harvard Cheating Scandal 42 Case 1-2: Giles and Regas 43 Case 1-3: NYC Subway Death: Bystander Effect or Moral Blindness 45 Case 1-4: Lone Star School District 46 Case 1-5: Reneging on a Promise 47 Case 1-6: Capitalization versus Expensing 48 Case 1-7: Eating Time 49 Case 1-8: A Faulty Budget 50 Case 1-9: Cleveland Custom Cabinets 51 Case 1-10: Telecommunications, Inc. 52

Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting 54

Ethics Reflection 54 Kohlberg and the Cognitive Development Approach 55

Heinz and the Drug 56 Universal Sequence 58

The Ethical Domain in Accounting and Auditing 59 Rest’s Four-Component Model of Ethical Decision Making 59

Moral Sensitivity 60 Moral Judgment 60 Moral Motivation 60 Moral Character 60

Rest’s Model and Organizational Behavior 61 Professional Judgment in Accounting: Transitioning from Moral Intent to Moral Action 63

Diem-Thi Le and Whistleblowing at the DCCA 64 Behavioral Ethics 67

Ethical Decision-Making Model 68 Application of the Model 71 Concluding Thoughts 72 Discussion Questions 72 Endnotes 74 Chapter 2 Cases 77

Case 2-1: WorldCom 78 Case 2-2: Better Boston Beans 79 Case 2-3: The Tax Return 80 Case 2-4: Shifty Industries 81 Case 2-5: Blues Brothers 83 Case 2-6: Supreme Designs, Inc. 84 Case 2-7: Milton Manufacturing Company 85 Case 2-8: Juggyfroot 87 Case 2-9: Phar-Mor 88 Case 2-10: Gateway Hospital 90

Chapter 3 Creating an Ethical Organization Environment and Effective Corporate Governance Systems 91

Ethics Reflection 91 Seven Signs of Ethical Collapse 92

Pressure to Maintain the Numbers 93 Fear of Reprisals 93

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xviii Table of Contents

Loyalty to the Boss 93 Weak Board of Directors 94

A Culture of Conflicting Interests 94 Innovation and Ethics 95 Community Involvement and Ethics 95 Organizational Influence on Ethical Decision Making 95 Individual-Organization Interchange 96 Ethical Dissonance Model 96

Business Ethics 98 Guiding Principles 98 Values 99 Ethical Standards 99 Business Ethics versus Personal Ethics 100 Ends versus Means 101 Trust in Business 101 Johnson & Johnson: A Case of Dr. Jekyll and Mr. Hyde? 103 Employees Perceptions of Ethics in the Workplace 105

Stakeholder Perspective 107 The Case of the Ford Pinto 107

Fraud in Organizations 109 Fraudulent Business Practices 109 Occupational Fraud 110 Financial Statement Fraud 112

Foundations of Corporate Governance Systems 114

Defining Corporate Governance 115 Views of Corporate Governance 115 The Importance of Good Governance 116 Executive Compensation 117

Corporate Governance Mechanisms 119 The Role of the Board of Directors 119 Audit Committee 120 Internal Controls as a Monitoring Device 122 Internal Auditors 123 Audited Financial Statements 125 NYSE Listing Requirements 125 Code of Ethics for CEOs and CFOs 127 Compliance Function 128

Bernie Madoff’s Ponzi Scheme 128 Whistleblowing 131

Detection, Reporting, and Retaliation 131 Incentivizing Whistleblowing under Dodd-Frank 134 Accountants’ Obligations for Whistleblowing 134 Has the Whistleblowing Program Been Successful? 135 The Ethics of Whistleblowing 136

Concluding Thoughts 137 Discussion Questions 137 Endnotes 140

Chapter 3 Cases 149 Case 3-1: The Parable of the Sadhu 150 Case 3-2: Amgen Whistleblowing Case 154 Case 3-3: United Thermostatic Controls 156 Case 3-4: Hewlett-Packard 160 Case 3-5: IRS Whistleblower and Informing on Tax Cheats 162 Case 3-6: Bennie and the Jets 163 Case 3-7: Exxon-XTO Merger 164 Case 3-8: Disclosure of Steve Jobs’s Health as Apple CEO: A Public or Private Matter? 167 Case 3-9: Bhopal, India: A Tragedy of Massive Proportions 168 Case 3-10: Accountability of Ex-HP CEO in Conflict of Interest Charges 174

Chapter 4 AICPA Code of Professional Conduct 175

Ethics Reflection 175 The Public Interest in Accounting: An International Perspective 177 Investigations of the Profession: Where Were the Auditors? 178

Metcalf Committee and Cohen Commission: 1977–1978 179 House Subcommittee on Oversight and Investigations: 1986 180 Savings and Loan Industry Failures: Late 1980s–Early 1990s 181

Treadway Commission Report: 1985; COSO: 1992; and Enterprise Risk Management: 2004 181 The Role of the Accounting Profession in the Financial Crisis of 2007–2008 183 AICPA Code of Professional Conduct and State Board Requirements 186

National Association of State Boards of Accountancy 187 Professional Services of CPAs 188

AICPA and IFAC Principles of Professional Conduct 190 Conceptual Framework for AICPA Independence Standards 191

Threats to Independence 191 Safeguards to Counteract Threats 193 Financial Relationships That Impair Independence 193 Providing Nonattest Services to an Attest Client 194

SEC Position on Auditor Independence 195 SEC Actions Against Auditing Firms 195 The PeopleSoft Case 196

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Table of Contents xix

Insider Trading Scandals Damage the Reputation of the Accounting Profession: Former KPMG Audit Partner, Scott London 196 Former Deloitte & Touche Management Advisory Partner, Thomas Flannigan 197

SOX Provisions 198 Restrictions on Nonattest Services 198

Integrity and Objectivity 200 Principles of Professional Practice 201 Responsibilities to Clients 203 Other Responsibilities and Practices 206

Commissions and Referral Fees 206 Advertising and Solicitation 207 Form of Organization and Name 208 Acts Discreditable—Client Books and Records; CPA Workpapers 210 Acts Discreditable—Negligence in the Preparation of Financial Statements or Records 212

Ethics and Tax Services 213 Rule 101—Independence 213 Rule 102—Integrity and Objectivity 214 Rule 201—Professional Competence and Due Care 214 Rule 202—Compliance with Professional Standards 214 Tax Compliance Services 214 Statements on Standards for Tax Services (SSTS) 214 Substantial Authority 216 Realistic Possibility of Success 216 Reasonable Basis 216 Tax Shelters 218

PCAOB Rules 219 Rule 3520—Auditor Independence 219 Rule 3521—Contingent Fees 219 Rule 3522—Tax Transactions 219 Rule 3523—Tax Services for Persons in Financial Reporting Oversight Roles 220 Rule 3524—Audit Committee Pre-Approval of Certain Tax Services 220 Rule 3525—Audit Committee Pre-Approval of Nonauditing Services Related to Internal Control over Financial Reporting 221 Rule 3526—Communication with Audit Committees Concerning Independence 221

Concluding Thoughts 221 Discussion Questions 222 Endnotes 225 Chapter 4 Cases 229

Case 4-1: America Online (AOL) 230 Case 4-2: Beauda Medical Center 233 Case 4-3: Family Games, Inc. 234

Case 4-4: First Community Church 235 Case 4-5: Lee & Han, LLC 236 Case 4-6: Gee Wiz 237 Case 4-7: Family Outreach 238 Case 4-8: HealthSouth Corporation 239 Case 4-9: Healthcare Fraud and Accountants’ Ethical Obligations 242 Case 4-10: Independence Violations at PwC 243

Chapter 5 Fraud in Financial Statements and Auditor Responsibilities 246

Ethics Reflection 246 Fraud in Financial Statements and the Audit Function 247 Nature and Causes of Misstatements 249

Errors, Fraud, and Illegal Acts 249 Reporting an Illegal Act 251 Auditors’ Responsibilities for Fraud Prevention, Detection, and Reporting 252 The Fraud Triangle 252 Incentives/Pressures to Commit Fraud 253 Opportunity to Commit Fraud 254 Rationalization for the Fraud 255 Tyco Fraud 255

Fraud Considerations in the Audit 259 Fraud Risk Assessment 260 Fraud Associated with Management Override of Controls 260 Rite Aid Fraud and Failure of Internal Controls 262 Communicating About Possible Fraud to Management and Those Charged with Governance 262 Management Representations and Financial Statement Certifications 263

Contents of the Audit Report 264 Background 264 Introductory Paragraph 265 Management’s Responsibility 265 Auditor’s Responsibility 265 Opinion 267 Types of Audit Opinions 267

Generally Accepted Auditing Standards (GAAS)—Overview 269

GAAS Requirements 271 Audit Evidence 272 Limitations of the Audit Report 273 Reasonable Assurance 273 Materiality 273

What Is Meant by “Present Fairly”? 275 Audit Risk Assessment 277

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xx Table of Contents

Internal Control Assessment 278 Internal Control—Integrated Framework 278

PCAOB Standards 282 AS 4: Reporting on Previously Reported Material Weakness 283 AS 5: An Audit of Internal Control over Financial Reporting That Is Integrated with an Audit of Financial Statements 283 AS 6: Evaluating Consistency of Financial Statements 284 AS 8—Audit Risk 285 AS 9—Audit Planning 285 AS 10—Supervision of the Audit Engagement 285 AS No. 11—Consideration of Materiality in Planning and Performing an Audit 286 AS No. 12—Identifying and Assessing Risks of Material Misstatement 286 AS No. 13—The Auditor’s Responses to the Risks of Material Misstatement 286 AS No. 14—Evaluating Audit Results 286 AS No. 15—Audit Evidence 287 Communications with Audit Committees 287 Auditor’s Evaluation of the Quality of the Company’s Financial Reporting 289 Financial Statements Restatements 291 PCAOB Enforcement Program 293

Concluding Thoughts 294 Discussion Questions 295 Endnotes 297 Chapter 5 Cases 303

Case 5-1: Computer Associates 304 Case 5-2: ZZZZ Best 307 Case 5-3: Imperial Valley Thrift & Loan 311 Case 5-4: Audit Client Considerations and Risk Assessment 317 Case 5-5: Krispy Kreme Doughnuts, Inc. 319 Case 5-6: Dunco Industries 321 Case 5-7: First Community Bank 322 Case 5-8: Fannie Mae: The Government’s Enron 324 Case 5-9: Royal Ahold N.V. (Ahold) 329 Case 5-10: Groupon 333

Chapter 6 Legal, Regulatory, and Professional Obligations of Auditors 335

Ethics Reflection 335 Client Confidentiality, Fraud, and Whistleblowing 337

Confidentiality Obligation and Fraud 337 Dodd-Frank and Whistleblowing 337

Ethical and Legal Responsibilities of Officers and Directors 339

Duty of Care—Managers and Directors 339 Duty of Loyalty 339 Director Duty of Good Faith 339 Business Judgment Rule 340 Caremark Opinion 340 Shareholder Derivative Suit—Citigroup Subprime Lending 340 Clawback of Incentive Compensation from Executive Officers 341 Audit Committee and Business Judgment Rule 342

Legal Liability of Auditors: An Overview 343 Common-Law Liability 343 Liability to Clients—Privity Relationship 344 Liability to Third Parties 345 Actually Foreseen Third Parties 345 Reasonably Foreseeable Third Parties 346 Auditor Liability to Third Parties 348

Statutory Liability 350 Securities Act of 1933 352 Key Court Decisions 353 Securities Exchange Act of 1934 354

Interaction of Ethics and Legal Liability 356 Court Decisions and Auditing Procedures 357 Liability for Securities Violations 359

Honest Services Assessment in Criminal Matters 359 Is There a Difference Between Lying and Stealing in Securities Fraud? 360

Insider Reporting and Trading 361 Leaking Nonpublic Information 361 Auditor Betrayal of Client Confidences and Insider Trading 363

Private Securities Litigation Reform Act (PSLRA) 365

Reporting Requirements 365 Proportionate Liability 366

Sarbanes Oxley (SOX) Legal Liabilities 367 Section 302. Corporate Responsibility for Financial Reports 367 Section 302. Liability in Private Civil Actions 368 Section 302. Liability in Civil and Criminal Government Actions 369 Perspective on Accomplishments of SOX 369

Other Laws Affecting Accountants and Auditors 370 Foreign Corrupt Practices Act (FCPA) 370 SEC Charges Pfizer with FCPA Violations 371 FCPA Violations and Tyco 375 FCPA and Whistleblowing 375

Federal Sentencing Guidelines for Organizations 375

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Table of Contents xxi

Concluding Thoughts 377 Discussion Questions 378 Endnotes 380 Chapter 6 Cases 385

Case 6-1: SEC v. Halliburton Company and KBR, Inc. 386 Case 6-2: Con-way Inc. 390 Case 6-3: Insider Trading and Accounting Professionals 392 Case 6-4: Anjoorian et al.: Third-Party Liability 393 Case 6-5: Vertical Pharmaceuticals Inc. et al. v. Deloitte & Touche LLP 396 Case 6-6: SEC v. DHB Industries, Inc., n/k/a Point Blank Solutions, Inc. 397 Case 6-7: Livingston & Haynes, P. C. 400 Case 6-8: Kay & Lee, LLP 405 Case 6-9: Reznor v. J. Artist Management (JAM), Inc. 406 Case 6-10: SEC v. Zurich Financial Services 407

Chapter 7 Earnings Management and the Quality of Financial Reporting 410

Ethics Reflection 410 Motivation for Earnings Management 412

Earnings Guidance 412 Income Smoothing 414

Analysis of Earnings Management from a Financial Reporting Perspective 415

Definition of Earnings Management 415 Ethics of Earnings Management 416 How Managers and Accountants Perceive Earnings Management 418 Accruals and Earnings Management 419 Acceptability of Earnings Management from a Materiality Perspective 420 Current Auditing Standards and Presumptions 424

Financial Statement Restatements 426 The Nature of Restatements 426 Restatements Due to Errors in Accounting and Reporting 427

Earnings Management Techniques 428 Financial Shenanigans 429

1. Recording Revenue Too Soon or of Questionable Quality 429 2. Recording Bogus Revenue 430 3. Boosting Income with One-Time Gains 430 4. Shifting Current Expenses to a Later or Earlier Period 430

5. Failing to Record or Improperly Reducing Liabilities 430 6. Shifting Current Revenue to a Later Period 431 7. Shifting Future Expenses to the Current Period as a Special Charge 431

Descriptions of Financial Shenanigans 431 The Case of Xerox 432 Sanctions by the SEC on KPMG 433 The Case of Lucent Technologies 433 The Story of Enron 435 FASB Rules on SPEs 441 Enron’s Role in the Creation and Passage of SOX 442 Lessons to Be Learned from Enron 442

Earnings Quality 442 Concluding Thoughts 443 Discussion Questions 444 Endnotes 447 Chapter 7 Cases 451

Case 7-1: Nortel Networks 452 Case 7-2: Solutions Network, Inc. 456 Case 7-3: Cubbies Cable 458 Case 7-4: Solway, Inc. 460 Case 7-5: Dell Computer 461 Case 7-6: Sweat Construction Company 463 Case 7-7: Sunbeam Corporation 465 Case 7-8: Diamond Foods 468 Case 7-9: The North Face, Inc. 470 Case 7-10: Vivendi Universal 473

Chapter 8 International Financial Reporting: Ethics and Corporate Governance Considerations 475

Ethics Reflection 475 The Influence of Culture on International Financial Reporting 477 Restoring the Public Trust: An International Perspective 479 International Financial Reporting Environment 480

Movement toward IFRS 480 Harmonization of Standards 480 Comparability of Financial Statements 481 Convergence of Standards 482 Condorsement 483 Auditing, Corporate Governance, and Ethics Considerations 484 True and Fair View versus Present Fairly 485

IFRS for Small and Medium-Sized Entities 485

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xxii Table of Contents

Principles versus Rules-based Standards 487 Ethical Considerations 487 Earnings Management Concerns 488 Examples of Rules-based versus Principles- Based Standards 489 The Problem with Provisions and Reserves 491

Global Business Ethics 492 Global Code of Ethics 495 Global Fraud, Bribery, and Suspected Illegal Acts 496

Global Fraud 496 Global Bribery 497 Responding to a Suspected Illegal Act 499

Comparative Corporate Governance 501 Legal and Cultural Considerations 501 Comply or Explain Principle 502 Corporate Governance in Germany 503 Corporate Governance in China 504 Corporate Governance in India 507

CLSA Corporate Governance Watch 2012 508 Concluding Thoughts 510

Discussion Questions 510 Endnotes 513 Chapter 8 Cases 517

Case 8-1: SEC v. Siemens Aktiengesellschaft 518 Case 8-2: Parmalat: Europe’s Enron 521 Case 8-3: Satyam: India’s Enron 526 Case 8-4: Royal Dutch Shell plc 530 Case 8-5: Autonomy 534 Case 8-6: Olympus 537

Major Cases 542 Major Case 1: Adelphia Communications Corporation 543 Major Case 2: Royal Ahold N.V. (Ahold) 551 Major Case 3: MicroStrategy, Inc. 556 Major Case 4: Cendant Corporation 561 Major Case 5: Navistar International 567 Major Case 6: Waste Management 572

Name Index 579

Subject Index 583

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1 Ethical Reasoning: Implications for Accounting


PENN STATE CHILD ABUSE SCANDAL: A CULTURE OF INDIFFERENCE What motivates an otherwise ethical person to do the wrong thing when faced with an ethical dilemma? Why did Joe Paterno and administrators at Penn State University look the other way and fail to act on irrefutable evidence that former assistant football coach Jerry Sandusky had raped and molested young boys, an offense for which Sandusky currently is serving a 30- to 60-year sentence? According to the independent report by Louis Freeh that investigated the sexual abuse, four of the most powerful people at Penn State, including president Graham Spanier, athletic director Timothy Curley, senior vice president Gary Schultz, and head football coach Joe Paterno, shel- tered a child predator harming children for over a decade by concealing Sandusky’s activities from the board of trus- tees, the university community, and authorities. The Freeh report characterizes the inactions as lacking empathy for the victims by failing to inquire as to their safety and well- being. Not only that, but they exposed the first abused child to additional harm by alerting Sandusky, who was the only one who knew the child’s identity, of what assistant coach Mike McQueary saw in the shower on the night of February  9, 2001. 1 McQueary testified at the June  2012 trial of Sandusky that when he was a graduate assistant, he walked into the locker room and heard sounds of slapping

and observed Sandusky up against a boy, whose hands were up against the wall. 2 He reported the suspected child abuse to Paterno who reported the incident to his superiors but did not confront Sandusky or report the incident to the board of trustees or the police. 3

REASONS FOR UNETHICAL ACTIONS The report gives the following explanations for the failure of university leaders to take action to identify this child vic- tim and for not reporting Sandusky to the authorities:

• The desire to avoid the bad publicity that reporting the incident would bring

• The failure of the university’s board of trustees to have reporting mechanisms in place to ensure disclosure of major risks to the university

• A president who discouraged discussion and dissent • A lack of awareness of child abuse issues and the Clery

Act, which requires all colleges and universities partici- pating in federal financial aid programs to keep and dis- close information about crimes committed on and near their campuses

• A lack of whistleblower policies and protections • A culture of reverence for the football program that was

ingrained at all levels of the campus community

Ethics Reflection


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EXPLANATIONS FOR UNETHICAL ACTIONS Former Penn State president Spanier who was fired by the board of trustees in November 2011, is quoted as saying in an interview with Jeffrey Toobin of the New Yorker online after the trial of Sandusky that ended on June 22, 2012, about how the university worked that “honesty, integrity, and always doing what was in the best interests of the uni- versity [italics added] was how everyone agreed to operate and . . . we’ve always operated as a family. Our personal and social and professional lives were all very intertwined.” 4

At Penn State, a culture existed that placed the interests of the university, as perceived by its leadership, ahead of the interests of the abused children and the public trust. The tone that was set by Paterno and Spanier was to cover up any potentially damaging information about the insti- tution and its football program. This happens in other organizations as well, such as Enron and WorldCom, where acting ethically took a back seat to self-interest, including maximizing earnings and share price. The culture of an organization should be built on ethical values such as hon- esty, integrity, responsibility, and accountability. While Penn State may have claimed to follow such principles, the reality was that its actions did not match these behavioral norms.

ETHICAL BLIND SPOTS Leaders of organizations who may be successful at what they do and see themselves as ethical and moral still culti- vate a collection of what Max Bazerman and Ann Trebrunsel call blind spots . 5 Blind spots are the gaps between who you want to be and the person you actually are. In other words,

most of us want to do the right thing—to act ethically— but internal and external pressures get in the way. These authors attribute blind spots to the concept of bounded ethicality; that is, psychological processes that lead even good people to engage in ethically questionable behavior that contradicts their own preferred ethics. At Penn State, bounded ethicality came into play because individuals such as Paterno decided to keep the scandal quiet, thereby ena- bling the abuse and harm to the affected children to con- tinue even though that harm was inconsistent with their purported beliefs and preferences.

Our workday lives can create ethical challenges where there is a difference between knowing the right thing to do and doing it. One reason is organizational goals (such as what is in the best interests of Penn State), rewards, com- pliance systems, and informal pressures, all of which can contribute to ethical fading, a process by which the ethical dimensions are eliminated from a decision and replaced by “avoiding bad publicity” or making the deal at any costs. Enron had a code of conduct in place, but that didn’t stop it from rewarding officers involved in conflicts of interest such as the former chief financial officer (CFO), Andy Fastow, who managed special-purpose-entities that dealt directly with Enron at the same time he served as Enron’s CFO.

As you read this chapter, think about the following ques- tions: (1) What would you have done if you had been in Joe Paterno’s position, and why? (2) What factors might have enabled you to act in accordance with your own values and beliefs? (3) What factors might have served as disablers and made it more difficult to act on your values and beliefs?

Ethics Reflection (Concluded)

Have the courage to say no. Have the courage to face the truth. Do the right thing because it is right. These are the magic keys to living your life with integrity. W. Clement Stone (1902–2002)

This quote by William Clement Stone, a businessman, philanthropist, and self-help book author, underscores the importance of integrity in decision making. Notice that the quote addresses integrity in one’s personal life. That is because one has to act with integrity when making personal decisions in order to be best equipped to act with integrity on a professional level. Integrity, indeed all of ethics, is not a spigot that can be turned on or off depending on one’s whims or whether the matter at hand is personal or professional. As the ancient Greeks knew, we learn how to be ethical by practicing and exercising those virtues that enable us to lead a life of excellence.

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Chapter 1 Ethical Reasoning: Implications for Accounting 3

Joe Paterno and other university leaders did not act with integrity. They let external considerations of reputation and image dictate their internal actions. Ironically, the very factor—reputation—that they guarded so closely was the first to be brought down by the disclosure of a cover-up in the sex scandal case.

In accounting, internal accountants and auditors may be pressured by superiors to manipulate financial results. The external auditors may have to deal with pressures imposed on them by clients to put the best face on the financial statements regardless of whether they conform to generally accepted accounting principles (GAAP). It is the ethical value of integrity that provides the moral courage to resist the temptation to stand by silently while a company misstates its financial statement amounts.

Integrity: The Basis of Accounting

According to Mintz (1995), “Integrity is a fundamental trait of character that enables a CPA to withstand client and competitive pressures that might otherwise lead to the sub- ordination of judgment.” 6 A person of integrity will act out of moral principle and not expediency. That person will do what is right, even if it means the loss of a job or client. In accounting, the public interest (i.e., investors and creditors) always must be placed ahead of one’s own self-interest or the interests of others, including a supervisor or client.

Integrity means that a person acts on principle—a conviction that there is a right way to act when faced with an ethical dilemma. For example, assume that your tax client fails to inform you about an amount of earned income for the year, and you confront the client on this issue. The client tells you not to record it and reminds you that there is no W-2 or 1099 form to document the earnings. The client adds that you will not get to audit the company’s financial statements anymore if you do not adhere to the client’s wishes. Would you decide to “go along to get along”? If you are a person of integrity, you should not allow the client to dictate how the tax rules will be applied in the client’s situation. You are the professional and know the tax regulations best, and you have an ethical obligation to report taxes in accordance with the law. If you go along with the client and the Internal Revenue Service (IRS) investigates and sanctions you for failing to follow the IRS Tax Code, then you may suffer irreparable harm to your reputation. An important point is that a professional must never let loyalty to a client cloud good judgment and ethical decision making.

WorldCom: Cynthia Cooper: Hero and Role Model Cynthia Cooper’s experience at WorldCom illustrates how the internal audit function should work and how a person of integrity can put a stop to financial fraud. It all unraveled in April and May 2002 when Gene Morse, an auditor at WorldCom, couldn’t find any documentation to support a claim of $500 million in computer expenses. Morse approached Cooper, the company’s director of internal auditing and Morse’s boss, who instructed Morse to “keep going.” A series of obscure tips led Morse and Cooper to suspect that WorldCom was cooking the books. Cooper formed an investigation team to determine whether their hunch was right.

In its initial investigation, the team discovered $3.8 billion of misallocated expenses and phony accounting entries. 7 Cooper approached the CFO, Scott Sullivan, but was dissatisfied with his explanations. The chief executive officer (CEO) of the company, Bernie Ebbers, had already resigned under pressure from WorldCom’s board of directors, so Cooper went to the audit committee. The committee interviewed Sullivan about the accounting issues and did not get a satisfactory answer. Still, the committee was reluctant to take any action. Cooper persisted anyway. Eventually, one member of the audit committee told her to approach the outside auditors to get their take on the matter. Cooper gathered additional evidence of fraud, and ultimately KPMG, the firm that had replaced Arthur Andersen LLP—the auditors during the fraud—supported Cooper. Sullivan was asked to resign, refused to do so, and was fired. 8

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Lingzi Wang


4 Chapter 1 Ethical Reasoning: Implications for Accounting

Religious and Philosophical Foundations of Ethics

Virtually all the world’s great religions contain in their religious texts some version of the Golden Rule: “Do unto others as you would wish them to do unto you.” In other words, we should treat others the way we would want to be treated. This is the basic ethic that guides all religions. If we believe honesty is important, then we should be honest with others and expect the same in return. One result of this ethic is the concept that every person shares certain inherent human rights, which will be discussed later in this chapter and the next. Exhibit 1.1 provides some examples of the universality of the Golden Rule in world religions provided by the character education organization Teaching Values. 11

Integrity is the key to carrying out the Golden Rule. A person of integrity acts with truthfulness, courage, sincerity, and honesty. Integrity means to have the courage to stand by your principles even in the face of pressure to bow to the demands of others. As previously mentioned, integrity has particular importance for certified public accountants (CPAs), who often are pressured by their employers and clients to give in to their demands. The ethical responsibility of a CPA in these instances is to adhere to the ethics of the accounting profession and not to subordinate professional judgment to others. Integrity encompasses the whole of the person, and it is the foundational virtue of the ancient Greek philosophy of virtue.

One tragic result of the fraud and cover-up at WorldCom is the case of Betty Vinson. It is not unusual for someone who is genuinely a good person to get caught up in fraud. Vinson, a former WorldCom mid- level accounting manager, went along with the fraud because her superiors told her to do so. She was convinced that it would be a one-time action. It rarely works that way, however, because once a company starts to engage in accounting fraud, it feels compelled to continue the charade into the future to keep up the appearance that each period’s results are as good as or better than prior periods. The key to maintaining one’s integrity and ethical perspective is not to take the first step down the proverbial ethical slippery slope.

Vinson pleaded guilty in October 2002 to participating in the financial fraud at the company. She was sentenced to five months in prison and five months of house arrest. Vinson represents the typical “pawn” in a financial fraud: an accountant who had no interest or desire to commit fraud but got caught up in it when Sullivan, her boss, instructed her to make improper accounting entries. The rationalization by Sullivan that the company had to “make the numbers appear better than they really were” did nothing to ease her guilty conscience. Judge Barbara Jones, who sentenced Vinson, commented that “Ms. Vinson was among the least culpable members of the conspiracy at WorldCom. . . . Still, had Vinson refused to do what she was asked, it’s possible this conspiracy might have been nipped in the bud.” 9

Accounting students should reflect on what they would do if they faced a situation similar to the one that led Vinson to do something that was out of character. Once she agreed to go along with making improper entries, it was difficult to turn back. The company could have threatened to disclose her role in the original fraud and cover-up if Vinson then acted on her beliefs. From an ethical (and practical) perspective it is much better to just do the right thing from the very beginning, so that you can’t be blackmailed or intimidated later.

Vinson became involved in the fraud because she had feared losing her job, her benefits, and the means to provide for her family. She must live with the consequences of her actions for the rest of her life. On the other hand, Cynthia Cooper, on her own initiative, ordered the internal investigation that led to the discovery of the $11 billion fraud at WorldCom. Cooper did all the right things to bring the fraud out in the open. Cooper received the Accounting Exemplar Award in 2004 given by the American Accounting Association and was inducted into the American Institute of Certified Public Accountants (AICPA) Hall of Fame in 2005.

Cooper truly is a positive role model. She discusses the foundation of her ethics that she developed as a youngster because of her mother’s influence in her book Extraordinary Circumstances: The Journey of a Corporate Whistleblower. Cooper says: “Fight the good fight. Don’t ever allow yourself to be intimidated. . . . Think about the consequences of your actions. I’ve seen too many people ruin their lives.” 10

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Lingzi Wang
Lingzi Wang
Lingzi Wang
Lingzi Wang


Chapter 1 Ethical Reasoning: Implications for Accounting 5

EXHIBIT 1.1 The Universality of the Golden Rule in the World Religions

Religion Expression of the Golden Rule Citation

Christianity All things whatsoever ye would that men should do to you, Do ye so to them; for this is the law and the prophets.

Matthew 7:1

Confucianism Do not do to others what you would not like yourself. Then there will be no resentment against you, either in the family or in the state.

Analects 12:2

Buddhism Hurt not others in ways that you yourself would find hurtful.

Uda–navarga 5,1

Hinduism This is the sum of duty, do naught onto others what you would not have them do unto you.

Mahabharata 5, 1517

Islam No one of you is a believer until he desires for his brother that which he desires for himself.


Judaism What is hateful to you, do not do to your fellowman. This is the entire Law; all the rest is commentary.

Talmud, Shabbat 3id

Taoism Regard your neighbor’s gain as your gain, and your neighbor’s loss as your own loss.

Tai Shang Kan Yin P’ien

Zoroastrianism That nature alone is good which refrains from doing another whatsoever is not good for itself.

Dadisten-I-dinik, 94, 5

The origins of Western philosophy trace back to the ancient Greeks, including Socrates, Plato, and Aristotle. The ancient Greek philosophy of virtue deals with questions such as: What is the best sort of life for human beings to live? Greek thinkers saw the attainment of a good life as the telos, the end or goal of human existence. For most Greek philoso- phers, the end is eudaimonia, which is usually translated as “happiness.” However, the Greeks thought that the end goal of happiness meant much more than just experiencing pleasure or satisfaction. The ultimate goal of happiness was to attain some objectively good status, the life of excellence. The Greek word for excellence is arete, the customary translation of which is “virtue.” Thus for the Greeks, “excellences” or “virtues” were the qualities that made a life admirable or excellent. They did not restrict their thinking to characteristics we regard as moral virtues, such as courage, justice, and temperance, but included others we think of as nonmoral, such as wisdom. 12

Modern philosophies have been posited as ways to living an ethical life. Unlike virtue theory that relies on both the characteristics of a decision and the person making that deci- sion, these philosophies rely more on methods of ethical reasoning, and they, too, can be used to facilitate ethical decision making. We review these philosophies later in the chapter.

What Is Ethics?

The term ethics is derived from the Greek word ethikos, which itself is derived from the Greek word ethos, meaning “custom” or “character.” Morals are from the Latin word moralis, meaning “customs,” with the Latin word mores being defined as “manners, mor- als, character.” Therefore, ethics and morals are essentially the same.

In philosophy, ethical behavior is that which is “good.” The Western tradition of ethics is sometimes called “moral philosophy.” The field of ethics or moral philosophy involves developing, defending, and recommending concepts of right and wrong behavior. These concepts do not change as one’s desires and motivations change. They are not relative to the situation. They are immutable.

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6 Chapter 1 Ethical Reasoning: Implications for Accounting

In a general sense, ethics (or moral philosophy) addresses fundamental questions such as: How should I live my life? That question leads to others, such as: What sort of person should I strive to be? What values are important? What standards or principles should I live by? 13 There are various ways to define the concept of ethics. The simplest may be to say that ethics deals with “right” and “wrong.” However, it is difficult to judge what may be right or wrong in a particular situation without some frame of reference.

Ethics must be based on accepted standards of behavior. For example, in virtually all societies and cultures, it is wrong to kill someone or steal property from someone else. These standards have developed over time and come from a variety of sources, including:

• The influence of religious writing and interpretations • The influence of philosophical thought • The influence of community (societal) values

In addition, the ethical standards for a profession, such as accounting, are heavily influenced by the practices of those in the profession, state laws and board of accountancy rules, and the expectations of society. Gaa and Thorne define ethics as “the field of inquiry that concerns the actions of people in situations where these actions have effects on the welfare of both oneself and others.” 14 We adopt that definition and emphasize that it relies on ethical reasoning to evaluate the effects of actions on others— the stakeholders.

Norms, Values, and the Law Ethics deals with well-based standards of how people ought to act, does not describe the way people actually act, and is prescriptive, not descriptive. Ethical people always strive to make the right decision in all circumstances. They do not rationalize their actions based on their own perceived self-interests. Ethical decision making entails following certain well- established norms of behavior. The best way to understand ethics may be to differentiate it from other concepts.

Values and Ethics Values are basic and fundamental beliefs that guide or motivate attitudes or actions. In accounting, the values of the profession are embedded in its codes of ethics that guide the actions of accountants and auditors in meeting their professional responsibilities.

Values are concerned with how a person behaves in certain situations and is predicated on personal beliefs that may or may not be ethical, whereas ethics is concerned with how a moral person should behave to act in an ethical manner. A person who values prestige, power, and wealth is likely to act out of self-interest, whereas a person who values hon- esty, integrity, and trust will typically act in the best interests of others. It does not follow, however, that acting in the best interests of others always precludes acting in one’s own self-interest. Indeed, the Golden Rule prescribes that we should treat others the way we want to be treated.

The Golden Rule requires that we try to understand how our actions affect others; thus, we need to put ourselves in the place of the person on the receiving end of the action. The Golden Rule is best seen as a consistency principle, in that we should not act one way toward others but have a desire to be treated differently in a similar situation. In other words, it would be wrong to think that separate standards of behavior exist to guide our personal lives but that a different standard (a lower one) exists in business.

Laws versus Ethics Being ethical is not the same as following the law. Although ethical people always try to be law-abiding, there may be instances where their sense of ethics tells them it is best not to follow the law. These situations are rare and should be based on sound ethical reasons.

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Chapter 1 Ethical Reasoning: Implications for Accounting 7

Assume that you are driving at a speed of 45 miles per hour (mph) on a two-lane divided roadway (double yellow line) going east. All of a sudden, you see a young boy jump into the road to retrieve a ball. The boy is close enough to your vehicle so that you know you cannot continue straight down the roadway and stop in time to avoid hitting him. You quickly look to your right and notice about 10 other children off the road. You cannot avoid hitting 1 or more of them if you swerve to the right to avoid hitting the boy in the middle of the road. You glance to the left on the opposite side of the road and notice no traffic going west or any children off the road. What should you do?

Ethical Perspective

If you cross the double yellow line that divides the roadway, you have violated the motor vehicle laws. We are told never to cross a double yellow line and travel into oncoming traffic. But the ethical action would be to do just that, given that you have determined it appears to be safe. It is better to risk getting a ticket than hit the boy in the middle of your side of the road or those children off to the side of the road.

Laws and Ethical Obligations Benjamin Disraeli (1804–1881), the noted English novelist, debater, and former prime minister, said, “When men are pure, laws are useless; when men are corrupt, laws are broken.” A person of goodwill honors and respects the rules and laws and is willing to go beyond them when circumstances warrant. As indicated by the previous quote, such people do not need rules and laws to guide their actions. They always try to do the right thing. On the other hand, the existence of specific laws prohibiting certain behaviors will not stop a person who is unethical (e.g., does not care about others) from violating those laws. Just think about a Ponzi scheme such as the one engaged in by Bernie Madoff, whereby he duped others to invest with him by promising huge returns that, unbeknownst to each individual investor, would come from additional investments of scammed investors and not true returns. Madoff’s story will be discussed in more detail in Chapter 3.

Laws create a minimum set of standards. Ethical people often go beyond what the law requires because the law cannot cover every situation a person might encounter. When the facts are unclear and the legal issues uncertain, an ethical person should decide what to do on the basis of well-established standards of ethical behavior. This is where moral philoso- phies come in and, for accountants and auditors, the ethical standards of the profession.

Ethical people often do less than is permitted by the law and more than is required. A useful perspective is to ask these questions:

• What does the law require of me? • What do ethical standards of behavior demand of me? • How should I act to conform to both?

The Gray Area When the rules are unclear, an ethical person looks beyond his / her own self-interest and evaluates the interests of the stakeholders potentially affected by the action or decision. Ethical decision making requires that a decision maker be willing, at least sometimes, to take an action that may not be in his / her best interest. This is known as the “moral point of view.”

Sometimes people believe that the ends justify the means. In ethics it all depends on one’s motives for acting. If one’s goals are good and noble, and the means we use to achieve them are also good and noble, then the ends do justify the means. However, if one views the concept as an excuse to achieve one’s goals through any means necessary, no matter how immoral, illegal, or offensive to others the means may be, then that person is attempting to justify the wrongdoing by pointing to a good outcome regardless of ethi- cal considerations such as how one’s actions affect others. Nothing could be further from

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8 Chapter 1 Ethical Reasoning: Implications for Accounting

the truth. The process you follow to decide on a course of action is more important than achieving the end goal. If this were not true from a moral point of view, then we could rationalize all kinds of actions in the name of achieving a desired goal, even if that goal does harm to others while satisfying our personal needs and desires.

Imagine that you work for a CPA firm and are asked to evaluate three software packages for a client. Your boss tells you that the managing partners are pushing for one of these packages, which just happens to be the firm’s internal software. Your initial numerical analysis of the packages based on functionality, availability of upgrades, and customer ser- vice indicates that a competitor’s package is better than the firm’s software. Your boss tells you, in no uncertain terms, to redo the analysis. You know what she wants. Even though you feel uncomfortable with the situation, you decide to “tweak” the numbers to show a preference for the firm’s package. The end result desired in this case is to choose the firm’s package. The means to that end was to alter the analysis, an unethical act because it is dishonest and unfair to the other competitors (not to mention the client) to change the objectively determined results. In this instance, ethical decision making requires that we place the client’s interests (to get the best software package for his needs) above those of the firm (to get the new business and not upset the boss).

Ethical Relativism Ethical relativism is the philosophical view that what is right or wrong and good or bad is not absolute but variable and relative, depending on the person, circumstances, or social situation. Ethical relativism holds that morality is relative to the norms of one’s culture. That is, whether an action is right or wrong depends on the moral norms of the society in which it is practiced. The same action may be morally right in one society but be morally wrong in another. For the ethical relativist, there are no universal moral standards— standards that can be universally applied to all peoples at all times. The only moral standards against which a society’s practices can be judged are its own. If ethical relativism is correct, then there can be no common framework for resolving moral disputes or for reaching agree- ment on ethical matters among members of different societies.

Most ethicists reject the theory of ethical relativism. Some claim that while the moral practices of societies may differ, the fundamental moral principles underlying these practices do not. For example, there was a situation in Singapore in the 1990s where a young American spray-painted graffiti on several cars. The Singaporean government’s penalty was to “cane” the youngster by striking him on the buttocks four times. In the United States, some said it was cruel and unusual punishment for such a minor offense. In Singapore, the issue is that to protect the interests of society, the government treats harshly those who commit relatively minor offenses. After all, it does send a message that in Singapore, this and similar types of behavior will not be tolerated. While such a practice might be condemned in the United States, most people would agree with the underlying moral principle—the duty to protect the safety and security of the public (life and liberty concerns). Societies, then, may differ in their application of fundamental moral principles but agree on the principles.

Situation Ethics Situation ethics , a term first coined in 1966 by an Episcopalian priest, Joseph Fletcher, is a body of ethical thought that takes normative principles—like the virtues, natural law, and Kant’s categorical imperative that relies on the universality of actions—and general- izes them so that an agent can “make sense” out of one’s experience when confronting ethical dilemmas. Unlike ethical relativism that denies universal moral principles, claim- ing the moral codes are strictly subjective, situational ethicists recognize the existence of normative principles but question whether they should be applied as strict directives

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(i.e., imperatives) or, instead, as guidelines that agents should use when determining a course of ethical conduct. In other words, situationists ask: Should these norms, as general- izations about what is desired, be regarded as intrinsically valid and universally obliging of all human beings? For situationists, the circumstances surrounding an ethical dilemma can and should influence an agent’s decision-making process and may alter an agent’s decision when warranted. Thus, situation ethics holds that “what in some times and in some places is ethical can be in other times and in other places unethical.” 15 A problem with a situation ethics perspective is that it can be used to rationalize actions such as those in the Penn State scandal.

Student Cheating Another danger of situational ethics is it can be used to rationalize cheating. Cheating in general is at epidemic proportions in society. The 2012 Report Card on the Ethics of American Youth, conducted by the Josephson Institute of Ethics, found that of 43,000 high school students surveyed, 51 percent admitted to having cheated on a test during 2012, 55 percent admitted to lying and 20 percent admitted to stealing. 16

Cheating in college is prevalent as well. The estimates of number of students engaging in some form of academic dishonesty at least once ranges from 50 to 70 percent. 17 In 1997, McCabe and Treviño surveyed 6,000 students in 31 academic institutions and found con- textual factors, such as peer influence, had the most effect on student cheating behavior. 18 Contextual appropriateness, rather than what is good or right, suggests that situations alter cases, thus changing the rules and principles that guide behavior. 19

A comprehensive study of 4,950 students at a small southwestern university identified neutralizing techniques to justify violations of accepted behavior. In the study, students rationalized their cheating behavior without challenging the norm of honesty. The most common rationale was denial of responsibility (i.e., circumstances beyond their control, such as excessive hours worked on a job, made cheating okay in that instance). Then, they blamed the faculty and testing procedures (i.e., exams that try to trick students rather than test knowledge). Finally, the students appealed to a higher loyalty by arguing that it is more important to help a friend than to avoid cheating. One student blamed the larger society for his cheating: “In America, we’re taught that results aren’t achieved through beneficial means, but through the easiest means.” The authors concluded that the use of these techniques of neutralization conveys the message that students recognize and accept cheating as an undesirable behavior but one that can be excused under certain circum- stances, reflecting a situational ethic. 20

Student Cheating and Workplace Behavior Some educators feel that a student’s level of academic integrity goes hand in hand with a student’s ethical values on other real-world events that present ethical challenges. 21 In other words, developing a sound set of ethical standards in one area of decision making, such as personal matters, will carry over and affect other areas such as work- place ethics.

Some educators believe that ethics scandals in the business world can be attributed to the type of education that graduates of MBA programs obtained in business schools. 22 In 2006, McCabe, Butterfield, and Treviño reported on their findings regarding the extent of cheating among MBA students compared to non-business graduate students at 32 uni- versities in the United States and Canada. The authors found that 56 percent of business students admitted to cheating, versus 47 percent of non-business students. 23

Several researchers have examined student cheating in college and the tendency of those students to cheat in the workplace. Lawson surveyed undergraduate and graduate students enrolled in business schools and found a strong relationship between “students’

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10 Chapter 1 Ethical Reasoning: Implications for Accounting

propensity to cheat in an academic setting and their attitude toward unethical behavior in the business world.” 24 Another study looked at the issue of graduate students cheating versus workplace dishonesty. Sims surveyed MBA students and found that students who engaged in behaviors considered severely dishonest in college also engaged in behaviors considered severely dishonest at work. 25

If students who cheat in the university setting subsequently cheat in the workplace, then ethics education is all the more important. Once a student rationalizes cheating by blaming others or circumstances, it is only a small step to blaming others in the workplace for one’s inability to get things done or unethical behavior.

Cultural Values Between 1967 and 1973, Dutch researcher Geert Hofstede conducted one of the most comprehensive studies of how values in the workplace are influenced by culture. Using responses to an attitude study of approximately 116,000 IBM employees in 39 countries, Hofstede identified four cultural dimensions that can be used to describe general similari- ties and differences in cultures around the world: (1) individualism, (2) power distance, (3) uncertainty avoidance, and (4) masculinity. 26 In 2001, a fifth dimension, long-term orientation—initially called Confucian dynamism—was identified. 27 More recently, a sixth variable was added—indulgence versus restraint—as a result of Michael Minkov’s analysis of data from the World Values Survey. 28 We briefly discuss Hofstede’s cultural variables in this chapter, and in Chapter 8, we extend it to Gray’s model, which overlies accounting values and systems and their linkage to societal values and institutional norms. Exhibit 1.2 summarizes the five dimensions from Hofstede’s work for Japan, the United Kingdom, and the United States, representing leading industrialized nations; and the so-called BRIC countries (Brazil, Russia, India, and China), which represent four major emerging economies. 29

Individualism (IDV) focuses on the degree that the society reinforces individual or col- lective achievement and interpersonal relationships. In individualist societies (high IDV), people are supposed to look after themselves and their direct family, while in collectivist societies (low IDV), people belong to “in-groups” that take care of them in exchange for loyalty. Imagine, for example, you are the manager of workers from different cultures and cheating/unethical behavior occurs in the workplace. A workgroup with collectivist values such as China and Japan (low IDV) might be more prone to covering up the behavior of one member of the group, whereas in the United Kingdom and United States (high IDV), there is a greater likelihood of an individual blowing the whistle.

Uncertainty Avoidance (UAI) is another cultural value that has important implications for workplace behavior, as it describes the tolerance for uncertainty and ambiguity within society. A high UAI ranking indicates that a country has a low tolerance of uncertainty

EXHIBIT 1.2 Hofstede’s Cultural Dimensions *


Cultural Variables Brazil Russia India China Japan U.K. U.S.

Power Distance (PDI) 69 93 77 80 54 35 40

Individualism (IDV) 38 39 48 20 46 89 91

Masculinity (MAS) 49 36 56 66 95 66 62

Uncertainty Avoidance (UAI) 76 95 40 30 92 35 46

Long-Term Orientation (LTO) 65 N/A 61 118 80 25 29

* High scores indicate a propensity towards the cultural variable; low scores indicate the opposite.

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Chapter 1 Ethical Reasoning: Implications for Accounting 11

and ambiguity. Such a society is likely to institute laws, rules, regulations, and controls to reduce the amount of uncertainty. A country such as Russia has a high UAI, while the United States and United Kingdom have lower scores (low UAI), indicating more tolerance for a variety of opinions. One implication is the difficulty of doing business in a country like Russia, which has strict rules and regulations about what can and cannot be done by multinational enterprises.

Other variables have important implications for workplace behavior as well, such as the Power Distance index (PDI), which focuses on the degree of equality between people in the country’s society. A high PDI indicates inequalities of wealth and power have been allowed to grow within society, as has occurred in China and Russia as they develop economically. Long-term orientation (LTO) versus short-term orientation has been used to illustrate one of the differences between Asian cultures, such as China and Japan, and the United States and United Kingdom. In societies like China and Japan, high LTO scores reflect the values of long-term commitment and respect for tradition, as opposed to low- LTO countries, such as the United Kingdom and United States, where change can occur more rapidly. Time can often be a stumbling block for Western-cultured organizations entering the China market. The length of time it takes to get business deals done in China can be two or three times that in the West. One final point is to note that Brazil and India show less variability in their scores than other countries, perhaps reflecting fewer extremes in cultural dimensions.

Our discussion of cultural dimensions is meant to explain how workers from different cultures might interact in the workplace. The key point is that cultural sensitivity is an essen- tial ingredient in establishing workplace values and may affect ethical behavioral patterns.

The Six Pillars of Character

It has been said that ethics is all about how we act when no one is looking. In other words, ethical people do not do the right thing because someone observing their actions might judge them otherwise, or because they may be punished as a result of their actions. Instead, ethical people act as they do because their “inner voice” or conscience tells them that it is the right thing to do. Assume that you are leaving a shopping mall, get into your car to drive away, and hit a parked car in the lot on the way out. Let’s also assume that no one saw you hit the car. What are your options? You could simply drive away and forget about it, or you can leave a note for the owner of the parked car with your telephone number. What would you do and why? Your actions will reflect the character of your inner being.

According to “virtue ethics,” there are certain ideals, such as excellence or dedication to the common good, toward which we should strive and which allow the full development of our humanity. These ideals are discovered through thoughtful reflection on what we as human beings have the potential to become.

Virtues are attitudes, dispositions, or character traits that enable us to be and to act in ways that develop this potential. They enable us to pursue the ideals we have adopted. Honesty, courage, compassion, generosity, fidelity, integrity, fairness, self-control, and prudence are all examples of virtues in Aristotelian ethics. A quote attributed to Aristotle is, “We are what we repeatedly do. Therefore, excellence is not an act. It is a habit.” 30

The Josephson Institute of Ethics identifies Six Pillars of Character that provide a foundation to guide ethical decision making. These ethical values include trustworthiness, respect, responsibility, fairness, caring, and citizenship. Josephson believes that the Six Pillars act as a multilevel filter through which to process decisions. So, being trustworthy is not enough—we must also be caring. Adhering to the letter of the law is not enough; we must accept responsibility for our actions or inactions. 31

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12 Chapter 1 Ethical Reasoning: Implications for Accounting

Trustworthiness The dimensions of trustworthiness include being honest, acting with integrity, being reli- able, and exercising loyalty in dealing with others.

Honesty Honesty is the most basic ethical value. It means that we should express the truth as we know it and without deception. In accounting, the full disclosure principle supports transparency and requires that the accounting professional disclose all the information that owners, investors, creditors, and the government need to know to make informed deci- sions. To withhold relevant information is dishonest. Transparent information is that which helps one understand the process followed to reach a decision. In other words it supports an ethical ends versus means belief.

Let’s assume that you are a member of a discussion group in your Intermediate Accounting II class, and in an initial meeting with all members, the leader asks whether there is anyone who has not completed Intermediate I. You failed the course last term and are retaking it concurrently with Intermediate II. However, you feel embarrassed and say nothing. Now, perhaps the leader thinks that this point is important because a case study assigned to your group uses knowledge gained from Intermediate I. You internally justify the silence by thinking: Well, I did complete the course, albeit with a grade of F. This is an unethical position. You are rationalizing silence by interpreting the question in your own self-interest rather than in the interests of the entire group. The other members need to know whether you have completed Intermediate I because the leader may choose not to assign a specific project to you that requires the Intermediate I prerequisite knowledge.

Integrity The integrity of a person is an essential element in trusting that person. MacIntyre, in his account of Aristotelian virtue, states, “There is at least one virtue recognized by tradition which cannot be specified except with reference to the wholeness of a human life—the virtue of integrity or constancy.” 32 A person of integrity takes time for self-reflection, so that the events, crises, and challenges of everyday living do not determine the course of that person’s moral life. Such a person is trusted by others because that person is true to her word.

Going back to the previous example, if you encounter a conflict with another group member who pressures you to plagiarize a report available on the Internet that the two of you are working on, you will be acting with integrity if you refuse to go along. Integrity requires that you have the courage of your convictions. You know it’s wrong to plagiarize another writer’s material. Someone worked hard to get this report published. You would not want another person to take material you had published without permission and proper citation. Why do it to that person, then? If you do it simply because it might benefit you, then you act out of self-interest, or egoism, and that is wrong.

Reliability The promises that we make to others are relied on by them, and we have a moral duty to follow through with action. Our ethical obligation for promise keeping includes avoiding bad-faith excuses and unwise commitments. Imagine that you are asked to attend a group meeting on Saturday and you agree to do so. That night, though, your best friend calls and says he has two tickets to the basketball game between the Dallas Mavericks and San Antonio Spurs. The Spurs are one of the best teams in basketball and you don’t get this kind of opportunity very often, so you decide to go to the game instead of the meeting. You’ve broken your promise, and you did it out of self-interest. You figured, who wouldn’t want to see the Spurs play? What’s worse, you call the group leader and say that you can’t

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attend the meeting because you are sick. Now you’ve also lied. You’ve started the slide down the ethical slippery slope, and it will be difficult to climb back to the top.

Loyalty We all should value loyalty in friendship. After all, you wouldn’t want the friend who invited you to the basketball game to telephone the group leader later and say that you went to the game on the day of the group meeting.

Loyalty requires that friends not violate the confidence we place in them. In accounting, loyalty requires that we keep financial and other information confidential when it deals with our employer and client. For example, if you are the in-charge accountant on an audit of a client for your CPA firm-employer and you discover that the client is “cooking the books,” you shouldn’t telephone the local newspaper and tell the story to a reporter. Instead, you should go to the partner in charge of the engagement and tell her. Your ethical obligation is to report what you have observed to your supervisor and let her take the appropriate action.

A Word about Whistleblowing There are limits to the confidentiality obligation. For example, let’s assume that you are the accounting manager at a publicly owned company and your supervisor (the controller) pressures you to keep silent about the manipulation of financial information. You then go to the CFO, who tells you that both the CEO and board of directors support the controller. Out of a misplaced duty of loyalty in this situation, you might rationalize your silence as did Betty Vinson. Ethical values sometimes conflict, and loyalty is the one value that should never take precedence over other values such as honesty and integrity. Otherwise, we can imagine all kinds of cover-ups of information in the interest of loyalty or friendship.

Internal whistleblowing typically is appropriate to clarify the positions of your superi- ors and bring matters of concern to the highest levels within an organization, including the audit committee of the board of directors. In fact, the ethics of the accounting profession [Interpretation 102-4 of the AICPA Code of Professional Conduct] 33 obligates the CPA to do just that. The prior example may represent a situation where you may be tempted to take the matter outside your employer or circumvent the firm-employer relationship to air your concerns. You should be careful if you choose to do this; get legal advice before acting. Informing parties outside an entity violates confidentiality. While acting out of conscience and a sense that the right thing to do is the highest ethical choice one can make, it is important to be aware of the consequences of one’s actions before taking the ultimate step of external whistleblowing. Exhibit 1.3 describes the ethical standards for CPAs under Interpretation 102-4. More will be said about whistleblowing in Chapter 3.

Notice that the process is clearly defined and requires bringing any concerns to higher- ups in the organization, including the audit committee, and preparing an informative memorandum that would summarize the various positions, including that of members of top management. The memo should help provide a defense of due care and compliance with ethical standards in case it becomes a regulatory or legal matter.

While attending a Josephson Institute of Ethics training program for educators, one of the authors of this book heard Michael Josephson make an analogy about loyal behavior that sticks with him to this day. Josephson said: “Dogs are loyal to their master, while cats are loyal to the house.” How true it is that dogs see their ultimate allegiance to their owner while cats get attached to the place they call home—their own personal space. Now, in a business context, this means that a manager should try to encourage “cat” behavior in the organization (sorry, dog lovers). In that way, if a cover-up of a financial wrongdoing exists, the “cat loyalty” mentality incorporated into the business environment dictates that the information be disclosed because it is not in the best interests of the organization to hide or ignore it. If we act with “dog loyalty,” we will cover up for our supervisor, who has a say about what happens to us in the organization. Recall our discussion of cultural

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values, and that someone from a country or group with a low score on individualism (a collectivist society) is more likely to hide a damaging fact out of loyalty to the controller and her superiors, while someone from a more individualistic society is more likely to come forward with information about the wrongdoing. A cover-up may be an understand- able position because of internal pressures that work against voicing one’s concerns, but it is unethical all the same. Moreover, once we go along with the cover-up, we have started the slide down the ethical slippery slope, and there may be no turning back. In fact, our supervisor may come to us during the next period and expect us to go along with the same cover-up in a similar situation. If we refuse at that point, the first instance may be brought up and used as a threat against us because we’ve already violated ethical standards once and don’t want to get caught. It is important to emphasize that we should not act ethically out of fear of the consequences of hiding information. Instead, we should act ethically out of a positive sense that it is the right way to behave.

Often when we cover up information in the present, it becomes public knowledge later. The consequences at that time are more serious because trust has been destroyed. We have already discussed the Penn State scandal and forfeiture of trust by Joe Paterno for failing to take steps to stop child abuse. Another example is Lance Armstrong, who for years denied taking performance-enhancing drugs while winning seven Tour de France titles. In 2012, he finally admitted to doing just that, and as a result, all those titles were stripped away by the U.S. Anti-Doping Agency. Or consider former president Richard Nixon, who went along with the cover-up in the Watergate break-in only to be forced to resign the presidency once the cover-up became public knowledge.

No adjustment

Still no adjustment



Possible material misstatement of financial statements?


Express concerns to supervisor




Consider the following steps:

continued employment responsibilities to external auditors responsibilities to outsiders

Bring concerns to higher levels

EXHIBIT 1.3 Ethical Responsibilities of Industry CPAs to Avoid Subordinating Judgment *

* A depiction of the requirements of Interpretation 102-4 developed by Steven Mintz.

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Chapter 1 Ethical Reasoning: Implications for Accounting 15

Respect All people should be treated with dignity. We do not have an ethical duty to hold all people in high esteem, but we should treat everyone with respect, regardless of their circumstances in life. In today’s slang, we might say that respect means giving a person “props.” The Golden Rule encompasses respect for others through notions such as civility, courtesy, decency, dignity, autonomy, tolerance, and acceptance. 34

By age 16, George Washington had copied by hand 110 Rules of Civility & Decent Behavior in Company and Conversation. They are based on a set of rules composed by French Jesuits in 1595. While many of the rules seem out of place in today’s society, Washington’s first rule is noteworthy: “Every Action done in Company, ought to be with Some Sign of Respect, to those that are Present.” 35

Washington’s vernacular was consistent with the times as indicated by the last of his rules: “Labour to keep alive in your Breast that Little Spark of Celestial fire Called Conscience.” 36 We have found many definitions of conscience, but the one we like best is the universal lexical English wordnet used for research and developed by the Cognitive Sciences Laboratory at Princeton University. The definition is: “Motivation deriving logically from ethical or moral principles that govern a person’s thoughts and actions.” 37

As a member of the case discussion group in the previous example, it would be wrong to treat another member with discourtesy or prejudice because you have drawn conclusions about that person on the basis of national origin or some other factor rather than her abili- ties and conduct. You would not want to be treated unfairly because of how you dress or walk or talk, so others should not be judged based on similar considerations. We should judge people based on their character.

The Nobel Peace Prize–winning activist Dr. Martin Luther King said it best in his “I Have a Dream” speech, delivered on the steps at the Lincoln Memorial in Washington, D.C., on August 28, 1963. Dr. King said the following in reference to the true meaning of the nation’s creed: “‘We hold these truths to be self-evident; that all men are created equal.’ . . . I have a dream that my four little children will one day live in a nation where they will not be judged by the color of their skin but by the content of their character.” 38

Responsibility Josephson points out that our capacity to reason and our freedom to choose make us mor- ally responsible for our actions and decisions. We are accountable for what we do and who we are. 39

A responsible person carefully reflects on alternative courses of action using ethical principles. A responsible person acts diligently and perseveres in carrying out moral action. Imagine if you were given the task by your group to interview five CPAs in public practice about their most difficult ethical dilemma, and you decided to ask one person, who was a friend of the family, about five dilemmas that person faced in the practice of public accounting. Now, even if you made an “honest” mistake in interpreting the requirement, it is clear that you did not exercise the level of care that should be expected in this instance in carrying out the instructions to interview five different CPAs. The due care test is whether a “reasonable person” would conclude that you had acted with the level of care, or diligence, expected in the circumstance. The courts have used this test for many years to evaluate the actions of professionals.

Fairness A person of fairness treats others equally, impartially, and openly. In business, we might say that the fair allocation of scarce resources requires that those who have earned the right to a greater share of corporate resources as judged objectively by performance measures should receive a larger share than those whose performance has not met the standard.

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16 Chapter 1 Ethical Reasoning: Implications for Accounting

Let’s assume that your instructor told the case study groups at the beginning of the course that the group with the highest overall numerical average would receive an A, the group with second highest a B, and so on. At the end of the term, the teacher gave the group with the second-highest average—90.5—an A and the group with the highest average—91.2—a B. Perhaps the instructor took subjective factors into account in deciding on the final grading. You might view the instructor’s action as unfair to the group with the highest average. It certainly contradicts his original stated policy, is capricious and unfair, especially if the instructor does not explain his reason for doing this. As Josephson points out, “Fairness implies adherence to a balanced standard of justice without relevance to one’s own feelings or inclinations.” 40

Caring The late Edmund L. Pincoffs, a philosopher who formerly taught at the University of Texas at Austin, believed that virtues such as caring, kindness, sensitivity, altruism, and benevo- lence enable a person who possesses these qualities to consider the interests of others. 41 Josephson believes that caring is the “heart of ethics and ethical decision making.” 42

The essence of caring is empathy. Empathy is the ability to understand, be sensitive to, and care about the feelings of others. Caring and empathy support each other and enable a person to put herself in the position of another. This is essential to ethical decision making.

Let’s assume that on the morning of an important group meeting, your child comes down with a temperature of 103 degrees. You call the group leader and say that you can’t make it to the meeting. Instead, you suggest that the meeting be taped and you will listen to the discussions later that day and telephone the leader with any questions. The leader reacts angrily, stating that you are not living up to your responsibilities. Assuming that your behavior is not part of a pattern and you have been honest with the leader up to now, you would have a right to be upset with the leader, who seems uncaring. In the real world, emergencies do occur, and placing your child’s health and welfare above all else should make sense in this situation to a person of rational thought. You also acted diligently by offering to listen to the discussions and, if necessary, follow up with the leader.

Putting yourself in the place of another is sometimes difficult to do because the cir- cumstances are unique to the situation. For example, what would you do if a member of your team walked into a meeting all bleary-eyed? You might ignore it, or you might ask that person if everything is all right. If you do and are informed that the person was up all night with a crying baby, then you might say something like, “If there’s anything I can do to lighten the load for you today, just say the word.”

A person who can empathize seems to know just what to say to make the other person feel better about circumstances. On the other hand, if you have never been married and have not had children, you might not be able to understand the feelings of a mother who has just spent the night trying to comfort a screaming child.

Citizenship Josephson points out that “citizenship includes civic virtues and duties that prescribe how we ought to behave as part of a community.” 43 An important part of good citizenship is to obey the laws, be informed about the issues, volunteer in your community, and vote in elections. President Barack Obama has called for citizens to engage in some kind of public service to benefit society as a whole.


It might be said that judgments made about one’s character contribute toward how another party views that person’s reputation. In other words, what is the estimation in which a person is commonly held, whether favorable or not? The reputation of a CPA is critical to

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Chapter 1 Ethical Reasoning: Implications for Accounting 17

a client’s trusting that CPA to perform services competently and maintain the confidential- ity of client information (except for whistleblowing instances). One builds “reputational capital” through favorable actions informed by ethical behavior.

All too often in politics and government, a well-respected leader becomes involved in behavior that, once disclosed, tears down a reputation earned over many years of service. The example of former senator and presidential candidate John Edwards shows how quickly one’s reputation can be destroyed—in this case because of the disclosure of an extramarital affair that Edwards had with a 42-year-old campaign employee, Rielle Hunter, that Edwards covered up.

In 2006, Edwards’s political action committee (PAC) paid Hunter’s video production firm $100,000 for work. Then the committee paid another $14,086 on April 1, 2007. The Edwards camp said the latter payment from the PAC was in exchange for 100 hours of unused videotape Hunter shot. The same day, the Edwards presidential campaign had injected $14,034.61 into the PAC for a “furniture purchase,” according to federal election records.

Edwards, a U.S. senator representing North Carolina from 1998 until his vice presiden- tial bid in 2004, acknowledged in May 2009 that federal investigators were looking into how he used campaign funds. Edwards was accused of soliciting nearly $1 million from wealthy backers to finance a cover-up of his illicit affair during his 2008 bid for the White House.

Edwards admitted to ABC News 44 in an interview with Bob Woodruff in August 2009 that he repeatedly lied about having an affair with Hunter. Edwards strenuously denied being involved in paying the woman hush money or fathering her newborn child, admit- ted the affair was a mistake in the interview, and said: “Two years ago, I made a very serious mistake, a mistake that I am responsible for and no one else. In 2006, I told Elizabeth [his wife] about the mistake, asked her for her forgiveness, asked God for His forgiveness. And we have kept this within our family since that time.” Edwards said he told his entire family about the affair after it ended in 2006, and that his wife Elizabeth was “furious” but that their marriage would survive. On January 21, 2010, he also finally admitted to fathering Hunter’s child, Quinn (and since the girl was born in 2008, that indicates pretty clearly that Edwards’s statement that the affair ended in 2006 was less than truthful).

On May 31, 2012, a jury found him not guilty on one of six counts in the campaign- finance trial and deadlocked on the remaining charges; the Department of Justice decided not to retry him on those charges. On the courthouse steps, Edwards acknowledged his moral shortcomings.

Edwards violated virtually every tenet of ethical behavior and destroyed his reputa- tion. He lied about the affair and attempted to cover it up, including allegations that he fathered Hunter’s baby. He violated the trust of the public and lied after telling his family about the affair in 2006. He even had the audacity to run for the Democratic nomination for president in 2008. One has to wonder what it says about Edwards’s ethics that he was willing to run for president of the United States while hiding the knowledge of his affair, without considering what might happen if he had won the Democratic nomination in 2008, and then the affair became public knowledge during the general election campaign. His behavior is the ultimate example of ethical blindness and the pursuit of one’s own self-interests to the detriment of all others. Perhaps the noted Canadian-American chemist and author Orlando Aloysius Battista (1917–1995), said it best: “An error doesn’t become a mistake until you refuse to correct it.” In other words, when you do something wrong, admit it, take responsibility for your actions, accept the consequences, and move on. Unfortunately, most adulterers like Edwards go to great lengths to cover up their moral failings and don’t admit to them until they have been caught.

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18 Chapter 1 Ethical Reasoning: Implications for Accounting

The Public Interest in Accounting

Following the disclosure of numerous accounting scandals in the early 2000s at companies such as Enron and WorldCom, the accounting profession and professional bodies turned their attention to examining how to rebuild the public trust and confidence in financial reporting. Stuebs and Wilkinson point out that restoring the accounting profession’s public interest focus is a crucial first step in recapturing the public trust and securing the profession’s future. 45 Copeland believes that in order to regain the trust and respect the profession enjoyed prior to the scandals, the profession must rebuild its reputation on its historical foundation of ethics and integrity. 46

In response to widespread financial statement fraud and the failure of accountants and auditors to meet their professional responsibilities, regulatory bodies have turned their attention to developing ethics education requirements for university accounting students. In the United States, the state boards of accountancy are charged with protecting the public interest in licensing candidates to become CPAs. The National Association of State Boards of Accountancy (NASBA) provides a forum for discussion of the different state board requirements to develop an ideal set of regulations in the Uniform Accountancy Act. In 2009, NASBA revised its Rule 5.2 on education and set an either/or approach that recom- mends either the integration of the course material throughout the undergraduate and/or graduate curriculum or a three-hour stand-alone course in ethics. 47

Even before NASBA’s involvement, in 2003 the Texas legislature reacted to the implosion of Enron and its subsequent bankruptcy that shocked the Houston business community by questioning the Texas State Board of Public Accountancy (TSBPA) about how the CPAs at Andersen failed to see the ethical problems at Enron that led to its financial statement fraud. The board called for a mandated three-unit course in ethics for applicants initially taking the CPA exam, effective July 1, 2005. Rule 511.58 details that the required course “should provide students with a framework of ethical reasoning, professional values and attitudes for exercising professional skepticism, and other behavior that is in the best interest of the public and profession and include the core values of integrity, objectivity, and independence.” 48

Other states requiring a stand-alone ethics course at the time of this writing included California, Colorado, Maryland, New York, and West Virginia. The Colorado Board of Accountancy requires a separate course in accounting ethics beginning July 1, 2015, 49 while the California Board is phasing in that requirement during the 2014–2017 period. 50

The California and Texas requirements provide a broad framework to identify the foun- dation of accounting ethics education. According to the California requirements, “Ethics Study Guidelines” means a program of learning that provides students with a framework of ethical reasoning, professional values and attitudes for exercising professional skepticism, and other behavior that is in the best interest of the investing and consuming public and the profession, and the core values of integrity, objectivity, and independence consistent with International Education Standard 4 (IES 4) of the International Accounting Education Standards Board (IAESB), the International Federation of Accountants Code of Ethics (IFAC Code) and the AICPA Code. 51 These international organizations will be discussed more fully in Chapter 8.

Professional Accounting Associations The accounting profession is a community with values and standards of behavior. These are embodied in the various codes of conduct in the profession. The AICPA is a voluntary association of CPAs with nearly 370,000 members in 128 countries, including CPAs in busi- ness and industry, public accounting, government, education, student affiliates, and interna- tional associates. Other professional associations exist in the United States. The Institute of Management Accountants (IMA), with a membership of more than 60,000, is the worldwide

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Chapter 1 Ethical Reasoning: Implications for Accounting 19

association for accountants and financial professionals working in business. We discuss eth- ics standards of the IMA later in this chapter. The Institute of Internal Auditors (IIA) is an international professional association representing the internal audit profession with 175,000 members. We look at the IIA’s standards in Chapter 3. On an international level, the largest professional accounting association is the Institute of Chartered Accountants [equivalent to CPAs] in England and Wales (ICAEW) that has over 138,000 members worldwide. A truly global professional association is the International Federation of Accountants (IFAC). IFAC is a global professional body dedicated to serve the public interest with 173 members and associate members in 129 countries representing approximately 2.5 million accountants. Standards related to IFAC will be discussed in Chapter 8.

AICPA Code of Conduct Given the broader scope of membership in the AICPA and the fact that state boards of accountancy generally recognize its ethical standards in state board rules of conduct, we emphasize the AICPA Code of Professional Conduct in most of this book. Moreover, the previously discussed ethics education requirement pertains to those students who sit for the CPA exam, so it seems only natural to focus on AICPA rules. The Principles section of the AICPA Code, which mirrors virtues-based principles, are discussed next. We discuss the Rules of Conduct that are the enforceable provisions of the AICPA Code in Chapter 4. Later in this chapter, we explain the IMA Statement of Ethical Professional Practice.

The Principles of the AICPA Code are aspirational statements that form the foundation for the Code’s enforceable rules. The Principles guide members in the performance of their professional responsibilities and call for an unyielding commitment to honor the public trust, even at the sacrifice of personal benefits. While CPAs cannot be legally held to the Principles, they do represent the expectations for CPAs on the part of the public in the performance of professional services. In this regard, the Principles are based on values of the profession and traits of character (virtues) that enable CPAs to meet their obligations to the public.

The Principles include (1) Responsibilities, (2) The Public Interest, (3) Integrity, (4) Objectivity and Independence, (5) Due Care, and (6) Scope and Nature of Services. 52

The umbrella statement in the Code is that the overriding responsibility of CPAs is to exercise sensitive professional and moral judgments in all activities. By linking profes- sional conduct to moral judgment, the AICPA Code recognizes the importance of moral reasoning in meeting professional obligations. That is one reason why we discuss the clas- sic moral philosophies later in the chapter.

The second principle defines the public interest to include “clients, credit grantors, governments, employers, investors, the business and financial community, and others who rely on the objectivity and integrity of CPAs to maintain the orderly functioning of com- merce.” This principle calls for resolving conflicts between these stakeholder groups by recognizing the primacy of a CPA’s responsibility to the public as the way to best serve clients’ and employers’ interests.

Integrity has been discussed already in this chapter. As a principle of CPA conduct, integrity recognizes that the public trust is served by (1) being honest and candid within the constraints of client confidentiality, (2) not subordinating the public trust to personal gain and advantage, (3) observing both the form and spirit of technical and ethical standards, and (4) observing the principles of objectivity and independence and of due care.

Objectivity requires that all CPAs maintain a mental attitude of impartiality and intel- lectual honesty and be free of conflicts of interest in meeting professional responsibilities. Independence applies only to CPAs who provide attestation services (i.e., auditing), not tax and advisory services. The reason lies in the scope and purpose of an audit. When conducting an audit of a client’s financial statements, the CPA gathers evidence to support

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20 Chapter 1 Ethical Reasoning: Implications for Accounting

an opinion on whether the financial statements present fairly, in all material respects, the client’s financial position and the results of operations and cash flows in accordance with GAAP. The audit opinion is relied on by the public (external users), thereby triggering the need to be independent of the client entity to enhance assurances. In tax and advisory engagements, the service is provided primarily for the client (internal user) so that the CPA might become involved in some relationships with the client that might otherwise impair audit independence but do not come into play when providing nonattest services; nonattest services do require objectivity in decision making to protect the public interest.

Independence is required both in fact and in appearance. Because it is difficult to determine independence in fact because it involves identifying a mindset, CPAs should avoid relationships with a client entity that may be seen as impairing objective judgment by a “reasonable” observer. The foundational standard of independence is discussed in the context of the audit function in Chapter 4.

The due care standard (diligence) calls for continued improvement in the level of com- petency and quality of services by (1) performing professional services to the best of one’s abilities, (2) carrying out professional responsibilities with concern for the best interests of those for whom the services are performed, (3) carrying out those responsibilities in accor- dance with the public interest, (4) following relevant technical and ethical standards, and (5) properly planning and supervising engagements. A CPA who undertakes to perform professional services without having the necessarily skills violates the due care standard. The requirement for continuing education to maintain one’s CPA certificate helps meet the due care standard. Most states now require CPAs to complete a specified number of continuing education hours in ethics to maintain their license to practice.

What follows is an example of the importance of the due care standard. Imagine if a CPA were asked to perform an audit of a school district and the CPA never engaged in governmental auditing before and never completed a course of study in governmental auditing. While the CPA or CPA firm may still obtain the necessary skills to perform the audit—for example, by hiring someone with the required skills—the CPA/firm would have a hard time supervising such work without the proper background and knowledge.

The due care standard also relates to the scope and nature of services performed by a CPA. The latter requires that CPAs practice in firms that have in place internal qual- ity control procedures to ensure that services are competently delivered and adequately supervised and that such services are consistent with one’s role as a professional. Also, CPAs should determine, in their individual judgments, whether the scope and nature of other services provided to an audit client would create a conflict of interest in performing an audit for that client.

A high-quality audit features the exercise of professional judgment by the auditor and, importantly, a mindset that includes professional skepticism throughout the planning and performance of the audit. Professional skepticism is an essential attitude that enhances the auditor’s ability to identify and respond to conditions that may indicate possible misstate- ment of the financial statements. It includes a questioning mind and critical assessment of audit evidence. Professional judgment is a critical component of ethical behavior in accounting. The qualities of behavior that enable professional judgment come not only from the profession’s codes of conduct, but also the virtues and ability to reason through ethical conflicts using ethical reasoning methods.

Virtue, Character, and CPA Obligations

Traits of character such as honesty, integrity, and trustworthiness enable a person to act with virtue and apply the moral point of view. Kurt Baier, a well-known moral philoso- pher, discusses the moral point of view as being one that emphasizes practical reason and

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Chapter 1 Ethical Reasoning: Implications for Accounting 21

rational choice. 53 To act ethically means to incorporate ethical values into decision making and to reflect on the rightness or wrongness of alternative courses of action. The ethical val- ues in accounting flow from its professional codes of conduct and include those identified by state boards of accountancy: the core values of integrity, objectivity, and independence; attitudes for exercising professional skepticism; and a framework for ethical reasoning.

Aristotle believed that deliberation (reason and thought) precedes the choice of action and we deliberate about things that are in our power (voluntary) and can be realized by action. The deliberation that leads to the action always concerns choices, not the ends. We take the end for granted—a life of excellence or virtue—and then consider in what manner and by what means it can be realized. In accounting, we might say that the end is to gain the public trust and serve the public interest, and the means to achieve that end is by acting in accordance with the profession’s ethical standards.

Aristotle’s conception of virtue incorporates positive traits of character that enable rea- soned judgments to be made, and in accounting, they support integrity—the inner strength of character to withstand pressures that might otherwise overwhelm and negatively influ- ence their professional judgment. A summary of the virtues is listed in Exhibit 1.4 . 54

Modern Moral Philosophies

The ancient Greeks believed that reason and thought precede the choice of action and that we deliberate about things we can influence with our decisions. In making decisions, most people want to follow laws and rules. However, rules are not always clear, and laws may not cover every situation. Therefore, it is the ethical foundation that we develop and nurture that will determine how we react to unstructured situations that challenge our sense of right and wrong. In the end, we need to rely on moral principles to guide our decision making. However, the ability to reason out ethical conflicts may not be enough to assure ethical deci- sion making occurs in accounting as discussed in Chapters 2 through 5. This is because while we believe that we should behave in accordance with core values, we may wind up deviating from these values that trigger ethical reasoning in accounting because of internal pressures from supervisors and others in top management. In the end, a self-interest motive may prevail over making a decision from an ethical perspective, and unethical behavior may result. This is the moral of the story of Betty Vinson’s role in the WorldCom fraud.

Moral philosophies provide specific principles and rules that we can use to decide what is right or wrong in specific instances. They can help a business decision maker formulate strategies to deal with ethical dilemmas and resolve them in a morally appropriate way. There are many such philosophies, but we limit the discussion to those that are most appli- cable to the study of accounting ethics, including teleology, deontology, justice, and virtue ethics. Our approach focuses on the most basic concepts needed to help you understand the ethical decision making process in business and accounting that we outline in Chapter 2. We do not favor any one of these philosophies because there is no one correct way to

EXHIBIT 1.4 Virtues and Ethical Obligations of CPAs

Aristotle’s Virtues Ethical Standards for CPAs

Trustworthiness, benevolence, altruism Integrity

Honesty, integrity Truthfulness, non-deception

Impartiality, open-mindedness Objectivity, independence

Reliability, dependability, faithfulness Loyalty (confidentiality)

Trustworthiness Due care (competence and prudence)

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22 Chapter 1 Ethical Reasoning: Implications for Accounting

resolve ethical issues in business. Instead, we present them to aid in resolving ethical dilemmas in accounting. Exhibit 1.5 summarizes the basis for making ethical judgments for each of the major moral philosophies. The discussion that follows elaborates on these principles and applies them to a common situation in accounting.

Teleology Recall that telos is the Greek word for “end” or “purpose.” In teleology, an act is considered morally right or acceptable if it produces some desired result such as pleasure, the realiza- tion of self-interest, fame, utility, wealth, and so on. Teleologists assess the moral worth of behavior by looking at its consequences, and thus moral philosophers often refer to these theories as consequentialism. Two important teleological philosophies that typically guide decision making in individual business decisions are egoism and utilitarianism.

Egoism and Enlightened Egoism Egoism defines right or acceptable behavior in terms of its consequences for the individual. Egoists believe that they should make decisions that maximize their own self-interest, which is defined differently by each individual. In other words, the individual should “[d]o the act that promotes the greatest good for oneself.” 55 Many believe that egoistic people and companies are inherently unethical, are short-term-oriented, and will take advantage of others to achieve their goals. Our laissez-faire economic system enables the selfish pursuit of individual profit, so a regulated marketplace is essential to protect the interests of those affected by individual (and corporate) decision making.

There is one form of egoism that emphasizes more of a direct action to bring about the best interests of society. Enlightened egoists take a long-range perspective and allow for the well-being of others because they help achieve some ultimate goal for the decision maker, although their own self-interest remains paramount. For example, enlightened ego- ists may abide by professional codes of ethics, avoid cheating on taxes, and create safe working conditions. They do so not because their actions benefit others, but because they help achieve some ultimate goal for the egoist, such as advancement within the firm. 56

Let’s examine the following example from the perspectives of egoism and enlightened egoism. The date is Friday, January 17, 2014, and the time is 5:00 p.m. It is the last day of fieldwork on an audit, and you are the staff auditor in charge of receivables. You are wrapping up the test of subsequent collections of accounts receivable to determine whether certain receivables that were outstanding on December 31, 2013, and that were not con- firmed by the customer as being outstanding have now been collected. If these receivables have been collected and in amounts equal to the year-end outstanding balances, then you will be confident that the December 31 balance is correct and this aspect of the receivables audit can be relied on. One account receivable for $1 million has not been collected, even though it is 90 days past due. You go to your supervisor and discuss whether to establish an allowance for uncollectibles for part of or for the entire amount. Your supervisor contacts the manager in charge of the audit, who goes to the CFO to discuss the matter. The CFO says in no uncertain terms that you should not record an allowance of any amount. The CFO does not want to reduce earnings below the current level because that will cause the company to fail to meet financial analysts’ estimates of earnings for the year. Your supervi- sor informs you that the firm will go along with the client on this matter, even though the $1 million amount is material. In fact, it is 10 percent of the overall accounts receivable balance on December 31, 2013.

The junior auditor faces a challenge to integrity in this instance. The client is attempting to circumvent GAAP. The ethical obligation of the staff auditor is not to subordinate judg- ment to others, including top management of the firm.

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EXHIBIT 1.5 Ethical Reasoning Method Bases for Making Ethical Judgments

Teleology Deontology Justice Virtue Ethics


Enlightened Egoism Utilitarianism Rights Theory


Ethical Judgments

Defines “right” behavior by consequences for the decision maker

Considers well-being of others within the scope of deciding on a course of action based on self-interest.

Evaluates consequences of actions (harms and benefits) on stakeholders

Considers “rights” of stakeholders and related duties to them.

Treats people as an end and not merely as a means to an end.

Universality Perspective: Would I want others to act in a similar manner for similar reasons in this situation?

Emphasizes rights, fairness, and equality.

Those with equal claims to justice should be treated equally; those with unequal claims should be treated unequally.

Only method where ethical reasoning methods—“virtues” (internal traits of character)—apply both to the decision maker and the decision

Judgments are made not by applying rules, but by possessing those traits that enable the decision maker to act for the good of others.

Similar to Principles of AICPA Code and IMA Standards.


Evaluate whether the intended action provides the greatest net benefits.


Select the action that conforms to the correct moral rule that produces the greatest net benefits

Problems with Implementation

Fails to consider interests of those affected by the decision

Interests of others are subservient to self-interest.

Can be difficult to assign values to harms and benefits.

Relies on moral absolutes—no exceptions; need to resolve conflicting rights

Can be difficult to determine the criteria to distinguish equal from unequal claims.

Virtues may conflict, requiring choices to be made.


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24 Chapter 1 Ethical Reasoning: Implications for Accounting

If you are an egoist, you might conclude that it is in your best interests to go along with the firm’s position to support the client’s presumed interests. After all, you do not want to lose your job. An enlightened egoist would consider the interests of others, including the investors and creditors, but still might reason that it is in her long-run interests to go along with the firm’s position to support the client because she may not advance within the firm unless she is perceived to be a “team player.”

Utilitarianism Utilitarians follow a relatively straightforward method for deciding the morally correct course of action for any particular situation. First, they identify the various courses of action that they could perform. Second, they determine the utility of the consequences of all possible alternatives and then select the one that results in the greatest net benefit. In other words, they identify all the foreseeable benefits and harms (consequences) that could result from each course of action for those affected by the action would result from each course of action for those affected by the action of the decision maker,, and then choose the course of action that provides the greatest benefits after the costs have been taken into account. 57 Given its emphasis on evaluating the benefits and harms of alternatives on stakeholders, utilitarianism requires that people look beyond self-interest to consider impartially the interest of all persons affected by their actions.

The utilitarian theory was first formulated in the eighteenth century by the English writer Jeremy Bentham (1748–1832) and later refined by John Stuart Mill (1806–1873). Bentham sought an objective basis that would provide a publicly acceptable norm for determining what kinds of laws England should enact. He believed that the most promising way to reach an agreement was to choose the policy that would bring about the greatest net benefits to society once the harms had been taken into account. His motto became “the greatest good for the greatest number.” Over the years, the principle of utilitarianism has been expanded and refined so that today, there are many different variations of the principle. Modern utilitarians often describe benefits and harms in terms of satisfaction of personal preferences or in purely economic terms of monetary benefits over monetary costs. 58

Utilitarians differ in their views about the kind of question we ought to ask ourselves when making an ethical decision. Some believe the proper question is: What effect will my doing this action in this situation have on the general balance of good over evil? If lying would produce the best consequences in a particular situation, we ought to lie. 59 These act-utilitarians examine the specific action itself, rather than the general rules governing the action, to assess whether it will result in the greatest utility. For example, a rule such as “don’t subordinate judgment” would serve only as a general guide for an act-utilitarian. If the overall effect of giving in to the client’s demands brings net utility to all the stakehold- ers, then the rule is set aside.

Rule-utilitarians, on the other hand, claim that we must choose the action that conforms to the general rule that would have the best consequences. For the rule-utilitarian, actions are justified by appealing to rules such as “don’t subordinate judgment.” According to the rule-utilitarian, an action is selected because it is required by the correct moral rules that everyone should follow. The correct moral rules are those that maximize intrinsic value and minimize intrinsic disvalue. For example, a rule such as “don’t deceive” (an element of truthfulness) might be interpreted as requiring the full disclosure of the possibility that the client will not collect on a material, $1 million receivable. A rule-utilitarian might reason that the long-term effects of deceiving the users of financial statements are a breakdown of the trust that exists between the users and preparers and auditors of financial information.

In other words, we must ask ourselves: What effect would everyone’s doing this kind of action (subordination of judgment) have on the general balance of good over evil? So, for

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Chapter 1 Ethical Reasoning: Implications for Accounting 25

example, the rule “to always tell the truth” in general promotes the good of everyone and therefore should always be followed, even if lying would produce the best consequences in certain situations. Notwithstanding differences between act- and rule-utilitarians, most hold to the general principle that morality must depend on balancing the beneficial and harmful consequences of conduct. 60

While utilitarianism is a very popular ethical theory, there are some difficulties in rely- ing on it as a sole method for moral decision making because the utilitarian calculation requires that we assign values to the benefits and harms resulting from our actions. But it is often difficult, if not impossible, to measure and compare the values of certain benefits and costs. Let’s go back to our receivables example. It would be difficult to quantify the possible effects of going along with the client. How can a utilitarian measure the costs to the company of possibly having to write off a potential bad debt after the fact, including possible higher interest rates to borrow money in the future because of a decline in liquid- ity? What is the cost to one’s reputation for failing to disclose an event at a point in time that might have affected the analysis of financial results? On the other hand, how can we measure the benefits to the company of not recording the allowance? Does it mean the stock price will rise and, if so, by how much?

Deontology The term deontology is derived from the Greek word deon, meaning “duty.” Deontology refers to moral philosophies that focus on the rights of individuals and on the intentions associated with a particular behavior, rather than on its consequences. Deontologists believe that moral norms establish the basis for action. Deontology differs from rule-utilitarianism in that the moral norms (or rules) are based on reason, not outcomes. Fundamental to deontological theory is the idea that equal respect must be given to all persons. 61 In other words, individuals have certain inherent rights and I, as the decision maker, have a duty (obligation, commitment, or responsibility) to respect those rights.

Philosophers claim that rights and duties are correlative. That is, my rights establish your duties and my duties correspond to the rights of others. The deontological tradition focuses on duties, which can be thought of as establishing the ethical limits of my behavior. From my perspective, duties are what I owe to others. Other people have certain claims on my behavior; in other words, they have certain rights against me. 62

As with utilitarians, deontologists may be divided into those who focus on moral rules and those who focus on the nature of the acts themselves. In act deontology, principles are or should be applied by individuals to each unique circumstance allowing for some space in deciding the right thing to do. Rule deontologists believe that general moral principles determine the relationship between the basic rights of the individual and a set of rules governing conduct. It is particularly appropriate to the accounting profession, where the Principles of the AICPA Code support the rights of investors and creditors for accurate and reliable financial information and the duty of CPAs to act in accordance with the profes- sion’s rules of conduct. In this book, we adopt the rule deontological perspective when evaluating rights theories as a method of moral reasoning. Rule deontologists believe that conformity to general moral principles based on logic determines ethicalness. Examples include Kant’s categorical imperative, discussed next, and the Golden Rule of the Judeo- Christian tradition: “Do unto others as you would have them do unto you.” Unlike act deontologists, who hold that actions are the proper basis on which to judge morality or ethicalness and treat rules only as guidelines in the decision-making process, rule deontolo- gists argue there are some things we should never do. 63 Similarly, unlike act-utilitarians, rule deontologists argue that some actions would be wrong regardless of utilitarian benefits. For example, rule deontologists would consider it wrong for someone who has no money to steal bread, because it violates the right of the storeowner to gain from his hard work

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26 Chapter 1 Ethical Reasoning: Implications for Accounting

baking and selling the bread. This is the dilemma in the classic novel Les Misérables by Victor Hugo. The main character, Jean Valjean, serves a 19-year sentence at hard labor for stealing a loaf of bread to feed his starving family.

Rights Principles A right is a justified claim on others. For example, if I have a right to freedom, then I have a justified claim to be left alone by others. Turned around, I can say that others have a duty or responsibility to leave me alone. 64 In accounting, because investors and creditors have a right to accurate and complete financial information, I have the duty to ensure that the financial statements “present fairly” the financial position, results of operations, and changes in cash flows.

Formulations of rights theories first appeared in the seventeenth century in writings of Thomas Hobbes and John Locke. One of the most important and influential interpretations of moral rights is based on the work of Immanuel Kant (1724–1804), an eighteenth-century philosopher. Kant maintained that each of us has a worth or dignity that must be respected. This dignity makes it wrong for others to abuse us or to use us against our will. Kant expressed this idea as a moral principle: Humanity must always be treated as an end, not merely as a means. To treat a person as a mere means is to use her to advance one’s own interest. But to treat a person as an end is to respect that person’s dignity by allowing each the freedom to choose for himself. 65

An important contribution of Kantian philosophy is the so-called categorical impera- tive: “Act only according to that maxim by which you can at the same time will that it should become universal law.” 66 The “maxim” of our acts can be thought of as the inten- tion behind our acts. The maxim answers the question: What am I doing, and why? In other words, moral intention is a prerequisite to ethical action, as we discuss more fully in the next chapter.

Kant tells us that we should act only according to those maxims that could be uni- versally accepted and acted on. For example, Kant believed that truth telling could be made a universal law, but lying could not. If we all lied whenever it suited us, rational communication would be impossible. Thus, lying is unethical. Imagine if every company falsified its financial statements. It would be impossible to evaluate the financial results of one company accurately over time and in comparison to other companies. The financial markets might ultimately collapse because reported results were meaningless, or even misleading. This condition of universality, not unlike the Golden Rule, prohibits us from giving our own personal point of view special status over the point of view of others. It is a strong requirement of impartiality and equality for ethics. 67

One problem with deontological theory is that it relies on moral absolutes—absolute principles and absolute conclusions. Kant believed that a moral rule must function without exception. The notions of rights and duties are completely separate from the consequences of one’s actions. This could lead to making decisions that might adhere to one’s moral rights and another’s attendant duties to those rights, but which also produce disastrous consequences for other people. For example, imagine if you were the person hiding Anne Frank and her family in the attic of your home and the Nazis came banging at the door and demanded, “Do you know where the Franks are?” Now, a strict application of rights theory requires that you tell the truth to the Nazi soldiers. However, isn’t this situation one in which an exception to the rule should come into play for humanitarian reasons?

Whenever we are confronted with a moral dilemma, we need to consider whether the action would respect the basic rights of each of the individuals involved. How would the action affect the well-being of those individuals? Would it involve manipulation or deception—either of which would undermine the right to truth that is a crucial personal right? Actions are wrong to the extent that they violate the rights of individuals. 68

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Chapter 1 Ethical Reasoning: Implications for Accounting 27

Sometimes the rights of individuals will come into conflict, and one has to decide which right has priority. There is no clear way to resolve conflicts between rights and the corre- sponding moral duties to respect those rights. One of the most widely discussed cases of this kind is taken from William Styron’s Sophie’s Choice. Sophie and her two children are at a Nazi concentration camp. A guard confronts Sophie and tells her that one of her children will be allowed to live and one will be killed. Sophie must decide which child will be killed. She can prevent the death of either of her children, but only by condemning the other to be killed. The guard makes the situation even more painful for Sophie by telling her that if she chooses neither, then both will be killed. With this added factor, Sophie has a morally compelling reason to choose one of her children. But for each child, Sophie has an equally strong reason to save him or her. Thus, the same moral precept gives rise to conflicting obligations. 69

Now, we do not face such morally excruciating decisions in accounting (thank good- ness). The ultimate obligation of accountants and auditors is to honor the public trust. The public interest obligation that is embedded in the profession’s codes of ethics requires that if a conflict exists between the obligations of a decision maker to others, the deci- sion maker should always decide based on protecting the public’s right (i.e., investors and creditors), such as in the receivables example, to receive accurate and reliable financial information about uncollectibles.

Justice Justice is usually associated with issues of rights, fairness, and equality. A just act respects your rights and treats you fairly. Justice means giving each person what she or he deserves. Justice and fairness are closely related terms that are often used interchangeably, although differences do exist. While justice usually has been used with reference to a standard of rightness, fairness often has been used with regard to an ability to judge without reference to one’s feelings or interests. This is the basis of the objectivity principle in the AICPA Code. When people differ over what they believe should be given, or when decisions have to be made how benefits and burdens should be distributed among a group of people, ques- tions of justice or fairness inevitably arise. These are questions of distributive justice . 70

The most fundamental principle of justice, defined by Aristotle more than 2,000 years ago, is that “equals should be treated equally and unequals unequally.” In other words, indi- viduals should be treated the same unless they differ in ways that are relevant to the situation in which they are involved. The problem with this interpretation is in determining which criteria are morally relevant to distinguish between those who are equal and those who are not. It can be a difficult theory to apply in business if, for example, a CEO of a company decides to allocate a larger share of the resources than is warranted (justified) based on the results of operations, to one product line over another to promote that operation because it is judged to have more long-term expansion and income potential. If I am the manager in charge of the operation getting fewer resources but producing equal or better results, then I may believe that my operation has been (I have been) treated unfairly. On the other hand, it could be said that the other manager deserves to receive a larger share of the resources because of the long-term potential of that other product line. That is, the product lines are not equal; the former deserves more resources because of its greater upside potential.

In our discussion of ethical behavior in this and the following chapters, questions of fairness will be tied to making objective judgments. Auditors should render objective judg- ments about the fair presentation of financial results. In this regard, auditors should act as impartial arbiters of the truth, just as judges who make decisions in court cases should. The ethical principle of objectivity requires that such judgments be made impartially, unaf- fected by pressures that may exist to do otherwise. An objective auditor with knowledge about the failure to allow for the uncollectible receivables would not stand idly by and allow the financial statements to be materially misleading.

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28 Chapter 1 Ethical Reasoning: Implications for Accounting

For purposes of future discussions about ethical decision making, we elaborate on the concept of procedural justice. Procedural justice considers the processes and activities that produce a particular outcome. For example, an ethical organization environment should positively influence employees’ attitudes and behaviors toward work-group cohesion. When there is strong employee support for decisions, decision makers, organizations, and outcomes, procedural justice is less important to the individual. In contrast, when employees’ support for decisions, decision makers, and organizations, or outcomes is not very strong, then procedural justice becomes more important. 71 Consider, for example, a potential whistleblower who feels confident about bringing her concerns to top manage- ment because specific procedures are in place to support that person. Unlike the Betty Vinson situation, an environment built on procedural justice supports the whistleblower, who perceives the fairness of procedures used to make decisions.

Virtue Ethics Virtue considerations apply both to the decision maker and to the act under consideration by that party. This is one of the differences between virtue theory and the other moral philosophies that focus on the act. To make an ethical decision, I must internalize the traits of character that make me an ethical (virtuous) person. This philosophy is called virtue ethics, and it posits that what is moral in a given situation is not only what conventional morality or moral rules require but also what a well-intentioned person with a “good” moral character would deem appropriate.

Virtue theorists place less emphasis on learning rules and instead stress the importance of developing good habits of character, such as benevolence. Plato emphasized four vir- tues in particular, which were later called cardinal virtues: wisdom, courage, temperance, and justice. Other important virtues are fortitude, generosity, self-respect, good temper, and sincerity. In addition to advocating good habits of character, virtue theorists hold that we should avoid acquiring bad character traits, or vices, such as cowardice, insensibility, injustice, and vanity. Virtue theory emphasizes moral education because virtuous character traits are developed in one’s youth. Adults, therefore, are responsible for instilling virtues in the young. Virtue characteristics are particularly relevant to the cognitive moral develop- ment models discussed in Chapter 2.

The philosopher Alasdair MacIntyre states that the exercise of virtue requires “a capac- ity to judge and to do the right thing in the right place at the right time in the right way.” Judgment is exercised not through a routinizable application of the rules, but as a function of possessing those dispositions (tendencies) that enables choices to be made about what is good for people and by holding in check desires for something other than what will help achieve this goal. 72

At the heart of the virtue approach to ethics is the idea of “community.” A person’s character traits are not developed in isolation, but within and by the communities to which he belongs, such as the Principles in the AICPA Code that pertain to standards of accept- able behavior in the accounting profession (its community).

MacIntyre relates virtues to the internal rewards of a practice (i.e., the accounting profes- sion). He differentiates between the external rewards of a practice (such as money, fame, and power) and the internal rewards, which relate to the intrinsic value of a particular practice. MacIntyre points out that every practice requires a certain kind of relationship between those who participate in it. The virtues are the standards of excellence (i.e., principles of conduct) that characterize relationships within the practice. To enter into a practice is to accept the authority of those standards, obedience to the rules, and commitment to achieve the internal rewards. Some of the virtues that MacIntyre identifies are truthfulness, trust, justice, courage, and honesty. 73

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Chapter 1 Ethical Reasoning: Implications for Accounting 29

Mintz points out that the accounting profession is a practice with inherent virtues that enable accountants to meet their ethical obligations to clients, employers, the government, and the public at large. For instance, for auditors to render an objective opinion of a client’s financial statements, they must be committed to perform such services without bias and to avoid conflicts of interest. Impartiality is an essential virtue for judges in our judicial system. CPAs render judgments on the fairness of financial statements. Therefore, they should act impartially in carrying out their professional responsibilities. 74

The virtues enable accounting professionals to resolve conflicting duties and loyalties in a morally appropriate way. They provide accountants with the inner strength of charac- ter to withstand pressures that might otherwise overwhelm and negatively influence their professional judgment in a relationship of trust. 75 For example, if your boss, the CFO, pressures you to overlook a material misstatement in financial statements, the virtues of honesty and trustworthiness will lead you to place your obligation to the public, including investors and creditors, ahead of any perceived loyalty obligation to your immediate super- visor or other members of top management (as occurred in the Betty Vinson case). The virtue of integrity enables you to withstand the pressure to look the other way. Now, in the real world, this is easier said than done. You may be tempted to be silent because you fear losing your job. However, the ethical standards of the accounting profession, as depicted in part in Exhibit 1.3 , obligate accountants and auditors to bring these issues to the attention of those in the highest positions in an organization, including the audit committee of the board of directors, as did Cynthia Cooper in the WorldCom fraud.

We realize that for students, it may be difficult to internalize the concept that, when forced into a corner by one’s supervisor to go along with financial wrongdoing, you should stand up for what you know to be right, even if it means losing your job. However, ask yourself the following questions: Do I even want to work for an organization that does not value my professional opinion? If I go along with it this time, might the same demand be made at a later date? Will I begin to slide down that ethical slippery slope where there is no turning back? How much is my reputation for honesty and integrity worth? Would I be proud if others found out what I did (or didn’t do)? To quote the noted Swiss psychologist and psychiatrist, Carl Jung: “You are what you do, not what you say you’ll do.”

Application of Ethical Reasoning in Accounting

In this section, we discuss the application of ethical reasoning in its entirety to a com- mon dilemma faced by internal accountants and auditors. The case deals with the classic example of when pressure is imposed on accountants by top management to ignore mate- rial misstatements in financial statements.

As we have seen, accountants have ethical obligations under the AICPA Code that require them to place the public interest ahead of all other interests, including their own self-interest and that of an employer or client, and to be independent of the client; make decisions objectively; exercise due care in the performance of professional services; and act with integrity. Many internal accountants, such as controllers and CFOs, are CPAs and members of the IMA. The IMA’s Statement of Ethical Professional Practice 76 is presented in Exhibit 1.6 . Other than independence, which is a specific ethical requirement of an external audit, the standards of the IMA are similar to the Principles of Professional Conduct in the AICPA Code. Most important, read through the “Resolution of Ethical Conflict” section, which defines the steps to be taken by members when they are pressured to go along with financial statement improprieties. Specific steps to be taken include discussing matters of concern with the highest levels of the organization, including the audit committee. Recall that Interpretation 102-4 of the AICPA Code contains a similar provision.

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30 Chapter 1 Ethical Reasoning: Implications for Accounting

Members of IMA shall behave ethically. A commitment to ethical professional practice includes overarching principles that express our values, and standards that guide our conduct.

Principles IMA’s overarching ethical principles include: Honesty, Fairness, Objectivity, and Responsibility. Members shall act in accordance with these principles and shall encourage others within their organizations to adhere to them.

Standards A member’s failure to comply with the following standards may result in disciplinary action.

I. Competence Each member has a responsibility to:

1. Maintain an appropriate level of professional expertise by continually developing knowledge and skills. 2. Perform professional duties in accordance with relevant laws, regulations, and technical standards. 3. Provide decision support information and recommendations that are accurate, clear, concise, and timely. 4. Recognize and communicate professional limitations or other constraints that would preclude responsible judgment or

successful performance of an activity.

II. Confidentiality Each member has a responsibility to:

1. Keep information confidential except when disclosure is authorized or legally required. 2. Inform all relevant parties regarding appropriate use of confidential information. Monitor subordinates’ activities to

ensure compliance. 3. Refrain from using confidential information for unethical or illegal advantage.

III. Integrity Each member has a responsibility to:

1. Mitigate actual conflicts of interest, regularly communicate with business associates to avoid apparent conflicts of interest. Advise all parties of any potential conflicts.

2. Refrain from engaging in any conduct that would prejudice carrying out duties ethically. 3. Abstain from engaging in or supporting any activity that might discredit the profession.

IV. Credibility Each member has a responsibility to:

1. Communicate information fairly and objectively. 2. Disclose all relevant information that could reasonably be expected to influence an intended user’s understanding of

the reports, analyses, or recommendations. 3. Disclose delays or deficiencies in information, timeliness, processing, or internal controls in conformance with

organization policy and/or applicable law.

Resolution of Ethical Conduct In applying the Standards of Ethical Professional Practice, you may encounter problems identifying unethical behavior or resolving an ethical conflict. When faced with ethical issues, you should follow your organization’s established policies on the resolution of such conflict. If these policies do not resolve the ethical conflict, you should consider the following courses of action:

1. Discuss the issue with your immediate supervisor except when it appears that the supervisor is involved. In that case, present the issue to the next level. If you cannot achieve a satisfactory resolution, submit the issue to the next management level. If your immediate superior is the chief executive officer or equivalent, the acceptable reviewing authority may be a group such as the audit committee, executive committee, board of directors, board of trustees, or owners. Contact with levels above the immediate superior should be initiated only with your superior’s knowledge, assuming he or she is not involved. Communication of such problems to authorities or individuals not employed or engaged by the organization is not considered appropriate, unless you believe there is a clear violation of the law.

2. Clarify relevant ethical issues by initiating a confidential discussion with an IMA Ethics Counselor or other impartial advisor to obtain a better understanding of possible courses of action.

3. Consult your own attorney as to legal obligations and rights concerning the ethical conflict.

EXHIBIT 1.6 Institute of Management Accountants Statement of Ethical Professional Practice

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Chapter 1 Ethical Reasoning: Implications for Accounting 31

DigitPrint Case Study DigitPrint was formed in March 2013 with the goal of developing an outsource business for high-speed digital printing. The company is small and does not yet have a board of directors. The comparative advantage of the company is that its founder and president, Henry Higgins, owned his own print shop for several years before starting DigitPrint. Higgins recently hired Liza Doolittle to run the start-up business. Wally Wonderful, who holds the Certified Management Accountant (CMA) certification from the IMA, was hired to help set up a computerized system to track incoming purchase orders, sales invoices, cash receipts, and cash payments for the printing business.

DigitPrint received $2 million as venture capital to start the business. The venture capitalists were given an equity share in return. From the beginning, they were concerned about the inability of the management to bring in customer orders and earn profits. In fact, only $200,000 net income had been recorded during the first year. Unfortunately, Wonderful had just discovered that $1 million of accrued expenses had not been recorded at year-end. Had that amount been recorded, the $200,000 net income of DigitPrint would have changed to an $800,000 loss.

Wonderful approached his supervisor, Doolittle, with what he had uncovered. She told him in no uncertain terms that the $1 million of expenses and liabilities could not be recorded, and warned him of the consequences of pursuing the matter any further. The reason was that the venture capitalists might pull out from financing DigitPrint because of the reduction of net income, working capital, and the higher level of liabilities. Wonderful is uncertain whether to inform Higgins. On one hand, he feels a loyalty obligation to go along with Doolittle. On the other hand, he believes he has an ethical obligation to the venture capitalists and other financiers that might help fund company operations.

We provide a brief analysis of ethical reasoning methods based on the following. First, consider the ethical standards of the IMA and evaluate potential actions for Wonderful. Then, use ethical reasoning with reference to the obligations of an accountant to analyze what you think Wonderful should do.

IMA Standards Wonderful is obligated by the competence standard to follow relevant laws, regulations, and technical standards, including GAAP, in reporting financial information. Of particular importance is his obligation to disclose all relevant information, including the accrued expenses, that could reasonably be expected to influence an intended user’s understanding (i.e., venture capitalists) of the financial reports. Doolittle has refused to support his posi- tion and told him in no uncertain terms not to pursue the matter. At this point, Wonderful should follow the Resolution of Ethical Conduct procedures outlined in the IMA Standards and take the matter up the chain of command. Typically, in a public corporation, this would mean to go as far as the audit committee of the board of directors. However, DigitPrint is a small company without a board, so Henry Higgins, the founder and president, is the final authority. If Higgins backs Doolittle’s position of nondisclosure, then Wonderful should seek outside advice from a trusted adviser, including an attorney, to help evaluate legal obligations and rights concerning the ethical conflict. The danger for Wonderful would be if he goes along with the improper accounting for the accrued expenses, the venture capitalists find out about the material misstatement in the financial statements at a later date, and then Wonderful is blamed both by the company and the venture capitalists.

Utilitarianism Wonderful should attempt to identify the harms and benefits of the act of recording the transactions versus not recording them. The consequences of failing to inform the venture capitalists about the accrued expenses are severe, not only for Wonderful but also for

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32 Chapter 1 Ethical Reasoning: Implications for Accounting

DigitPrint. These include a possible lawsuit, investigation by regulators for failing to record the information, and, most important, a loss of reputational capital in the marketplace. The primary benefit to Wonderful is acceptance by his superiors, and he can be secure in the knowledge that he’ll keep his job. Utilitarian values are difficult to assign to each potential act. Still, Wonderful should act in accordance with the moral rule that honesty requires not only truth telling, but disclosing all the information that another party has a need (or right) to know.

Rights Theory The venture capitalists have an ethical right to know about the higher level of payables, lower income, and the effect of the unrecorded transactions on working capital; the com- pany has a duty to the venture capitalists to record the information. Wonderful should take the necessary steps to support such an outcome. The end goal of securing needed financing should not cloud Wonderful’s judgment about the means chosen to accomplish the goal (i.e., nondisclosure). Wonderful should ask whether he believes that others in a similar situation should cover up the existence of $1 million in accrued expenses. Assuming that this is not the case, he shouldn’t act in this way.

Justice In this case, the justice principle is linked to the fairness of the presentation of the financial statements. The omission of the $1 million of unrecorded expenses means that the state- ments would not “present fairly” financial position and results of operations. It violates the rights of the venture capitalists to receive accurate and reliable (fair presentation) financial information. As previously explained, a procedural justice perspective applied to the case means to assess the support for employee decisions on the part of the company. As a new employee, Wonderful needs to understand the corporate culture at DigitPrint.

Virtue Considerations Wonderful is expected to reason through the ethical dilemma and make a decision that is consistent with virtue considerations. The virtue of integrity requires Wonderful to have the courage to withstand the pressure imposed by Doolittle and not subordinate his judgment to hers. Integrity is the virtue that enables Wonderful to act in this way. While he has a loyalty obligation to his employer, it should not override his obligation to the venture capitalists, who expect to receive truthful financial information. A lie by omission is dishonest and inconsistent with the standards of behavior (virtues) in the accounting profession.

What Should Wonderful Do? Wonderful should inform Doolittle that he will take his concerns to Higgins. That may force Doolittle’s hand and cause her to back off from pressuring Wonderful. As presi- dent of the company, Higgins has a right to know about the situation. After all, he hired Doolittle because of her expertise and, presumably, based on certain ethical expectations. Higgins may decide to disclose the matter immediately and cut his losses because this is the right thing to do. On the other hand, if Higgins persists in covering up the matter, then, after seeking outside/legal advice, Wonderful must decide whether to go outside the company. His conscience may move him in this direction. However, the confidentiality standard requires that he not do so unless legally required.

A Message for Students As you can tell from the DigitPrint case, ethical matters in accounting are not easy to resolve. On one hand, the accountant feels an ethical obligation to his employer or the client. On the other hand, the profession has strong codes of ethics that require accoun- tants and auditors to place the public interest ahead of all other interests. Accounting

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Chapter 1 Ethical Reasoning: Implications for Accounting 33

professionals should analyze conflicting situations and evaluate the ethics by considering professional standards and the moral principles discussed in this chapter. A decision should be made after careful consideration of these factors and by applying logical reasoning to resolve the dilemma. Keep in mind that you may be in a position during your career where you feel pressured to remain silent about financial wrongdoing. You might rationalize that you didn’t commit the unethical act, so your hands are clean. That’s not good enough, though, as your ethical obligation to the public and the profession is to do whatever it takes to prevent a fraud from occurring and, if it does, take the necessary steps to correct the matter. Betty Vinson learned this lesson the hard way. We hope that you will internalize the importance of acting ethically and in accordance with the ethical values of the accounting profession, and look at the bigger picture when pressured by a superior to go along with financial wrongdoing. The road is littered with CFO/CPAs who masterminded (or at least directed) financial frauds at companies such as Enron, WorldCom, and Tyco. The result of their trials was a jail sentence for Andy Fastow of 10 years, Scott Sullivan of 5 years, and Mark Swartz of 8 1/3 to 25 years. Most important is they lost their livelihood, as well as the respect of the community. A reputation for trust takes a long time to build, but it can be destroyed in no time at all.

Scope and Organization of the Text

The overriding philosophy of this text is that the ethical obligations of accountants and auditors are best understood in the context of professional responsibilities, including one’s role in the corporate governance system, the requirements of financial reporting, the audit function, obligations to prevent and detect fraud, and legal liabilities. Given the rapid pace of globalization in the business world, we also believe that today’s accounting students should gain an appreciation for ethical issues related to international financial reporting and global ethics standards.

Accounting professionals serve as internal accountants and auditors, external auditors, tax preparers and advisers, and consultants to their clients in a variety of advisory services. The ethics standards of the accounting profession, as defined by the AICPA Code of Professional Conduct and IMA’s Statement of Ethical Professional Practice, provide the foundation for ethical decision making in the performance of professional responsibilities. These are discussed throughout this book. We also look at the Institute of Internal Auditors Code of Ethics (Chapter 3), and the Global Code of Ethics (Chapter 8).

Ethical decision making in accounting is predicated on moral reasoning. In this chapter, we have attempted to introduce the complex philosophical reasoning methods that help to fulfill the ethical obligations of accounting professionals. In Chapter 2, we address theories of moral development and the link to ethical reasoning and professional judgment in accounting. We also introduce a decision-making model that provides a framework for ethical decision making and can be used to help analyze cases presented at the end of each chapter. In Chapter 3, we transition to the culture of an organization and how processes and procedures can help to create and sustain an ethical organization environment, including effective corporate governance systems.

The remainder of this book focuses more directly on accounting ethics. Chapter 4 addresses the rules of professional conduct in the AICPA Code; investigations of the pro- fession leading up to the Sarbanes-Oxley (SOX) Act, which created the Public Accounting Oversight Board; and whistleblowing obligations of accounting professionals under SOX and Dodd-Frank Financial Reform Act, which was signed into law by President Obama on July 21, 2010, in response to the financial meltdown in 2007–2008.

The accounting profession has been investigated by Congress several times over a number of years following disclosures of financial fraud. A common question has been: Where were

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34 Chapter 1 Ethical Reasoning: Implications for Accounting

the auditors? In Chapter 5, we review generally accepted auditing standards (GAAS), the basis for the independent audit and expectations for professional accountants and auditors. Students do not need to have completed an Auditing course to understand this discussion. We also address the important topic of financial statement fraud, including the Fraud Triangle, which describes the elements of fraud and so-called red flags that increase fraud risk.

In Chapter 6, we look at legal liability issues and regulatory requirements building on the discussion of laws that define acceptable behavior in accounting including whistleblowing requirements. The techniques used to manipulate earnings and obscure financial statement items are discussed in the context of earnings management in Chapter 7. Finally, in Chapter 8, we address global ethics considerations related to international financial reporting that have become increasingly more important for U.S. and non-U.S. companies. Recent estimates indicate that many U.S. companies earn 50 percent or more of their revenue from overseas operations, including Intel (85 percent), Dow Chemical (67 percent), IBM (64 percent), McDonald’s (66 percent), General Electric (54 percent), and Ford (51 percent). 77

There are 160 discussion questions, 76 cases, and 6 major cases in the end-of-chapter materials at the back of the book. These cases may be used by your instructor to supple- ment chapter material and for individual and group projects, including in-class case presentations. About one-third of the cases in this book have been taken from the files of the Securities and Exchange Commission (SEC) to give a real-life dimension to the text. Many of them deal with well-known examples of financial statement fraud, both nationally and internationally.

This book covers a variety of areas in financial reporting. Most students will have taken the Intermediate Accounting sequence before using this book, so the financial reporting areas relevant to accounting ethics such as financial statement reporting, GAAP, and infor- mative disclosure already will have been covered.

In most of the cases, we have purposefully kept the materials as brief as possible. The reason for the brevity is we hope that students will focus on the ethical issues and not get too bogged down with numerical calculations.

Concluding Thoughts

Our culture seems to have morphed toward exhibitionist tendencies where people do silly (stupid) things just to get their 15 minutes of fame through a YouTube video and with the promise of their own reality television show. Think about the “balloon boy” incident in October 2009, when the whole world watched a giant balloon fly through the air as a tearful family expressed fears that their six-year-old boy could be inside, all the while knowing the whole thing was staged. Perhaps the height of ridiculousness is the television show Here Comes Honey Boo Boo. This series, which debuted in 2012, follows the travails of a 7-year-old beauty pageant queen, Alana Thompson, aka “Honey Boo Boo,” and her hillbilly family. The show is one of the most popular on cable television— in fact, during the 2012 Republican National Convention, it drew more viewers between 18 and 49 years old than Fox News’s coverage, and during the Democratic Convention a month later, it tied with CNN. Some critics have characterized the show as “offensive,” “outrageous,” and “exploitative,” while others call it “must-see TV.”

When was the last time you picked up a newspaper and read a story about someone doing the right thing because it was the right thing to do? It is rare these days. We seem to read and hear more about pursuing one’s own selfish interests, even to the detriment of others. It might be called the “What’s in it for me?” approach to life. Nothing could be more contrary to leading a life of virtue and, as the ancient Greeks knew, benevolence is an important virtue.

In a classic essay on friendship, Ralph Waldo Emerson said: “The only reward of virtue is virtue; the only way to have a friend is to be one.” 78 In other words, virtue is its own reward, just as we gain friendship in life by being a friend to someone else. In accounting, integrity is its own reward because it builds trust in client relationships and helps honor the public trust that is the foundation of the accounting profession.

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Chapter 1 Ethical Reasoning: Implications for Accounting 35

We want to conclude on a positive note. Heroes in accounting do exist: brave people who have spoken out about irregularities in their organizations, such as Cynthia Cooper from WorldCom, whom we have already discussed. Another such hero is David Walker, who served as comptroller general of the United States and head of the Government Accountability Office from 1998 to 2008. Walker appeared before an appropriations committee of the U.S. Senate in 2008 and spoke out about billions of dollars in waste spent by the U.S. government, including on the Iraqi war effort. Then there was auditor Joseph St. Denis, who spoke out about improper accounting practices at his former company, AIG, which received a $150 billion bailout from the U.S. government during the financial crisis of 2008. All three received the Accounting Exemplar Award from the Public Interest Section of the American Accounting Association and serve as role models in the profession.

Discussion Questions

1. A common ethical dilemma used to distinguish between philosophical reasoning methods is the following. Imagine that you are standing on a footbridge spanning some trolley tracks. You see that a runaway trolley is threatening to kill five people. Standing next to you, in between the oncoming trolley and the five people, is a railway worker wearing a large backpack. You quickly realize that the only way to save the people is to push the man off the bridge and onto the tracks below. The man will die, but the bulk of his body and the pack will stop the trolley from reaching the others. (You quickly understand that you can’t jump yourself because you aren’t large enough to stop the trolley, and there’s no time to put on the man’s backpack.) Legal concerns aside, would it be ethical for you to save the five people by pushing this stranger to his death? Use the deon- tological and teleological methods to reason out what you would do and why.

2. Another ethical dilemma deals with a runaway trolley heading for five railway workers who will be killed if it proceeds on its present course. The only way to save these people is to hit a switch that will turn the trolley onto a side track, where it will run over and kill one worker instead of five. Ignoring legal concerns, would it be ethically acceptable for you to turn the trolley by hitting the switch in order to save five people at the expense of one person? Use the deontological and teleological methods to reason out what you would do and why.

3. The following two statements about virtue were made by noted philosophers/writers:

a. MacIntyre, in his account of Aristotelian virtue, states that integrity is the one trait of char- acter that encompasses all the others. How does integrity relate to, as MacIntrye said, “the wholeness of a human life”?

b. David Starr Jordan (1851–1931), an educator and writer, said, “Wisdom is knowing what to do next; virtue is doing it.” Explain the meaning of this phrase as you see it.

4. a. Do you think it is the same to act in your own self-interest as it is to act in a selfish way? Why or why not?

b. Do you think “enlightened self-interest” is a contradiction in terms, or is it a valid basis for all actions? Evaluate whether our laissez-faire, free-market economic system does (or should) operate under this philosophy.

5. In this chapter, we have discussed the Joe Paterno matter at Penn State. Another situation where a respected individual’s reputation was tarnished by personal decisions is the resignation of former U.S. military general and head of the Central Intelligence Agency (CIA), David Petraeus. On November 9, 2012, Petraeus resigned from the CIA after it was announced he had an extra- marital affair with a biographer, Paula Broadwell, who wrote a glowing book about his life. Petraeus acknowledged that he exercised poor judgment by engaging in the affair. When Federal Bureau of Investigation (FBI) agents investigated the matter because of concerns there may have been security leaks, they discovered a substantial number of classified documents on her computer. Broadwell told investigators that she ended up with the secret military documents after taking them from a government building. No security leaks had been found. In accept- ing Petraeus’s resignation, President Obama praised Petraeus’s leadership during the Iraq and Afghanistan wars and said: “By any measure, through his lifetime of service, David Petraeus has made our country safer and stronger.” Should our evaluation of Petraeus’s lifetime of hard work and Petraeus’s success in his career be tainted by one act having nothing to do with job performance?

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6. One explanation about rights is that “there is a difference between what we have the right to do and what is the right thing to do.” Explain what you think is meant by this statement.

7. Steroid use in baseball is an important societal issue. Many members of society are concerned that their young sons and daughters may be negatively influenced by what apparently has been done at the major league level to gain an advantage and the possibility of severe health problems for young children from continued use of the body mass enhancer now and in the future. Mark McGwire, who broke Roger Maris’s 60-home-run record, initially denied using steroids. He has never come close to the 75 percent positive vote to be in the Hall of Fame. Unfortunately for McGwire, his approval rating has been declining each year since he received 23.7 percent of the vote in 2010 and only 16.9 percent of the sportscasters voted in 2013 to elect him into the Hall. Some believe that Barry Bonds and Roger Clemens, who were the best at what they did, should be listed in the record books with an asterisk after their names and an explanation that their records were established at a time when baseball productivity might have been positively affected by the use of steroids. Some even believe they should be denied entrance to the baseball Hall of Fame altogether. The results for Bonds (36.2 percent) and Clemens (37.6 percent) in their initial year of eligibility (2013) were not close to meeting the 75 percent requirement and that led some to question whether these superstars would ever be voted into the Hall. 79 Evaluate whether Bonds and Clemens should be elected to the Hall of Fame from a situational ethics point of view.

8. Your best friend is from another country. One day after a particularly stimulating lecture on the meaning of ethics by your instructor, you and your friend disagree about whether culture plays a role in ethical behavior. You state that good ethics are good ethics, and it doesn’t matter where you live and work. Your friend tells you that in her country, it is common to pay bribes to gain favor with important people. Comment on both positions from a relativistic ethics point of view. What do you believe and why?

9. Hofstede’s Cultural Dimensions in Exhibit 1.2 indicate that China has a score of only 30 in Uncertainty Avoidance, while the U.S. score is 46. Does this seem counterintuitive to you? Why or why not? Be sure to include an explanation of why China’s score is relatively low compared to the United States

10. a. What is the relationship between the ethical obligation of honesty and truth telling?

b. Is it ever proper to not tell someone something that he or she has an expectation of knowing? If so, describe under what circumstances this might be the case. How does this square with rights theory?

11. Is there a difference between cheating on a math test, lying about your age to purchase a cheaper ticket at a movie theater, and using someone else’s ID to get a drink at a bar?

12. Assume that you have been hired by the head of a tobacco industry group to do a cost–benefit analysis of whether the tobacco firms should disclose that nicotine is addictive. Assume that this is before the federal government required such disclosure on all packages of cigarettes. Explain how you would go about determining what are the potential harms and potential benefits of dis- closing this information voluntarily. Is there any information that you believe cannot be included in the evaluation? What is it? Why can’t you include it? If you could include it, would it affect your recommendation to the head of the industry group? Analyze the situation from a rights per- spective, justice, and virtue theory. How might these considerations affect your recommendation to the head of the industry group?

13. How does virtue theory apply to both the decision maker and the act under consideration by that party? Explain.

14. Distinguish between ethical rights and obligations from the perspective of accountants and auditors.

15. Assume in the DigitPrint case that the venture capitalists do not provide additional financing to the company, even though the accrued expense adjustments have not been made. The company hires an audit firm to conduct an audit of its financial statements to take to a local bank for a loan. The auditors become aware of the unrecorded $1 million in accrued expenses. Liza Doolittle pressures them to delay recording the expenses until after the loan is secured. The auditors do not know whether Henry Higgins is aware of all the facts. Identify the stakeholders in this case. What alternatives are available to the auditors? Use the AICPA Code of Professional Conduct and Josephson’s Six Pillars of Character to evaluate the ethics of the alternative courses of action.

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16. IFAC, the global organization for the accountancy profession dedicated to serving the pub- lic interest, issued IFAC Policy Position Paper #4, titled A Public Interest Framework for the Accountancy Profession, on November 4, 2010 . In that paper, IFAC identifies three criteria for the accounting profession serving the public interest: • Consideration of costs and benefits for society as a whole • Adherence to democratic principles and processes • Respect for cultural and ethical diversity

Review the policy statement and any changes since it was first issued and explain how these three criteria might enable us to assess whether or not (and the degree to which) a policy, action, process, or condition is in the public interest. 80

17. The 2011 National Business Ethics Survey, Workplace Ethics in Transition, issued by the Ethics Resource Center (ERC), reports the following results 81 : • The percentage of employees who witnessed misconduct at work fell to a new low of 45 per-

cent, compared to 49 percent in 2009 and well below the record high of 55 percent in 2007. • Those who reported bad behavior reached a record high of 65 percent, up from 64 percent in

2009 and the record low of 53 percent in 2005. • Retaliation against whistleblowers rose, with 22 percent who reported misconduct saying

they experienced some form of retaliation, compared to 15 percent in 2009 and 12 percent in 2007.

• The percentage of employees who perceived pressure to compromise standards in order to do their jobs climbed 5 points to 13 percent, just shy of the all-time high of 14 percent in 2000.

These results show a declining rate of instances of misconduct in workplace behavior, an increase in reporting it, an increase in retaliation against whistleblowers, and an increase in pres- sure to compromise standards. How should we interpret these somewhat-contradictory findings with respect to corporate culture and ethics in the workplace?

18. In the discussion of loyalty in this chapter, a statement is made that “your ethical obligation is to report what you have observed to your supervisor and let her take the appropriate action.” We point out that you may want to take your concerns to others. The IMA Statement of Ethical Professional Practice includes a confidentiality standard that requires members to “keep infor- mation confidential except when disclosure is authorized or legally required.”

Do you think there are any circumstances when you should go outside the company to report financial wrongdoing? If so, to what person/organization would you go? Why? If not, why would you not take the information outside the company?

19. Assume that a corporate officer or other executive asks you, as the accountant for the company, to omit or leave out certain financial figures from the balance sheet that may paint the business in a bad light to the public and investors. Because the request does not involve a direct manipula- tion of numbers or records, would you agree to go along with the request? What ethical consid- erations exist for you in deciding on a course of action?

20. Sir Walter Scott (1771–1832), the Scottish novelist and poet, wrote: “Oh what a tangled web we weave, when first we practice to deceive.” Comment on what you think Scott meant by this phrase.

Endnotes 1. Freeh, Sporkin, and Sullivan, LLP, Report of the Special Investigative Counsel Regarding the Actions of The Pennsylvania State University Related to the Child Sexual Abuse Committed by Gerald A. Sandusky, July 12, 2012, .

2. Graham Winch, “Witness: I Saw Sandusky Raping Boy in Shower,” June 12, 2012, Available at: . http://www.hlntv .com/article/2012/06/12/witness-i-saw-sandusky-raping-child .

3. Eyder Peralta, “Paterno, Others Slammed In Report For Failing To Protect Sandusky’s Victims,” July 12, 2012, Available at: was-there-a-coverup-report-on-penn-state-scandal-may-tell-us .

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4. Jeffrey Toobin, “Former Penn State President Graham Spanier Speaks,” the New Yorker online, August 22, 2012, Available at: spanier-interview-on-sandusky-scandal.html#ixzz2PQ326lkq .

5. Max H. Bazerman and Ann E. Trebrunsel, Blind Spots: Why We Fail to Do What’s Right and What to Do about It (Princeton, NJ: Princeton University Press, 2011).

6. Steven M. Mintz, “Virtue Ethics and Accounting Education,” Issues in Accounting Education 10, no. 2 (Fall 1995), p. 257.

7. Susan Pulliam and Deborah Solomon, “Ms. Cooper Says No to Her Boss,” The Wall Street Journal, October 30, 2002, p. A1.

8. Lynne W. Jeter, Disconnected: Deceit and Betrayal at WorldCom (Hoboken, NJ: Wiley, 2003). 9. Securities Litigation Watch, Betty Vinson Gets 5 Months in Prison,

securities_litigation_blo/2005/08/betty_vinson_ge.html. 10. Cynthia Cooper, Extraordinary Circumstances (Hoboken, NJ: Wiley, 2008). 11. Teaching Values, The Golden Rule in World Religions,

.html . 12. William J. Prior, Virtue and Knowledge: An Introduction to Ancient Greek Ethics (London:

Routledge, 1991). 13. William H. Shaw and Vincent Barry, Moral Issues in Business (Belmont, CA: Wadsworth

Cengage Learning, 2010), p. 5. 14. James C. Gaa and Linda Thorne, “An Introduction to the Special Issue on Professionalism and

Ethics in Accounting Education,” Issues in Accounting Education 1, no. 1 (February 2004), p. 1. 15. Joseph Fletcher, Situation Ethics: The New Morality (Louisville: KY: Westminster John Knox

Press), 1966. 16. 2012 Report Card on the Ethics of American Youth’s Values and Actions (Los Angeles: Josephson

Institute of Ethics), 17. Eric G. Lambert, Nancy Lynee Hogan, and Shannon M. Barton, “Collegiate Academic

Dishonesty Revisited: What Have They Done, How Often Have They Done It, Who Does It, and Why Do They Do It?” Electronic Journal of Sociology, 2003, vol7.4/lambert_etal.html .

18. Donald L. McCabe and Linda Klebe Treviño, “Individual and Contextual Influences on Academic Dishonesty: A Multicampus Investigation,” Research in Higher Education 38, no. 3, 1997.

19. Paul Edwards, The Encyclopedia of Philosophy, Vol. 3 , edited by Paul Edwards (New York: Macmillan Company and Free Press, 1967).

20. Emily E. LaBeff, Robert E. Clark, Valerie J. Haines, and George M. Diekhoff, “Situational Ethics and College Student Cheating,” Sociological Inquiry 60, no. 2 (May 1990), pp. 190–197.

21. See, for example: Donald L. McCabe, Kenneth D. Butterfield, and Linda Klebe Treviño, “Academic Dishonesty in Graduate Business Programs: Prevalance, Causes, and Proposed Action,” Academy of Management Learning & Education 5 (2006): 294–305.

22. See, for example, Kathy Lund Dean and Jeri Mullins Beggs, “University Professors and Teaching Ethics: Conceptualizations and Expectations, Journal of Management Education, 30, no. 1 (2006), pp. 15–44.

23. McCabe, Butterfield, and Treviño. 24. Raef A. Lawson, “Is Classroom Cheating Related to Business Students’ Propensity to Cheat in

the ‘Real World’?” Journal of Business Ethics, 49, no. 2, (2004), pp. 189–199. 25. Randi L. Sims, “The Relationship between Academic Dishonesty and Unethical Business

Practices,” Journal of Education for Business, 68, no. 12, (1993), pp. 37–50. 26. Geert Hofstede, Culture’s Consequences: International Differences in Work-Related Values

( London: Sage, 1980). 27. Geert Hofstede, Culture’s Consequences: Comparing Values, Behaviours, Institutions, and

Organizations (Thousand Oaks, CA: Sage, 2001), p. 359. 28. Michael Minkov, What Makes Us Different and Similar: A New Interpretation of the World Values

Survey and Other Cross-Cultural Data (Sofia, Bulgaria: Klasika y Stil Publishing House, 2007).

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29. The results are published on a website devoted to Hofstede’s work: www. http://geert-hofstede .com/countries.html .

30. Aristotle, Nicomachean Ethics, trans. W. D. Ross (Oxford, U.K.: Oxford University Press, 1925).

31. Michael Josephson, Making Ethical Decisions, rev. ed. (Los Angeles: Josephson Institute of Ethics, 2002).

32. Alasdair MacIntyre, After Virtue, 2d ed. (Notre Dame, IN: University of Notre Dame Press, 1984). 33. American Institute of Certified Public Accountants (AICPA), AICPA Professional Standards.

Volume 2 as of June 1, 2009, Section 102-4 (New York: AICPA, 2009). 34. Josephson. 35. George Washington, George Washington’s Rules of Civility and Decent Behavior in Company

and Conversation (Bedford, ME: Applewood Books, 1994), p. 9. 36. Washington. 37. Cognitive Sciences Laboratory at Princeton University, WordNet, 38. Martin Luther King Jr., The Peaceful Warrior (New York: Pocket Books, 1968). 39. Josephson. 40. Josephson. 41. Edmund L. Pincoffs, Quandaries and Virtues against Reductivism in Ethics (Lawrence:

University Press of Kansas, 1986). 42. Josephson. 43. Josephson. 44. Rhonda Schwartz, Brian Ross, and Chris Francescani, “Edwards Admits Sexual Affair; Lied as

Presidential Candidate” (Interview with Nightline ), August 8, 2008. 45. Martin Steubs and Brett Wilkinson, “Restoring the Profession’s Public Interest Role,” The CPA

Journal 79, no. 11, (2009) pp. 62–66. 46. James E. Copeland, Jr., “Ethics as an Imperative,” Accounting Horizons 19, no. 1 (2005), pp. 35–43. 47. National Association of State Boards of Accountancy, Uniform Accountancy Act (UAA) Model

Rules Revised (2011), Nashville, TN: NASBA. 48. Texas Administrative Code (2011) Title 22, Part 22, Chapter 511, Subchapter C, §511.58 (c). . 49. Colorado Board of Accountancy (2010) Rules of the Colorado State Board of Accountancy . 50. California Board of Accountancy (2011) SB 773. . 51. SB 773. 52. American Institute of Certified Public Accountants, Code of Professional Conduct at June 1,

2012 (New York: AICPA, 2012); default.aspx .

53. Kurt Baier, The Rational and Moral Order: The Social Roots of Reason and Morality (Oxford, U.K.: Oxford University Press, 1994).

54. Steven M. Mintz, “Virtue Ethics and Accounting Education,” Issues in Accounting Education 10, no. 2 (1995), p. 260.

55. O. C. Ferrell, John Fraedrich, and Linda Ferrell, Business Ethics: Ethical Decision Making and Cases, 9th ed. (Mason, OH: South-Western, Cengage Learning, 2011), p. 157.

56. Ferrell et al., p. 157. 57. Ferrell et al., p. 158. 58. Manuel Velasquez, Claire Andre, Thomas Shanks, and Michael J. Meyer, “Calculating

Consequences: The Utilitarian Approach to Ethics,” Issues in Ethics 2, no. 1 (Winter 1989), .

59. Velasquez et al., 1989. 60. Velasquez et al., 1989. 61. Velasquez et al., 1989

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62. Velasquez et al., 1989. 63. Ferrell et al., pp. 160–161. 64. Manuel Velasquez, Claire Andre, Thomas Shanks, and Michael J. Meyer, “Rights,” Issues in

Ethics 3, no. 1 (Winter 1990), . 65. Velasquez et al., 1990. 66. Immanuel Kant, Foundations of Metaphysics of Morals, trans. Lewis White Beck (New York:

Liberal Arts Press, 1959), p. 39. 67. Velasquez et al., 1990. 68. Velasquez, et al. 1990. 69. William Styron, Sophie’s Choice (London: Chelsea House, 2001). 70. Manuel Velasquez, Claire Andre, Thomas Shanks, and Michael J. Meyer, “Justice and Fairness,”

Issues in Ethics 3, no. 2 (Spring 1990). 71. Ferrell et al., p. 165. 72. MacIntyre, pp. 187–190. 73. MacIntyre, pp. 190–192. 74. Mintz, 1995. 75. Mintz, 1995. 76. IMA—The Association of Accountants and Financial Professionals in Business, IMA Statement

of Ethical Professional Practice, . 77. “Why U.S. Companies Aren’t So American Anymore,” June 30, 2011,

.com/money/blogs/flowchart/2011/06/30/why-us-companies-arent-so-american-anymore . 78. Ralph Waldo Emerson, Essays: First and Second Series (New York: Vintage Paperback, 1990). 79. See: . 80. International Federation of Accountants (IFAC), A Public Interest Framework for the

Accountancy Profession, November 4, 2010, interest-framework-accountancy-profession .

81. Ethics Resource Center (ERC), 2011 National Business Ethics Survey: Workplace Ethics in Transition, .

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Chapter 1 Cases

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42 Chapter 1 Ethical Reasoning: Implications for Accounting

Yes. Cheating occurs at the prestigious Harvard University. In 2012, Harvard forced dozens of students to leave in its largest cheating scandal in memory but the institution would not address assertions that the blame rested partly with a pro- fessor and his teaching assistants. The issue is whether cheat- ing is truly cheating when students collaborate with each other to find the right answer—in a take-home final exam.

Harvard released the results of its investigation into the controversy, in which 125 undergraduates were alleged to have cheated on an exam in May 2012. 1 The university said that more than half of the students were forced to withdraw, a penalty that typically lasts from two to four semesters. Of the remaining cases, about half were put on disciplinary pro- bation—a strong warning that becomes part of a student’s official record. The rest of the students avoided punishment.

In previous years, students thought of Government 1310 as an easy class with optional attendance and frequent col- laboration. But students who took it in spring 2012 said that it had suddenly become quite difficult, with tests that were hard to comprehend, so they sought help from the gradu- ate teaching assistants who ran the class discussion groups, graded assignments, and advised them on interpreting exam questions.

Administrators said that on final-exam questions, some students supplied identical answers (right down to typo- graphical errors in some cases), indicating that they had written them together or plagiarized them. But some stu- dents claimed that the similarities in their answers were due to sharing notes or sitting in on sessions with the same teaching assistants. The instructions on the take-home exam explicitly prohibited collaboration, but many students said they did not think that included talking with teaching assistants.

The first page of the exam contained these instruc- tions: “The exam is completely open book, open note, open Internet, etc. However, in all other regards, this should fall under similar guidelines that apply to in-class exams. More

specifically, students may not discuss the exam with others— this includes resident tutors, writing centers, etc.”

Students complained about confusing questions on the final exam. Due to “some good questions” from students, the instruc- tor clarified three exam questions by email before the due date of the exams.

Students claim to have believed that collaboration was allowed in the course. The course’s instructor and the teach- ing assistants sometimes encouraged collaboration, in fact. The teaching assistants who graded the exams—graduate students graded the exams and ran weekly discussion sessions—varied widely in how they prepared students for the exams, so it was common for students in different sections to share lecture notes and reading materials. During the final exam, some teaching assistants even worked with students to define unfamiliar terms and help them figure out exactly what certain test questions were asking.

Some have questioned whether it is the test’s design, rather than the students’ conduct, that should be criticized. Others place the blame on the teaching assistants who opened the door to collaboration outside of class by their own behav- ior in helping students to understand the questions better.

Answer the following questions about the Harvard cheating scandal.

1. Using Josephson’s Six Pillars of Character, which of the character traits (virtues) apply to the Harvard cheating scandal and how do they apply with respect to the actions of each of the stakeholders in this case?

2. Who is at fault for the cheating scandal? Is it the students, the teaching assistants, the professor, or the institution? Use the concepts of egoism and enlightened egoism to support your answer.

3. From a deontological perspective and the point of view of achieving justice, were anyone’s rights violated by the events of the scandal and outcome of the case? Explain why or why not.

Case 1-1

Harvard Cheating Scandal

1 The facts of this case are taken from Richard Perez- Peña,”Students Disciplined in Harvard Scandal,” February 1, 2013, Available at harvard-forced-dozens-to-leave-in-cheating-scandal.html?_r=0 .

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Chapter 1 Ethical Reasoning: Implications for Accounting 43

Ed Giles and Susan Regas have never been happier than during the past four months since they have been seeing each other. Giles is a 35-year-old CPA and a partner in the medium-sized accounting firm of Saduga & Mihca. Regas is a 25-year-old senior accountant in the same firm. Although it is acceptable for peers to date, the firm does not permit two members of different ranks within the firm to do so. A partner should not date a senior in the firm any more than a senior should date a junior staff accountant. If such dating eventually leads to marriage, then one of the two must resign because of the conflicts of interest. Both Giles and Regas know the firm’s policy on dating, and they have tried to be discreet about their relationship because they don’t want to raise any suspicions.

While most of the staff seem to know about Giles and Regas, it is not common knowledge among the partners that the two of them are dating. Perhaps that is why Regas was assigned to work on the audit of CAA Industries for a sec- ond year, even though Giles is the supervising partner on the engagement.

As the audit progresses, it becomes clear to the junior staff members that Giles and Regas are spending personal time together during the workday. On one occasion, they were observed leaving for lunch together. Regas did not return to the client’s office until three hours later. On another occasion, Regas seemed distracted from her work, and later that day, she received a dozen roses from Giles. A friend of Regas’s who knew about the relationship, Ruth Revilo, became con- cerned when she happened to see the flowers and a card that accompanied them. The card was signed, “Love, Poochie.” Regas had once told Revilo that it was the nickname that Regas gave to Giles.

Revilo pulls Regas aside at the end of the day and says, “We have to talk.” “What is it?” Regas asks. “I know the flowers are from Giles,” Revilo says. “Are you crazy?” “It’s none of your business,” Regas responds. Revilo goes on to explain that others on the audit engage-

ment team are aware of the relationship between the two. Revilo cautions Regas about jeopardizing her future with the firm by getting involved in a serious dating relationship with someone of a higher rank. Regas does not respond to this comment. Instead, she admits to being distracted lately because of an argument that she had with Giles. It all started when Regas had suggested to Giles that it might be best if they did not go out during the workweek because she was having a hard time getting to work on time. Giles was upset at the suggestion and called her ungrateful. He said, “I’ve put everything on the line for you. There’s no turning back for me.” She points out to Revilo that the flowers are Giles’s way

of saying he is sorry for some of the comments he had made about her.

Regas promises to talk to Giles and thanks Revilo for her concern. That same day, Regas telephones Giles and tells him she wants to put aside her personal relationship with him until the CAA audit is complete in two weeks. She suggests that, at the end of the two-week period, they get together and thoroughly examine the possible implications of their contin- ued relationship. Giles reluctantly agrees, but he conditions his acceptance on having a “farewell” dinner at their favorite restaurant. Regas agrees to the dinner.

Giles and Regas have dinner that Saturday night. As luck would have it, the controller of CAA Industries, Mark Sax, is at the restaurant with his wife. Sax is startled when he sees Giles and Regas together. He wonders about the possible seriousness of their relationship, while reflect- ing on the recent progress billings of the accounting firm. Sax believes that the number of hours billed is out of line with work of a similar nature and the fee estimate. He had planned to discuss the matter with Herb Morris, the man- aging partner of the firm. He decides to call Morris on Monday morning.

“Herb, you son of a gun, it’s Mark Sax.” “Mark. How goes the audit?” “That’s why I’m calling,” Sax responds. “Can we meet to discuss a few items?” “Sure,” Morris replies. “Just name the time and place.” “How about first thing tomorrow morning?” asks Sax. “I’ll be in your office at 8:00 a.m.,” says Morris. “Better make it at 7:00 a.m., Herb, before your auditors arrive.” Sax and Morris meet to discuss Sax’s concerns about

seeing Giles and Regas at the restaurant and the possibility that their relationship is negatively affecting audit efficiency. Morris asks whether any other incidents have occurred to make him suspicious about the billings. Sax says that he is only aware of this one instance, although he sensed some apprehension on the part of Regas last week when they dis- cussed why it was taking so long to get the audit recommen- dations for adjusting entries. Morris listens attentively until Sax finishes and then asks him to be patient while he sets up a meeting to discuss the situation with Giles. Morris prom- ises to get back to Sax by the end of the week.

Questions 1. Analyze the behavior of each party from the perspec-

tive of the Six Pillars of Character. Assess the personal responsibility of Ed Giles and Susan Regas for the rela- tionship that developed between them. Who do you think is mostly to blame?

Case 1-2

Giles and Regas

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44 Chapter 1 Ethical Reasoning: Implications for Accounting

2. If Giles were a person of integrity but just happened to have a “weak moment” in starting a relationship with Regas, what do you think he will say when he meets with Herb Morris? Why?

3. Assume that Ed Giles is the biggest “rainmaker” in the firm. What would you do if you were in Herb Morris’s

position when you meet with Giles? In your response, consider how you would resolve the situation in regard to both the completion of the CAA Industries audit and the longer-term issue of the continued employment of Giles and Regas in the accounting firm.

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Chapter 1 Ethical Reasoning: Implications for Accounting 45

Case 1-3

NYC Subway Death: Bystander Effect or Moral Blindness On December 3, 2012, a terrible incident occurred in the New York City subway when Ki-Suck Han was pushed off a subway platform by Naeem Davis. Han was hit and killed by the train, while observers did nothing other than snap photos on their cell phones as Han was struggling to climb back onto the platform before the oncoming train struck him. Davis was arraigned on a second-degree murder charge and held with- out bail in the death of Han.

One of the most controversial aspects of this story is that of R. Umar Abbasi, a freelance photographer for the New York Post, who was waiting for a train when he said he saw a man approach Han at the Times Square station, get into an altercation with him, and push him into the train’s path. He too chose to take pictures of the incident, and the next day, the Post published the photographer’s handiwork: a photo of Han with his head turned toward the approaching train, his arms reaching up but unable to climb off the tracks in time.

Abbasi told NBC’s Today show that he was trying to alert the motorman to what was going on by flashing his cam- era. He said he was shocked that people nearer to the victim didn’t try to help in the 22 seconds before the train struck. “It took me a second to figure out what was happening . . . I saw the lights in the distance. My mind was to alert the train,” Abbasi said. “The people who were standing close to him . . . they could have moved and grabbed him and pulled him up. No one made an effort,” he added.

In a written account Abbasi gave the Post, he said that a crowd took videos and snapped photos on their cell phones after Han’s mangled body was pulled onto the platform. He said that he shoved the onlookers back while a doctor and

another man tried to resuscitate the victim, but Han died in front of them.

Some have attributed the lack of any attempt by those on the subway platform to get involved and go to Han’s aid as the bystander effect. The term bystander effect refers to the phenomenon in which the greater the number of people pres- ent, the less likely people will be to help a person in distress. When an emergency situation occurs, observers are more likely to take action if there are few or no other witnesses. One explanation for the bystander effect is that each individ- ual thinks that others will come to the aid of the threatened person. But when you are alone, either you will help, or no one will.

Questions 1. Do you think the bystander effect was at work in the sub-

way death incident? How might that effect translate to a situation where members of a work group observe finan- cial improprieties committed by one of their group that threatens the organization? In general, do you think that someone would come forward? How might culture play into the action that would be taken?

2. Another explanation for the inaction in the subway inci- dent is a kind of moral blindness, where a person fails to perceive the existence of moral issues in a particular situation. Do you believe moral blindness existed in the incident? Be sure to address the specific moral issues that give rise to your answer.

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46 Chapter 1 Ethical Reasoning: Implications for Accounting

Case 1-4

Lone Star School District Jose and Emily work as auditors for the state of Texas. They have been assigned to the audit of the Lone Star school dis- trict. There have been some problems with audit documenta- tion for the travel and entertainment reimbursement claims of the manager of the school district. The manager knows about the concerns of Jose and Emily, and he approaches them about the matter. The following conversation takes place:

Manager: Listen, I’ve requested the documentation you asked for, but the hotel says it’s no longer in their system.

Jose: Don’t you have the credit card receipt or credit card statement?

Manager: I paid cash. Jose: What about a copy of the hotel bill? Manager: I threw it out. Emily: That’s a problem. We have to document all

your travel and entertainment expenses for the city manager’s office.

Manager: Well, I can’t produce documents that the hotel can’t find. What do you want me to do?

Questions 1. Assume that Jose and Emily are CPAs and members

of the AICPA. What ethical standards in the Code of Professional Conduct should guide them in dealing with the manager’s inability to support travel and entertain- ment expenses?

2. Using Josephson’s Six Pillars of Character as a guide, evaluate the statements and behavior of the manager.

3. a. Assume that Jose and Emily report to Sharon, the manager of the school district audit. Should they inform Sharon of their concerns? Why or why not?

b. Assume that they don’t inform Sharon, but she finds out from another source. What would you do if you were in Sharon’s position?

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Chapter 1 Ethical Reasoning: Implications for Accounting 47

Case 1-5

Reneging on a Promise

Part A

Billy Tushoes recently received an offer to join the account- ing firm of Tick and Check LLP. Billy would prefer to work for Foot and Balance LLP but has not received an offer from the firm the day before he must decide whether to accept the position at Tick and Check. Billy has a friend at Foot and Balance and is thinking about calling her to see if she can find out whether an offer is forthcoming.

Question 1. Should Billy call his friend? Provide reasons why you

think he should or should not. Is there any other action you suggest Billy take prior to deciding on the offer of Tick and Check? Why do you recommend that action?

Part B

Assume that Billy calls his friend at Foot and Balance and she explains the delay is due to the recent merger of Vouch and Trace LLP with Foot and Balance. She tells Billy that

the offer should be forthcoming. However, Billy gets nervous about the situation and decides to accept the offer of Tick and Check. A week later, he receives a phone call from the partner at Foot and Balance who had promised to contact him about the firm’s offer. Billy is offered a position at Foot and Balance at the same salary as Tick and Check. He has one week to decide whether to accept that offer. Billy is not sure what to do. On one hand, he knows it’s wrong to accept an offer and then renege on it. On the other hand, Billy hasn’t signed a contract with Tick and Check, and the offer with Foot and Balance is his clear preference because he has many friends at that firm.

Questions 1. Do you think it is ever right to back out of a promise that you

gave to someone else? If so, under what circumstances? If not, why not?

2. Identify the stakeholders and their interests in this case. 3. Evaluate the alternative courses of action for Billy using

ethical reasoning. What should Billy do? Why?

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48 Chapter 1 Ethical Reasoning: Implications for Accounting

Gloria Hernandez is the controller of a public company. She just completed a meeting with her superior, John Harrison, who is the CFO of the company. Harrison tried to convince Hernandez to go along with his proposal to combine 12 expenditures for repair and maintenance of a plant asset into one amount ($1 million). Each of the expenditures is less than $100,000, the cutoff point for capitalizing expen- ditures as an asset and depreciating it over the useful life. Hernandez asked for time to think about the matter. As the controller and chief accounting officer of the company, Hernandez knows it’s her responsibility to decide how to record the expenditures. She knows that the $1 million amount is material to earnings and the rules in accounting

require expensing of each individual item, not capitaliza- tion. However, she is under a great deal of pressure to go along with capitalization to meet financial analysts’ earnings expectations and provide for a bonus to top management including herself. Her job may be at stake, and she doesn’t want to disappoint her boss.

Questions 1. What would motivate you to speak up and act or to stay

silent? 2. Assume that you were in Gloria Hernandez’s position.

What would you do and why?

Case 1-6

Capitalization versus Expensing

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Chapter 1 Ethical Reasoning: Implications for Accounting 49

Kevin Lowe is depressed. He has been with the CPA firm Stooges LLP for only three months. Yet the partners in charge of the firm—Bo Chambers and his brother, Moe— have asked for a “sit-down.” Here’s how it goes:

“Kevin, we asked to see you because your time reports indicate that it takes you 50 percent longer to complete audit work than your predecessor,” Moe said.

“Well, I am new and still learning on the job,” replied Lowe.

“That’s true,” Bo responded, “but you have to appreciate that we have fixed budgets for these audits. Every hour over the budgeted time costs us money. While we can handle it in the short run, we will have to bill the clients whose audit you work on a larger fee in the future. We don’t want to lose clients as a result.”

“Are you asking me to cut down on the work I do?” Lowe asked.

“We would never compromise the quality of our audit work,” Moe said. “We’re trying to figure out why it takes you so much longer than other staff members.”

At this point, Lowe started to perspire. He wiped his fore- head, took a glass of water, and asked: “Would it be better if I took some of the work home at night and on weekends, com- pleted it, but didn’t charge the firm or the client for my time?”

Bo and Moe were surprised by Kevin’s openness. On one hand, they valued that trait in their employees. On the other hand, they couldn’t answer with a yes. Moe looked at Bo, and then turned to Kevin and said: “It’s up to you to decide how to increase your productivity on audits. As you know, this is an important element of performance evaluation.”

Kevin cringed. Was the handwriting on the wall in terms of his future with the firm?

“I understand what you’re saying,” Kevin said. “I will do better in the future—I promise.”

“Good,” responded Bo and Moe. “Let’s meet 30 days from now and we’ll discuss your progress on the matters we’ve discussed today and your future with the firm.”

Questions 1. Given the facts in the case, evaluate using deontological

and teleological reasoning whether Kevin should take work home and not charge it to the job.

2. What would you do if you were Kevin and why? How would you explain your position to Bo and Moe when you meet in 30 days?

Case 1-7

Eating Time

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50 Chapter 1 Ethical Reasoning: Implications for Accounting

Jackson Daniels graduated from Lynchberg State College two years ago. Since graduating from the college, he has worked in the accounting department of Lynchberg Manufacturing. Daniels was recently asked to prepare a sales budget for the year 2014. He conducted a thorough analysis and came out with projected sales of 250,000 units of product. That repre- sents a 25 percent increase over 2013.

Daniels went to lunch with his best friend, Jonathan Walker, to celebrate the completion of his first solo job. Walker noticed Daniels seemed very distant. He asked what the matter was. Daniels stroked his chin, ran his hand through his bushy, black hair, took another drink of scotch, and looked straight into the eyes of his friend of 20 years. “Jon, I think I made a mistake with the budget.”

“What do you mean?” Walker answered. “You know how we developed a new process to manufac-

ture soaking tanks to keep the ingredients fresh?” “Yes,” Walker answered. “Well, I projected twice the level of sales for that product

than will likely occur.” “Are you sure?” Walker asked. “I checked my numbers. I’m sure. It was just a mistake on

my part,” Daniels replied. “So, what are you going to do about it?” asked Walker. “I think I should report it to Pete. He’s the one who acted

on the numbers to hire additional workers to produce the soaking tanks,” Daniels said.

“Wait a second,” Walker said. “How do you know there won’t be extra demand for the product? You and I both know

demand is a tricky number to project, especially when a new product comes on the market. Why don’t you sit back and wait to see what happens?”

“But what happens if I’m right and the sales numbers were wrong? What happens if the demand does not increase beyond what I now know to be the correct projected level?” Daniels asks.

“Well, you can tell Pete about it at that time. Why raise a red flag now when there may be no need?” Walker states.

As the lunch comes to a conclusion, Walker pulls Daniels aside and says, “Jack, this could mean your job. If I were in your position, I’d protect my own interests first.”

Questions 1. What should an employee do when he or she discovers

that there is an error in a projection? Why do you suggest that action? Would your answer change if the error was not likely to affect other aspects of the operation such as employment? Why or why not?

2. Identify the stakeholders potentially affected by what Daniels decides to do. How might each stakeholder be affected by Daniels’s action and decision? Use ethical reasoning to support your answer.

3. Assume that Daniels is both a CPA and holds the CMA certification granted by the IMA. Use the ethical stan- dards of these two organizations to identify what Daniels should do in this situation.

Case 1-8

A Faulty Budget

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Chapter 1 Ethical Reasoning: Implications for Accounting 51

Cleveland Custom Cabinets is a specialty cabinet manu- facturer for high-end homes in the Cleveland Heights and Shaker Heights areas. The company manufactures cabinets built to the specifications of homeowners and employs 125 custom cabinetmakers and installers. There are 30 adminis- trative and sales staff members working for the company.

James Leroy owns Cleveland Custom Cabinets. His accounting manager is Marcus Sims. Sims manages 15 accountants. The staff is responsible for keeping track of manufacturing costs by job and preparing internal and exter- nal financial reports. The internal reports are used by man- agement for decision making. The external reports are used to support bank loan applications.

The company applies overhead to jobs based on direct labor hours. For 2014, it estimated total overhead to be $9.6 million and 80,000 direct labor hours. The cost of direct materials used during the first quarter of the year is $600,000, and direct labor cost is $400,000 (based on 20,000 hours worked). The com- pany’s accounting system is old and does not provide actual overhead information until about four weeks after the close of a quarter. As a result, the applied overhead amount is used for quarterly reports.

On April 10, 2014, Leroy came into Sims’s office to pick up the quarterly report. He looked at it aghast. Leroy had planned to take the statements to the bank the next day and meet with the vice president to discuss a $1 million expan- sion loan. He knew the bank would be reluctant to grant the loan based on the income numbers in Exhibit 1 .


Net Income for the Quarter Ended March 31, 2014

Sales $6,400,000 Cost of goods sold 4,800,000 Gross margin $1,600,000 Selling and administrative expenses 1,510,000 Net income $ 90,000

Leroy asked Sims to explain how net income could have gone from 14.2 percent of sales for the year ended December 31, 2013, to 1.4 percent for March 31, 2014. Sims pointed out that the estimated overhead cost had doubled for 2014 compared to the actual cost for 2013. He explained to Leroy that rent had doubled and the cost of utilities skyrock- eted. In addition, the custom-making machinery was wearing out more rapidly, so the company’s repair and maintenance costs also doubled from 2013.

Leroy understood but wouldn’t accept Sims’s explana- tion. Instead, he told Sims that as the sole owner of the com- pany, there was no reason not to “tweak” the numbers on a one-time basis. “I own the board of directors, so no worries there. Listen, this is a one-time deal. I won’t ask you to do it again,” Leroy stated. Sims started to soften and asked Leroy just how he expected the tweaking to happen. Leroy flinched, held up his hands, and said, “I’ll leave the creative account- ing to you.”

Questions 1. Do you agree with Leroy’s statement that it doesn’t matter

what the numbers look like because he is the sole owner? Even if it is true that Sims “owns” the board of directors, what should be their role in this matter?

2. a. Assume that Sims is a CPA and holds the CMA. What are the ethical considerations for him in deciding whether to tweak the numbers? What should Sims do and why?

b. Assume that Sims did a utilitarian analysis to help de- cide what to do. Evaluate the harms and benefits of alternative courses of action.

3. Assume that Sims decided to reduce the estimated over- head for the year by 50 percent. How would that change the net income for the quarter? What would it be as a percentage of sales? Do you think Leroy would like the result? Do you think he will be content with the tweaking occurring just this one time, or will he be tempted to do it again in the future?

Case 1-9

Cleveland Custom Cabinets

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52 Chapter 1 Ethical Reasoning: Implications for Accounting

Telecommunications, Inc., is a U.S. company, a global leader in information technology, and it specializes in building data network systems. The company is a major player in the industry, although it is no match for companies like Cisco Systems. Recently, however, it has been more successful in securing contracts to build and support data network sys- tems outside the United States. In one recent competitive bidding situation with companies from two other countries, the Latin American country of Bolumbia awarded Telecom- munications a multimillion-dollar contract to develop a net- work for the corporate community. The job went so well that Telecommunications believes it will have a leg up on other companies in bidding for future contracts.

Telecommunications was the prime contractor on that job. It was responsible for the selection of subcontractors to per- form the work that Telecommunications did not want to do, or when the company believed it was advantageous to use a local contractor. According to the company’s contract with Bolumbia, only Latin American companies could be selected for subcontract work. In a recent competitive bidding selec- tion process, Bolumbia National Communications (BNC), S.A. was chosen to assist in infrastructure connectivity. (S.A., Sociedad Anonima, is the designation for a Spanish com- pany.) BNC wasn’t as well established as other companies such as Telefonica, the Spanish multinational company that operates throughout the Spanish- and Portuguese-speaking world, but it had submitted a bid that met all the specifica- tions of the job, including some that were unusual requests. Telefonica did not include these items in its subcontractor bid.

Ed Keller is employed as an engineer for Tele- communications, Inc. Keller recently graduated with a master’s degree in engineering and joined the company six months ago. Keller had a 3.92 grade point average and could have worked for a variety of engineering firms. He chose Telecommunications because of the opportunity it afforded to travel around the world and as a result of its reputation for quality service and high moral standards.

During lunch at the office one day, Keller was talking to several of the more senior members of the engineering staff of Telecommunications, who told him about their recent trip to Bolumbia. They visited four cities and a resort in one week, and all their expenses were paid for by BNC. Keller knew that BNC had just completed its work on the contract for infrastructure connectivity. Out of curiosity, Keller ques- tioned the engineering staff about the propriety of accepting an all-expenses-paid trip from a major subcontractor. Keller was told that it was common practice for Latin American companies to make gestures of gratitude, such as free travel and entertainment, in certain situations. Keller is told by one of the senior engineers that the culture in Bolumbia is one where the rules are not necessarily followed. Moreover, “There’s nothing wrong with accepting such gratuities.

After all, the offer of free travel was made after the decision to accept the bid of BNC and the completion of the job. We were not responsible for making the selection decision. All we did was to establish the engineering specifications for the job.”

Keller viewed this as an opportunity to learn more about the bidding process, so he approached Sam Jennings, the head of the internal audit department of Telecommunications. Keller grew up with Jennings’s son, and Sam Jennings has been a close friend of the Keller family for many years.

Keller asked Jennings to have lunch with him one day. Jennings was curious about the request because they hadn’t had lunch during the six months that Keller worked for Telecommunications. Keller said he had some questions about reporting expenses on trips that he might be assigned to in the future. Because it was a work-related request and their families go back a long time, Jennings cleared his calendar and agreed to have lunch with Keller.

During the lunch, Keller raised the issue of whether there was a conflict of interest when members of the senior engineering staff, such as those who worked on developing specifications for the BNC job, accept free travel and enter- tainment from a subcontractor. At first, Jennings was furi- ous because Keller had misled him about the purpose of the lunch, but he gave Keller the benefit of the doubt and pro- ceeded to answer the question.

Jennings informed Keller that the relationship between the engineers in question and BNC, and whether there was any inappropriate influence one way or the other, had been examined because of the company’s concern about a pos- sible violation of the Foreign Corrupt Practices Act (FCPA). Jennings went on to explain that the act prohibits U.S. multi- nationals or their agents from making payments that improp- erly influence government officials in another country, or their representatives, in the normal course of carrying out their responsibilities. Jennings told Keller that no evidence existed that the awarding of the contract was a prepayment for the promise of later free travel and entertainment, as Keller had expected. Moreover, explained Jennings, the deci- sion to accept the BNC bid was made by Richard Kimble, the engineering division manager, and Bob Gerard, the vice pres- ident for engineering, and neither of them received any free travel or lodging. The fact was, according to Jennings, the rejected bids, while lower than BNC’s, were inadequate and did not meet the specifications of the contract. Only BNC’s proposal could do that.

Keller felt better about the situation after discussing it with Jennings. Still, he wondered about the values of a com- pany that condones accepting free travel and entertainment from a subcontractor, as well as the value system of the engi- neers, who should be beyond reproach in carrying out their responsibilities.

Case 1-10

Telecommunications, Inc.

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Chapter 1 Ethical Reasoning: Implications for Accounting 53

Questions 1. An important issue in conducting business overseas is

whether a company should follow its home country’s ethical standards or those of the host country. The ancient adage “When in Rome, do as the Romans do” is quite instructive on this matter. The argument in favor of behav- ing according to the host country’s socially accepted morals is that it shows respect both to the citizens and the culture of the hosting country in which the business is conducting affairs. Evaluate these statements and the implications for conducting business outside’s one’s home country from an ethical relativistic point of view.

2. Some research into the effects of cultural variables on the application of ethical standards in a given society have shown that people in individualistic cultures tend to be more pervasive in applying their ethical standards to all, while people in collectivistic cultures tend to be more

particularistic, applying differential ethical value stan- dards to members of their in-groups and out-groups. We might conclude based on this research that people from different nations have distinct conceptions of ethical and unethical behavior. Assume that the score on Hofstede’s scale for Individualism in Bolumbia is 13, while in the United States, it is 91; the scores for Uncertainty Avoidance for these countries are 80 and 46, respectively. How might these cultural differences influence your judg- ment whether it is acceptable for the engineers to have accepted the gratuities?

3. Assume that the engineers of Telecommunications did influence the decision-making process by establishing engineering specifications that only BNC could meet. The engineers received free travel and lodging from BNC, but only after the job was completed. Is there anything wrong with this picture? Consider the ethical values of objectiv- ity and integrity in answering the question.

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2 Cognitive Processes and Ethical Decision Making in Accounting


connection with its auditing of Enron’s financial statements, as well as to bring to the attention of Enron’s board of direc- tors concerns about Enron’s internal controls over these related-party transactions.

The possibility of an accounting fraud at Enron was first discussed in an article by two Fortune magazine report- ers, Bethany McLean and Peter Elkind. A few years later, in 2004, they wrote a book, that became the basis for a movie of the same name, titled The Smartest Guys in the Room, 4 in which they criticized Andersen for failing to use the profes- sional skepticism that requires that an auditor approach the audit with a questioning mind and a critical assessment of audit evidence. David Duncan, the lead auditor, had per- sonal relationships with some of Enron’s executives that clouded his judgment, and he was influenced by the size of the fees that Andersen earned from Enron. The firm didn’t seem to care about the conflict of interest because Duncan was able to generate 20 to 25 percent in additional fees each year.

Andersen’s independence was called into question shortly after Enron disclosed that a large portion of the 1997 earnings restatement consisted of adjustments that the auditors had proposed at the end of the 1997 audit but had allowed to go uncorrected. Congressional investiga- tors wanted to know why Andersen tolerated $51 million of known misstatements during a year when Enron reported only $105 million of earnings. Andersen chief executive officer (CEO) Joseph Berardino explained that Enron’s 1997

Ethics Reflection

Arthur Andersen and Enron

One event more than any other that demonstrates the fail- ure of professional judgment and ethical reasoning in the period of accounting frauds of the late 1990s and early 2000s is the relationship between Enron and its auditors, Arthur Andersen LLP. Bazerman and Tenbrunsel characterize it as motivated blindness, a term that describes the common failure of people to notice others’ unethical behavior when seeing that behavior would harm the observer. 1 In 2000, Enron paid Andersen a total of $52 million: $25 million in audit fees and $27 million for consulting services. This amount was enough to make Enron Andersen’s second larg- est account in 2000 and the largest client in the Houston office. Andersen’s judgment was compromised by this rela- tionship and led to moral blindness with respect to Enron’s accounting for so-called special-purpose entities (SPEs)— entities set up by the firm and kept off the balance sheet. Andersen was constantly pressured by Enron to keep the debt accumulated by the SPEs off Enron’s books. When Enron declared bankruptcy, there was $13.1 billion in debt on the company’s books, $18.1 billion on its non-consolidated subsidiaries’ books, and an estimated $20 billion more off the balance sheets. 2 Barbara Toffler points out in Final Accounting, her book about the rise and fall of Andersen, 3 that The Powers Report, named after an Enron director and the head investigator of Enron’s failure, denounced Andersen for failing to fulfill its professional and ethical obligations in

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earnings were artificially low due to several hundred million dollars of nonrecurring expenses and write-offs. The pro- posed adjustments were not material, Berardino testified, because they represented less than 8 percent of “normal- ized” earnings. 5

The Enron-Andersen relationship illustrates how a certi- fied public accounting (CPA) firm can lose sight of its pro- fessional obligations. While examining Enron’s financial statements, the auditors at Andersen knew that diligent application of strict auditing standards required one deci- sion, but that the consequences for the firm were harmful to its own business interests. From an ethical perspective, the accounting firm compromised its professional judg- ment and acted out of egoism, failing to see that the rights of investors and creditors for accurate and reliable informa- tion had been compromised by its actions.

Some Andersen auditors paid a steep price for their ethical failings: their licenses to practice as CPAs in Texas were revoked. David Duncan was charged with failing to

exercise due care and professional skepticism in failing to conduct an audit in accordance with generally accepted auditing standards (GAAS) and acting recklessly in issuing unqualified opinions on the 1998–2000 audits, thus violat- ing Section 10(b) of the Securities and Exchange Act. 6

In this chapter, we explore the process of ethical deci- sion making and how it influences professional judgment. Ethical decision making relies on the ability to make moral judgments using the reasoning methods discussed in Chapter 1. However, the ability to reason ethically does not ensure that ethical action will be taken. The decision maker must follow up ethical intent with ethical action. Think about the following questions as you read this chapter: (1) What is the role of virtue in auditors’ ethical decision making? (2) What would you do if your attitudes and beliefs conflict with your intended behavior? Such conflicts create the problem of cognitive dissonance, which can affect professional judgment and ethical deci- sion making.

Ethics Reflection (Concluded)

Every act is to be judged by the intention of the agent. Unknown

This quote emphasizes one’s intent in making decisions. Moral intent is a critical component of ethical decision making. By internalizing the virtues discussed in the previous chapter and acting in accordance with the principles of the philosophical reasoning methods, an accountant is better equipped to make ethical, professional judgments.

Kohlberg and the Cognitive Development Approach

Cognitive development refers to the thought process followed in one’s moral development. An individual’s ability to make reasoned judgments about moral matters develops in stages. The psychologist Lawrence Kohlberg concluded, on the basis of 20 years of research, that people develop from childhood to adulthood through a sequential and hierarchical series of cognitive stages that characterize the way they think about ethical dilemmas. Moral reasoning processes become more complex and sophisticated with development. Higher stages rely upon cognitive operations that are not available to individuals at lower stages, and higher stages are thought to be “morally better” because they are consistent with philo- sophical theories of justice and rights. 7 Kohlberg’s views on ethical development are help- ful in understanding how individuals may internalize moral standards and, as they become more sophisticated in their use, apply them more critically to resolve ethical conflicts.

Kohlberg developed his theory by using data from studies on how decisions are made by individuals. The example of Heinz and the Drug, given here, illustrates a moral dilemma used by Kohlberg to develop his stage-sequence model.

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56 Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting

Heinz and the Drug In Europe, a woman was near death from a rare type of cancer. There was one drug that the doctors thought might save her. It was a form of radium that a druggist in the same town had recently discovered. The drug was expensive to make, but the druggist was charging 10 times what the drug cost him to make: It cost $200 for the radium and charged $2,000 for a small dose of the drug. The sick woman’s husband, Heinz, went to everyone he knew to borrow the money, but he could get together only about $1,000—half the cost. He told the druggist that his wife was dying and asked him to sell it cheaper or let him pay later. But the druggist said, “No, I discovered the drug and I’m going to make money from it.” Heinz got desperate and broke into the man’s store to steal the drug for his wife.

Should the husband have done that? Was it right or wrong? Most people say that Heinz’s theft was morally justified, but Kohlberg was less concerned about whether they approved or disapproved than with the reasons they gave for their answers. Kohlberg monitored the reasons for judgments given by a group of 75 boys ranging in age from 10 through 16 years and isolated the six stages of moral thought. The boys progressed in reasoning sequentially, with most never reaching the highest stages. He concluded that the universal principle of justice is the highest claim of morality. Kohlberg’s justice orientation has been criticized by Carol Gilligan, a noted psychologist and educator. 8 Gilligan claims that because the stages were derived exclusively from interviews with boys, the stages reflect a decidedly male orientation and they ignore the care-and-response orientation that characterizes female moral judgment. For males, advanced moral thought revolves around rules, rights, and abstract principles. The ideal is formal justice, in which all parties evaluate one another’s claims in an impartial manner. But this conception of morality, Gilligan argues, fails to capture the distinctly female voice on moral matters. Gilligan believes that women need more information before answering the question: Should Heinz steal the drug? Females look for ways of resolving the dilemma where no one—Heinz, his wife, or the druggist—will experience pain. Gilligan sees the hesitation to judge as a laudable quest for nonviolence, an aversion to cruel situations where someone will get hurt. However, much about her theories has been challenged in the literature. For example, Kohlberg considered it a sign of ethical relativism, a waffling that results from trying to please everyone (Stage 3). Moreover, Gilligan’s beliefs seem to imply that men lack a caring response when compared to females. Rest argues that Gilligan has exaggerated the extent of the sex differences found on Kohlberg’s scale. 9

The dilemma of Heinz illustrates the challenge of evaluating the ethics of a decision. Table 2.1 displays three types of responses. 10

Kohlberg considered how the responses were different and what problem-solving strategies underlie the three responses. Response A (Preconventional) presents a rather uncomplicated approach to moral problems. Choices are made based on the wants of the individual decision maker (egoism). Response B (Conventional) also considers the wife’s needs. Here, Heinz is concerned that his actions should be motivated by good inten- tions (i.e., the ends justify the means). In Response C (Postconventional), a societywide

TABLE 2.1 Three Sample Responses to the Heinz Dilemma

A: It really depends on how much Heinz likes his wife and how much risk there is in taking the drug. If he can get the drug in no other way and if he really likes his wife, he’ll have to steal it.

B: I think that a husband would care so much for his wife that he couldn’t just sit around and let her die. He wouldn’t be stealing for his own profit; he’d be doing it to help someone he loves.

C: Regardless of his personal feelings, Heinz has to realize that the druggist is protected by the law. Since no one is above the law, Heinz shouldn’t steal it. If we allowed Heinz to steal, then all society would be in danger of anarchy.

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Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting 57

TABLE 2.2 Kohlberg’s Stages of Moral Development

Level 1—Preconventional

At the preconventional level, the individual is very self-centered. Rules are seen as something external imposed on the self.

Stage 1: Obedience to Rules; Avoidance of Punishment At this stage, what is right is judged by one’s obedience to rules and authority.

Example: A company forbids making payoffs to government or other officials to gain business. Susan, the company’s contract negotiator, might justify refusing the request of a foreign government official to make a payment to gain a contract as being contrary to company rules, or Susan might make the payment if she believes there is little chance of being caught and punished.

Stage 2: Satisfying One’s Own Needs In Stage 2, rules and authority are important only if acting in accordance with them satisfies one’s own needs (egoism).

Example: Here, Susan might make the payment even though it is against company rules if she perceives that such payments are a necessary part of doing business. She views the payment as essential to gain the contract. Susan may believe that competitors are willing to make payments, and that making such payments are part of the culture of the host country. She concludes that if she does not make the payment, it might jeopardize her ability to move up the ladder within the organization and possibly forgo personal rewards of salary increases, bonuses, or both. Because everything is relative, each person is free to pursue her individual interests.

Level 2—Conventional

At the conventional level, the individual becomes aware of the interests of others and one’s duty to society. Personal responsibility becomes an important consideration in decision making.

Stage 3: Fairness to Others In Stage 3, an individual is not only motivated by rules but seeks to do what is in the perceived best interests of others, especially those in a family, peer group, or work organization. There is a commitment to loyalty in the relationship.

Example: Susan wants to be liked by others. She might be reluctant to make the payment but agrees to do so, not because it benefits her interests, but in response to the pressure imposed by her supervisor, who claims that the company will lose a major contract and employees will be fired if she refuses to go along.

Stage 4: Law and Order Stage 4 behavior emphasizes the morality of law and duty to the social order. One’s duty to society, respect for authority, and maintaining the social order become the focus of decision making.

Example: Susan might refuse to make the illegal payment, even though it leads to a loss of jobs in her company (or maybe even the closing of the company itself), because she views it as her duty to do so in the best interests of society. She does not want to violate the law.

Level 3—Postconventional

Principled morality underlies decision making at this level. The individual recognizes that there must be a societywide basis for cooperation. There is an orientation to principles that shape whatever laws and role-systems a society may have.

Stage 5: Social Contract In Stage 5, an individual is motivated by upholding the basic rights, values, and legal contracts of society. That person recognizes in some cases that legal and moral points of view may conflict. To reduce such conflict, individuals at this stage base their decisions on a rational calculation of benefits and harms to society.

Example: Susan might weigh the alternative courses of action by evaluating how each of the groups is affected by her decision to make the payment. For instance, the company might benefit by gaining the contract. Susan might even be rewarded for her action. The employees are more secure in their jobs. The customer in the other country gets what it wants. On the other hand, the company will be in violation of the Foreign Corrupt Practices Act (FCPA), which prohibits payments to foreign government officials. Susan then weighs the consequences of making an illegal payment, including any resulting penalties, against the ability to gain additional business. Susan might conclude that the harms of prosecution, fines, other sanctions, and the loss of one’s reputational capital are greater than the benefits.

perspective is used in decision making. Law is the key in making moral decisions 11 (for example, rule utilitarianism; justice orientation).

The examples in Table 2.2 demonstrate the application of Kohlberg’s model of cogni- tive development to possible decision making in business.


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58 Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting

Stage 6: Universal Ethical Principles Kohlberg was still working on Stage 6 at the time of his death in 1987. He believed that this stage rarely occurred. Still, a person at this stage believes that right and wrong are determined by universal ethical principles that everyone should follow. Stage 6 individuals believe that there are inalienable rights, which are universal in nature and consequence. These rights, laws, and social agreements are valid not because of a particular society’s laws or customs, but because they rest on the premise of universality. Justice and equality are examples of principles that are deemed universal. If a law conflicts with an ethical principle, then an individual should act in accordance with the principle.

An example of such a principle is Immanuel Kant’s categorical imperative, the first formulation of which can be stated as: “Act only according to that maxim [reason for acting] by which you can at the same time will that it would become a universal law.” 12 Kant’s categorical imperative creates an absolute, unconditional requirement that exerts its authority in all circumstances, and is both required and justified as an end in itself.

Example: Susan would go beyond the norms, laws, and authority of groups or individuals. She would disregard pressure from her supervisor or the perceived best interests of the company when deciding what to do. Her action would be guided only by universal ethical principles that would apply to others in a similar situation.

Let’s return to the receivables example in Chapter 1 that applies ethical reasoning to the methods discussed in Exhibit 1.5 (Ethical Reasoning Method Bases for Making Ethical Judgments). In the receivables example, an auditor who reasons at Stage 3 might go along with the demands of a client out of loyalty or because she thinks the company will benefit by such inaction. At Stage 4, the auditor places the needs of society and abiding by the law above all else, so the auditor will insist on recording an allowance for uncollectibles.

An auditor who reasons at Stage 5 would not want to violate the public interest prin- ciple embedded in the profession’s ethical standards, which values the public trust above all else. Investors and creditors have a right to know about the uncertainty surrounding collectibility of the receivables. At Stage 6, the auditor would ask whether she would want other auditors to insist on providing an allowance for the uncollectibles if they were involved in a similar situation. The auditor reasons that the orderly functioning of markets and a level playing field require that financial information should be accurate and reliable, so another auditor should also decide that the allowance needs to be recorded. The applica- tion of virtues such as objectivity and integrity enables her to carry out the ethical action.

Kohlberg’s model suggests that people continue to change their decision priorities over time and with additional education and experience. They may experience a change in val- ues and ethical behavior. 13 In the context of business, an individual’s moral development can be influenced by corporate culture, especially ethics training. 14 Ethics training and education have been shown to improve managers’ moral development. More will be said about corporate culture in Chapter 3.

Universal Sequence Kohlberg maintains that his stage sequence is universal; it is the same in all cultures. This seems to run contrary to Geert Hofstede’s five cultural dimensions discussed in Chapter 1. For example, we might expect those in a highly collectivist-oriented society to exhibit Stage 3 features more than in an individualistic one that reflects Stage 2 behavior.

William Crain addresses whether different cultures socialize their children differently, thereby teaching them different moral beliefs. 15 He points out that Kohlberg’s response has been that different cultures do teach different beliefs, but that his stages refer not to specific beliefs, but to underlying modes of reasoning. We might assume, then, that in a collectivist society, blowing the whistle on a member of a work group would be considered improper because of the “family” orientation, (Stage 3) while in a more individualistic one, it is considered acceptable because it is in the best interests of society (Stage 4). Thus, individuals in different cultures at the same stage-sequence might hold different beliefs about the appropriateness of whistleblowing but still reason the same because from a fairness perspective, it is the right way to behave.

TABLE 2.2 (Continued)

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Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting 59

The Ethical Domain in Accounting and Auditing

The ethical domain for accountants and auditors usually involves four key constituent groups, including (1) the client organization that hires and pays for accounting services; (2) the accounting firm that employs the practitioner, typically represented by the collec- tive interests of the firm’s management; (3) the accounting profession, including various regulatory bodies such as the Securities and Exchange Commission (SEC) and the Public Company Accounting Oversight Board (PCAOB); and (4) the general public, who rely on the attestations and representations of the practitioner and the firm. 16 Responsibilities to each of these groups may conflict. For example, fees are paid by the client organization rather than by the general public, including investors and creditors who are the direct ben- eficiary of the independent auditing services so that the public interest may conflict with client interests.

The accounting profession has instituted mechanisms such as professional standards and codes of conduct (i.e., the AICPA Code and IMA Ethical Standards) to encourage the individual practitioner’s ethical behavior in a way that is consistent with the stated rules and guidelines of the profession. These positive factors work in conjunction with an individual’s attitudes and beliefs and ethical reasoning capacity to influence professional judgment and ethical decision making.

Kohlberg’s theory of ethical development provides a framework that can be used to consider the effects of conflict areas on ethical reasoning in accounting. For example, if an individual accountant is influenced by the firm’s desire to “make the client happy,” then the result may be reasoning at Stage 3. The results of published studies during the 1990s by accounting researchers indicate that CPAs reason primarily at Stages 3 and 4. One possible implication of these results is that a larger percentage of CPAs may be overly influenced by their relationship with peers, superiors, and clients (Stage 3) or by rules (Stage 4). A CPA who is unable to apply the technical accounting standards and rules of conduct critically when these requirements are unclear is likely to be influenced by others in the decision- making process. 17 If an auditor reasons at the post conventional level, then that person may refuse to give in to the pressure applied by the supervisor to overlook the client’s failure to follow GAAP. This is the ethical position to take, although it may go against the culture of the firm to “go along to get along.”

Empirical studies have explored the underlying ethical reasoning processes of accoun- tants and auditors in practice. Findings show that ethical reasoning may be an important determinant of professional judgment, such as the disclosure of sensitive information 18 and auditor independence. 19 Results also show that unethical and dysfunctional audit behavior, such as the underreporting of time on an audit budget, may be systematically related to the auditor’s level of ethical reasoning. 20 In reviewing these and other works, Ponemon and Gabhart conclude that the results imply that ethical reasoning may be an important cognitive characteristic that may affect individual judgment and behavior under a wide array of conditions and events in extant professional practice. 21

Rest’s Four-Component Model of Ethical Decision Making

Cognitive-developmental researchers have attempted to understand the process of ethical decision making. In particular, James Rest asserts that ethical actions are not the outcome of a single, unitary decision process, but result from a combination of various cognitive structures and psychological processes. Rest’s model of ethical action is based on the presumption that an individual’s behavior is related to her level of moral development. Rest built on Kohlberg’s work by developing a four-component model of the ethical decision-making process. The four-component model describes the cognitive processes that individuals use in ethical

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60 Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting

decision making; that is, it depicts how an individual first identifies an ethical dilemma and then continues through to his intention and finally courage to behave ethically. 22

Moral Sensitivity The first step in moral behavior requires that the individual interpret the situation as moral. Absent the ability to recognize that one’s actions affect the welfare of others, it would be virtually impossible to make the most ethical decision when faced with a moral dilemma. For example, let’s assume that you go into a store to order a pizza. You go to the counter and place your order. As you move down to the cashier, you notice a $50 bill in the refrig- erated open area that contains cold sodas, which is just below the counter that spans the distance from the order line to the payment area. You notice that two people are ahead of you at the cashier and wonder whether either of them dropped the money. What would you do? Why?

This is an ethical situation because if you decide to keep the money, someone is $50 poorer. You, of course, are $50 richer. Should you act in your own self-interest? If so, how will you justify it? Will you say to yourself: Finders keepers, losers weepers? Or, will you say: If I had dropped the $50, then I would hope that the money would be returned to me.

Our ability to identify an ethical situation enables us to focus on how alternative courses of action might affect ourselves and others. If we simply acted without reflecting on the ethics of the situation in the store, we probably would have looked around, made sure no one was watching, and then pocketed the money. The important point to remember is that ethics is all about how we act when no one is looking.

Moral Judgment An individual’s ethical cognition of what “ideally” ought to be done to resolve an ethical dilemma is called prescriptive reasoning. 23 The outcome of one’s prescriptive reasoning is his ethical judgment of the ideal solution to an ethical dilemma. Generally, an individual’s prescriptive reasoning reflects his cognitive understanding of an ethical situation as mea- sured by his level of moral development. 24 Once a person is aware of possible lines of action and how people would be affected by the alternatives, a judgment must be made about which course of action is more morally justifiable (which alternative is just or right).

Moral Motivation Moral motivation reflects an individual’s willingness to place ethical values (e.g., honesty, integrity, trustworthiness, caring, and empathy) ahead of nonethical values (e.g., wealth, power, and fame) that relate to self-interest. An individual’s ethical motivation influences her intention to comply or not comply with her ethical judgment in the resolution of an ethical dilemma. In the previous example, if you decide to keep the $50, then enhancing your wealth (self-interest) overtakes the ethical values of honesty and empathy.

Moral Character Individuals do not always behave in accordance with their ethical intention. An individual’s intention to act ethically and her ethical actions may not be aligned because of a lack of ethical character. As previously noted, individuals with strong ethical character will be more likely to carry out their ethical intentions with ethical action than individuals with a weak ethical character because they are better able to withstand any pressures (integrity) to do oth- erwise. Once a moral person has considered the ethics of the alternatives, she must construct an appropriate plan of action, avoid distractions, and maintain the courage to continue.

The four components of Rest’s model are processes that must take place for moral behavior to occur. Rest does not offer the framework as a linear decision-making model, suggesting instead that the components interact through a complicated sequence of “feed-back” and “feed-forward” loops. An individual who demonstrates adequacy in

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Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting 61

one component may not necessarily be adequate in another and moral failure can occur when there is a deficiency in any one component. 25 For example, an individual who has good moral reasoning capacity, a skill that can be developed (Component 2), may fail to perceive an ethical problem because she does not clearly understand how others might feel or react—a lack of empathy (Component 1).

Rest’s Model and Organizational Behavior

Moral sensitivity is particularly important for a person to become aware of ethical issues. Extending moral sensitivity to a corporate setting, Schminke et al. found that a height- ened moral sensitivity in a corporation created a culture that supported ethical action. 26 However, sometimes moral agents in an organization may have to overcome opposition to carrying out the course of action. Johnson points out that this helps explain why there is only a moderate correlation between moral judgment and moral behavior. Many times, deciding does not lead to doing. 27 In other words, how we think we should behave is differ- ent from how we decide to behave. This creates a problem of cognitive dissonance , a term first coined by Leon Festinger in 1956. The inconsistency between our thoughts, beliefs, or attitudes and behavior creates the need to resolve contradictory or conflicting beliefs, values, and perceptions. 28 Tompkins and Lawley point out that:

This dissonance only occurs when we are “attached” to our attitudes or beliefs, i.e., they have emotional significance or consequences for our self-concept or sense of coherence about how the world works. The psychological opposition of irreconcilable ideas (cognitions) held simultaneously by one individual, create[s] a motivated force that [c]ould lead, under proper conditions, to the adjustment of one’s beliefs to fit one’s behavior instead of changing one’s behavior to fit one’s beliefs (the sequence conventionally assumed). 29

The Betty Vinson situation at WorldCom, discussed in Chapter 1, is a case in point about cognitive dissonance. Vinson knew it was wrong to “cook the books.” She felt it in her inner being, but she did not act on those beliefs. Instead, she followed the orders from superiors and later justified her behavior by rationalizing it as a one-time act and demanded by people who knew accounting better than herself

Rest’s model can be applied to the situation faced by Sherron Watkins in the Enron failure. Watkins had come up through the ranks of Andersen to become an audit manager. Later, she joined Enron, one of Andersen’s largest clients, and rose to the position of vice president. Watkins was savvy about accounting issues and was the first person at Enron to point out to top management that the accounting maneuvers conducted over a number of years, up until the time when the company went bankrupt in December 2001, had jeopardized its ability to remain in business. In a now-famous memo to the former chair of the board of directors of Enron, Ken Lay, Watkins commented on the sudden resigna- tion of the company’s CEO, Jeff Skilling, by stating: “Skilling’s departure . . . [will] raise suspicions of accounting improprieties and valuation issues.” Watkins went on to say that she is “incredibly nervous that [Enron] will implode in a wave of accounting scandals.” 30

Watkins clearly identified the ethical issues in the Enron debacle. She was motivated to do the right thing and managed to get the company to review its accounting practices, although to no avail. Still, Watkins put her professional future in jeopardy, both at Enron (somewhat of a moot point at the time) and possibly with other employers. She did not know how her actions would affect her ability to work and earn a living in the future.

It is difficult to hypothesize whether Watkins used proper moral judgment. She seemed to consider the interests of employees at Enron but may have been motivated by self-interest (enlightened egoism). One statement Watkins made in the memo to Lay appears to support this contention: “My eight years of Enron work history will be worth nothing on my resume,

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62 Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting

the business world will consider the past successes as nothing but an elaborate accounting hoax.” Notice how she thinks of herself and does not mention the interests of the thousands of stockholders who lost millions of dollars from a decline in Enron stock and thousands of employees who lost their jobs and most of their retirement money if it had been invested in 401(k) plans that included Enron stock. We don’t mean to be too critical of Watkins; she took an important step that no one else at Enron was willing to take. She became somewhat of an outcast at the company that had blinders on with respect to Enron’s unethical actions.

Watkins’s actions illustrate the difference between blowing the whistle internally and external whistleblowing. Watkins did go to the board chair so that internal whistleblow- ing practices were followed. However, she did not go outside the company (i.e., to the SEC) and disclose what she knew. Had Watkins gone to the SEC with her story on or around August 15, 2001, the day Skilling resigned, instead of or in addition to writing the internal memo to Lay, her actions may have saved thousands of people millions of dollars because the stock price was at $36 on that day, and ultimately, when all the dust settled on December 2, 2001, the stock sold for less than $1 a share. On the other hand, Watkins may have truly believed that Enron was still salvageable if Lay had acted on her concerns, so employees would still have their jobs and the stock price may have recovered. Moreover, the ethical obligation of confidentiality probably weighed heavily on Watkins’s mind, so we can understand why she would have been reluctant to go to the SEC. Nevertheless, her actions can be differentiated from those of Cynthia Cooper at WorldCom who did enlist the aid of the outside auditors—KPMG—to put an end to the fraud.

How does a person develop the courage to withstand pressures that challenge one’s commitment to act in an ethical manner? An important element is to have a supportive environment in the organization. An ethical tone must be set by top management. When an organization attempts to foster an ethical culture, the employees feel that they will be supported if they bring matters of concern out into the open. In this case, employees feel comfortable making decisions consistent with their beliefs rather than making decisions and then altering their beliefs to coincide with their behavior. The notion of creating an ethical organization environment will be explored in the next chapter.

The culture at Enron was to make the deal, regardless of which ethical standards had to be sacrificed,“for the good of the organization.” An amusing story that made the rounds on the Internet was described in a book written by Watkins and Mimi Swartz, titled Power Failure: The Inside Story of the Collapse at Enron. It speaks volumes about what motivated behavior at Enron 31 and deals with how Enron defined capitalism with respect to its activities:

Feudalism: You have two cows. Your lord takes some of the milk. Fascism: You have two cows. The government takes both, hires you to take

care of them, and sells you the milk. Communism: You have two cows. You must take care of them, but the

government takes all the milk. Capitalism: You have two cows. You sell one and buy a bull. Your herd multiplies,

and the economy grows. You sell them and retire on the income. Enron Capitalism: You have two cows. You sell three of them to your publicly listed

company, using letters of credit opened by your brother-in-law at the bank, then execute a debt-equity swap with an option so that you get all four cows back, with a tax exemption for five cows. The milk rights of the six cows are transferred through an intermediary to a Cayman Island company secretly owned by the majority shareholder, who sells the rights to all seven cows to your listed company. The Enron annual report says the company owns eight cows, with an option on one more.

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Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting 63

Professional Judgment in Accounting: Transitioning from Moral Intent to Moral Action

One question that arises from Rest’s model is how to align ethical behavior with ethical intent. The answer is through the exercise of virtue, according to a study conducted by Libby and Thorne. 32 The authors point out that audit failures at companies such as Enron and WorldCom demonstrate that the rules in accounting cannot replace auditors’ profes- sional judgment. Transactions (i.e., special-purpose entities at Enron) can be structured around rules, and rules cannot be made to fit every situation. The rules may be unclear or nonexistent, in which case professional judgment is necessary for decisions to be made in accordance with the values of the profession as embodied in its codes of conduct such as the AICPA Code and IMA Ethical Standards discussed in Chapter 1. Professional judgment requires not only technical competence, but also depends on auditors’ ethics and virtues.

Libby and Thorne surveyed members of the Canadian accounting community with the help of the Canadian Institute of Chartered Accountants (CICA), the equivalent of the AICPA in the United States, to develop a set of virtues important in the practice of auditing. 33 The authors divided the virtues into two categories: intellectual virtues, which indirectly influence an individual’s intentions to exercise professional judgment; and instrumental virtues, which directly influence an individual’s actions. Their results are consistent with the principles and standards of behavior discussed in Chapter 1. The most important intellectual virtues were found to be integrity, truthfulness, independence, objectivity, dependability, being principled, and healthy skepticism. The most important instrumental virtues were diligence (i.e., due care) and being alert, careful, resourceful, consultative, persistence, and courageous. The authors concluded from their study that virtue plays an integral role in both the intention to exercise professional judgment and the exercise of professional judgment, and the necessity of possessing both intellectual and instrumental virtues for auditors. 34

Generally accepted auditing standards (GAAS) require that auditors should obtain “sufficient competent evidential matter . . . through inspection, observation, inquiries, and confirmations to afford a reasonable basis for an opinion regarding the financial state- ments under audit.” 35 That evidence enables an auditor to make judgments that help deter- mine whether the client’s financial statements accurately record, in all material respects, the client’s actual income, financial position, and cash flows. An example of when an auditor might fail to live up to this standard is if she relies extensively on information provided by the client, often in the form of oral representations of management, and fails to obtain sufficient documentary and other evidence from independent sources to verify management’s representations. To carry out her professional responsibilities, the auditor should approach the engagement with a healthy dose of skepticism and objective mindset that supports the intention to do what it takes to gather the evidence necessary to support professional judgment. Such evidence is gathered by being careful and alert to circum- stances that might bring into question the reliability of the evidence and persistent in cases where the client fails to cooperate. According to Gaa, the matter of due professional care concerns what the auditor does and how well she does it. 36

Returning now to Rest’s model, in her seminal paper on the role of virtue on auditors’ ethical decision making, Thorne contends that the model fails to provide a theoretical description of the role of personal characteristics, except for level of moral development, in auditors’ ethical decision processes. Thorne develops a model of individuals’ ethical decision processes that integrates Rest’s components with the basic tenets of virtue ethics theory. Her model relies on virtue-based characteristics, which tend to increase the deci- sion maker’s propensity to exercise sound ethical judgment. Thorne believes that virtue

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64 Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting

theory is similar to the approach advocated by the cognitive-developmental perspective in three ways. First, both perspectives suggest that ethical action is the result of a rational decision-making process. Second, both perspectives are concerned with an individual’s ethical decision-making process. Third, both perspectives acknowledge the critical role of cognition in individuals’ ethical decision making. Figure 2.1 presents Thorne’s integrated model of the ethical decision-making process. 37

Figure 2.1 indicates that moral development and virtue are both required for ethical behavior. In her examination of the model, Armstrong suggests that moral development comprises sensitivity to the moral content of a situation or dilemma and prescriptive rea- soning, or the ability to understand the issues, think them through, and arrive at an ethical judgment. Similarly, virtue comprises ethical motivation, which describes an individual’s willingness to place the interests of others ahead of her own interest; and ethical character, which leads to ethical behavior. 38

The best way to explain how virtue-based ethical reasoning and ethical decision making should take place is through an example. The following case is a real-life example of how a government auditor acted on her beliefs in the face of strong resistance from her superiors, including retaliation for her actions.

Diem-Thi Le and Whistleblowing at the DCCA Diem-Thi Le is a senior auditor with the Defense Contract Audit Agency (DCCA) and CPA in the state of California. On September 10, 2008, Le testified before the U.S. Senate Committee on Homeland Security and Governmental Affairs that an audit opinion she had developed on the audit of a contractor receiving funds from the U.S. government had been changed by a branch manager at the DCCA without her knowledge or approval. So begins the story of Le, who was responsible for a ruling by the U.S. Office of the Special Counsel that the DCCA violated the Whistleblower Protection Act when it retaliated against Le for blowing the whistle on fraudulent practices. Le’s experiences and how she dealt with them stand as an example of moral reasoning and ethical action under fire. She knew that she had to do everything possible to change the culture at DCCA, which sanctioned manipulated audits by supervisors without consideration of the facts (and sometimes in response to pressure from federal procurement officials and the contractors themselves), potentially costing taxpayers millions of dollars. Here is a summary of the facts of the case as Le described them to the committee. 39

Ethical Intention

Ethical Behavior


Prescriptive Reasoning

Ethical Motivation

Ethical Character


Moral Virtue


Instrumental Virtue

Identification of Dilemma

Ethical Judgment

Moral Development


FIGURE 2.1 Thorne’s Integrated Model of Ethical Decision Making 1

1 Linda Thorne, “The Role of Virtue in Auditors’ Ethical Decision Making: An Integration of Cognitive-Developmental and Virtue Ethics Perspectives,” Research on Accounting Ethics, no. 4 (1998), pp. 291–308.

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Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting 65

In September 2005, Le was performing an accounting system audit at the corporate office of a contractor that was a publicly traded engineering, construction, maintenance, and project management company. She found that the accounting system was inadequate in part, and as a result, the contractor was misallocating and mischarging costs to the government. Le’s supervisor concurred with her audit findings; however, subsequently, the supervisor told Le that their branch manager disagreed with her. Le’s requests to meet with the branch manager to explain her findings were denied. She followed the guidelines given in the agency’s Contract Audit Manual and asked for her supervisor’s approval to elevate the unreconciled difference of audit opinion to the regional audit manager who was the supervisor of her branch manager. She also heard from other senior auditors that her experience was not the first time an audit opinion on a contractor’s inadequate system had been changed by a branch manager.

The regional audit manager told Le that because the branch manager was the one who signed the audit report, her opinion took precedence over Le’s. Essentially, the person performing the audit had no say in the final audit report opinion. Moreover, the regional manager instructed Le’s supervisor to put Le’s working papers in the “superseded work paper folder.” Her supervisor then deleted the audit findings from Le’s working papers and, without performing any additional audit work, represented those changed working papers as Le’s original working papers to support the change in the audit opinion from an inadequate accounting system to an adequate system. Shortly afterward, the audit report was issued, and the contractor accounting system was deemed adequate. Consequently, the contractor did not have to propose or implement any corrective actions to eliminate its accounting system deficiencies, which resulted in misallocating and mischarging costs to the govern- ment contracts. For the calendar year 2006, the contractor reported over $14 billion in revenue, including $2.9 billion in revenue from government business.

Le was skeptical, persistent, consultative, and courageous (instrumental virtues) in her actions. She recognized the importance of standing by her principles and acting with integ- rity (intellectual virtues). To satisfy her curiosity and give her branch manager the benefit of the doubt, she went to the office common drive that contained other audits and reviewed some system audits. She had hoped her experience was an anomaly, but as it turned out, it was not. She discovered a pattern of changing auditors’ opinions by the branch manager, but Le did not know why these branch managers were doing it. She found out the reason after consulting with other supervisory auditors of other offices. By making the contractor systems and related internal controls adequate, less audit risk would be perceived and, consequently, fewer audit hours would be incurred on other audits. Because one of the DCAA’s performance metrics is productivity rate, which measures the hours incurred ver- sus the dollar examined, having fewer audit hours incurred for the same amount of dollars examined would increase the productivity rate. The productivity rate was one of the factors on which a branch manager’s annual performance review was based.

Le told the committee that because of the emphasis on the increase of the productivity rate, DCAA auditors, including her, were pressured by management to perform audits within certain numbers of budgeted hours. Given the change in audit opinions by manage- ment without performing additional audit work or without discussing it with the auditors whose opinions were altered, she concluded that it was a lack of due professional care, at best, and negligent and fraudulent, at worst. She confided with other colleagues about her findings and was told she had no choice but to call the Department of Defense Inspector General (DoD IG) Hotline. She did so in November 2005.

Le said she never imagined that she would call the hotline and make an allegation against her management. She became disillusioned when she found out the complaint was sent back to her own agency for investigation. The independent process of review and determination of action by DoD IG personnel had been compromised. She followed up on

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66 Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting

her complaint several times, and in February 2006, she was told that it might take a long time for someone to work on her case due to limited staff. She then decided to contact the local office of the Defense Criminal Investigative Services (DCIS) and met with a special agent on March 4, 2006. She also found out that her complaint had been referred to DCAA headquarters, and that the referral included specific personal identifying information about her, such as her name and cell phone number, as well as details of the accounting system audit that triggered the hotline complaint. She concluded that her identity as a whistle- blower had not been adequately protected; therefore, she suffered reprisal from DCAA management.

Exhibit 2.1 summarizes Le’s description to the committee of the scope and nature of the retaliation by the DCAA.

Le concluded her testimony by stating that it was her opinion that DCAA manage- ment had become so metric driven that the quality of their audits and independence had suffered. Audits were not dictated by audit risks, but rather by the established budgeted hours and due dates. The pressure to close out audits and to meet the productivity rate was so intense that it often prevented auditors from following their instincts in questioning

• In September 2005, my management overruled my audit findings. In October 2005, I was transferred to another team. In the November 2005 Staff Conference, the regional audit manager stated that if we auditors did not like management’s audit opinion, we should find another job.

• In early July 2006, I was transferred to another team. In late July 2006, my management was interviewed by the DCIS special agent. In October 2006, I found out that I was the only auditor with an “Outstanding” performance rating who did not get a performance award.

• In early April 2007, the Office of Special Counsel (OSC) investigator contacted DCAA Western Region management to inform them of my OSC complaint. Shortly after that hap- pened, my supervisor told me that I should seek mental health counseling because of the stress I was under. She gave me an Employee Assistance Form and asked that I sign it.

• In August 2007, I was given my annual performance evaluation for the period of July 2006 through June 2007. I was downgraded from an “Outstanding” rating to a “Fully Successful” rating (two notches down). Also, my promotion points came down from 78 (out of a maxi- mum of 120) to 58 points. Please note that prior to this job performance evaluation, I had been an outstanding auditor for several years.

• On August 31, 2007, I was given a memorandum signed by my supervisor and prepared by the DCAA headquarters legal counsel. The memo instructed me that I was not allowed to provide any documents generated by a government computer, including emails and job performance evaluations, to any investigative units, including the OSC. Failure to follow those instructions would result in disciplinary actions. Subsequently, I discovered that Section 8 of Appendix A of the DCAA Personnel Management Manual Chapter 50 considers the reprisal against an employee for providing information or disclosures to an inspector general or OSC investigator a violation of the employee’s rights.

• On September 10, 2007, my supervisor advised me to read the 18 USC 641, Theft of Government Property. My supervisor stated that the unauthorized distribution of agency documents is theft, and it does not matter if the purpose is to respond to a hotline or OSC complaint.

• In August 2008, I was given my job performance evaluation for the period of July 2007 through June 2008. I remained at “Fully Successful,” which is one notch above the rating that one would be put on a Performance Improvement Plan (PIP). My promotion points came down to 53.

EXHIBIT 2.1 Summary of Retaliation Against Diem-Thi Le by the DCAA

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Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting 67

the contractor costs, reporting internal control deficiencies, and evaluating any suspected irregular conduct. In the end, contractors were “getting away with murder” because they knew that DCAA was so metric driven. She also pointed out that DCAA management had reduced the number of audit staff and created layers of personnel who did nothing but monitor metrics. She had hoped the culture would change and enable auditors to perform high-quality audits in accordance with generally accepted government auditing standards in order to protect the government’s interest and taxpayers’ money.

After a great deal of agonizing and disappointment with Le’s treatment by the DCAA, and vocal complaints that reached the highest levels of the agency, the Government Accountability Office (GAO) issued its report in July 2008, two years after she had com- plained, and with her career hanging in the balance. It is the GAO’s responsibility to deter- mine whether government entities (i.e., DCAA) are doing what they are supposed to, that funds are being spent for the intended purpose, and that applicable laws and regulations are being complied with. The GAO looked at seven of Le’s cases that had been overruled by her supervisors, as well as three other cases. The GAO report supported Le’s conclu- sions; indeed, it went even further, finding that the DCAA had a climate of cutting corners, rubber-stamping multi-billion-dollar contracts in the name of expediency, and cost-cutting.

As a result of the congressional investigation and GAO report, April Stephenson was removed as head of the DCAA in late October 2009. U.S. Army Auditor General Patrick J. Fitzgerald was chosen by President Barack Obama to take over the embattled agency. The audits were retooled to be less reliant on quantity and more focused on quality. Le got a promotion and was assigned to train auditors. She applied for whistleblower protection from the OSC, which ensured that the Department of Defense changed her employment ratings to the highest level and gave her retroactive performance awards. Correction and disciplinary actions were taken against her supervisors.

In reflecting on the incident in an interview with the Orange County Register, 40 Le admitted to struggling with her conscience for weeks, trying through sleepless nights to get the courage to report the bad audits. She said,” I got to live with myself when I look in the mirror at the end of the day.” She told the interviewer that management viewed her as the enemy, and even sympathetic coworkers were afraid of being associated with her. When [I] walked into the break room, everybody walked out.”

The process of ethical decision making in an organization is sometimes fraught with danger, as was the case with Diem-Thi Le. Like Cynthia Cooper’s experience at WorldCom, Le took the ultimate step even though she feared for her job. She knew early on there would be strong push-back by management against her. She was influenced in her actions by professional responsibilities as a CPA, virtue-based reasoning, and a genuine desire to improve the culture at the DCAA. Le’s experience illustrates the difficulty of transitioning from knowing the right thing to do and actually doing it. It demonstrates the process that she followed to convert her moral intention into moral action.

Behavioral Ethics The field of behavioral ethics emphasizes the need to consider how individuals actually make decisions, rather than how they would make decisions in an ideal world. Research in behavioral ethics reveals that our minds have two distinct modes of decision making— “System 1” and “System 2” thinking. 41 Daniel Kahneman, the Nobel Prize–winning behavioral economist, points out that System 1 thinking is our intuitive system of process- ing information: fast, automatic, effortless, and emotional decision processes; on the other hand, “System 2” thinking is slower, conscious, effortful, explicit, and a more reasoned decision process. 42 Many times in our lives, we use System 1 thinking and that is fine. For example, we see an article of clothing in the store. We like it, so we buy it. We act rather instinctively and decide whether we like it rather than whether we should consider other

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68 Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting

options that might better complement our appearance. What follows is an example of using System 1 thinking instead of the more deliberate approach of System 2, and you draw the wrong conclusion as a result. To illustrate, answer the following question: A baseball bat and ball together cost $110. If the bat costs $100 more than the ball, how much does the ball cost? Most people say $10. They decide quickly, without doing the math or thinking through the question. However, it is the wrong answer. The ball actually cost $5, and the bat cost $105.

The broader point of this exercise is to explain how System 1 thinking can lead to snap decisions that make it more difficult to resolve an ethical dilemma in a morally appropriate way. It may occur because you lack important information regarding a decision, fail to notice available information, or face time and cost constraints. You don’t have the time or inclination and fail to see the dangers of deciding too quickly.

Imagine for a moment what would have happened if Diem-Thi Le had used System 1 thinking. She may have concluded from the beginning that it would take too much time and effort to bring the audit opinion changes to top management’s attention, given that in the end, she might be risking her job and entire career. But if she exhibits System 2 thinking, as she did, she considers the consequences of her action for herself and other stakeholders. She weighs the costs and benefits of alternative courses of action. She seeks advice from others who might help clarify issues before deciding. It is a reflective, men- tally challenging process.

Many decisions in business and accounting have ethical challenges. This is because of the impacts of those decisions and the fact that outcomes are likely to affect stakeholders in different ways and will express different ethical values. A decision-making model built on System 2 thinking can provide a more systematic analysis that enables comprehensible judgment, clearer reasons, and a more justifiable and defensible action than otherwise would have been the case. An important part of a decision-making model is to address the professional values, behaviors, and attitudes discussed in Chapter 1 and use the ethical reasoning methods to judge the alternative courses of action. In the end, however, it is the virtues that will bridge the gap between moral judgment and ethical behavior. Virtue- based decision making is a reflective process that relies on deliberation and reason to think through conflict situations and it provides the courage (i.e., integrity) to carry through with ethical action. Diem-Thi Le is a virtuous person. She struggled with her dilemma, thought through alternative courses of action, and withstood pressures to accept management’s decision to change her audit opinion.

Ethical Decision-Making Model

A variety of ethical decision-making models exist, including the philosophical approach that combines the principles of utilitarianism, rights, and justice and states the principles in terms of questions. By answering these six questions, it should be possible to reach a decision. 43

1. What benefits and harms will each course of action produce? 2. Which course of action will produce the greatest overall benefit for all stakeholders? 3. What are the rights of stakeholders? 4. Which course of action respects the rights of individuals? 5. Which course of action treats people fairly and equally? 6. Which course of action results in a fair distribution of benefits and burdens?

Virtue is not specifically recognized in the philosophical model, although it is implied by the considerations. It would be difficult to answer these questions in a morally appropriate

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Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting 69

way without being an honest, trustworthy person in evaluating these considerations and willing to act out of integrity in deciding on the preferred course of action.

One of the first models suggested for accounting ethics education was proposed by Langenderfer and Rockness and adopted by the American Accounting Association in 1989. 44 The model consists of seven steps that broadly identify important considerations in making ethical decisions in accounting.

1. What are the facts? 2. What are the ethical issues? 3. What are the norms, principles, and values? 4. What are the alternative courses of action? 5. What is the best course of action? 6. What are the consequences of each possible course of action? 7. What is the decision?

The appeal of the model is its simplicity. However, this is also a shortcoming, in that it leaves out important considerations such as the basis for determining “norms, principles, and values,” virtue considerations, and reflection. Armstrong criticizes the model because of its reliance on consequences to drive the decision. This utilitarian approach seems to relegate rights to a secondary role. 45 We agree with her criticism.

Reflection can be seen as consciously thinking about and analyzing what one has done (or is doing). A decision-making process can help organize the various elements of ethical reasoning and professional judgment. A good model should be based on the virtues discussed in Chapter 1 that mirrors the obligations of accountants and auditors under the profession’s ethics codes and standards. The model should allow for the use of ethical reasoning to evaluate stakeholder interests, analyze the relevant operational and account- ing issues, and identify alternative courses of action.

We have developed a comprehensive model for students to use when analyzing ethics cases in the book. The model, presented in Exhibit 2.2 , is a tool for ethical analysis. Each step of the model may not be necessary in a given case, but the steps do identify important considerations in evaluating ethical dilemmas in accounting. In order to make the process more workable and to integrate Rest’s model of moral behavior, we also present an abbrevi- ated version of the model below that is used to analyze the Diem-Thi Le conflict at DCAA. The condensed model links to Rest’s framework as follows:

Integrated Ethical Decision-Making Process

1. Identify the ethical and professional issues (ethical sensitivity) • What are the ethical and professional issues in this case (i.e., GAAP and GAAS)? • Who are the stakeholders? • Which ethical standards apply (i.e., AICPA Code Principles, IMA Ethical Standards

and IFAC standards) 2. Identify and evaluate alternative courses of action (ethical judgment)

• What can and cannot be done in resolving the conflict under professional standards? • Which ethical reasoning methods apply to help reason through alternatives (i.e.,

rights theory, utilitarianism, justice, and virtue)? 3. Reflect on the core professional values, ethics, and attitudes to help carry through

with ethical action (ethical intent) • Consider how virtue considerations (i.e., moral virtues: intellectual and instrumental)

motivate ethical actions. • Consider how IES 4 46 standards (i.e., independence, objectivity, integrity, professional

skepticism) motivate ethical actions and behaviors.

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70 Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting

1. Frame the ethical issue. What is the primary ethical issue in this case? For example, in the uncollectibles situation discussed in Chapter 1, the ethical issue was whether the junior auditor should compromise his values and give in to the pressure of the audit manager not to report the estimated uncollectibles of $1 million that is currently unrecorded.

2. Gather all the facts. Specify the relevant facts, including disagreements and other conflict situations. Make a conscious effort to understand the situation and distinguish facts from mere opinion. An ethical judgment made after gathering the relevant facts is a more reasonable ethical judgment than one made without regard for the facts.

3. Identify the stakeholders and obligations. Identify and consider all the people affected by a decision—the stakeholders. These include all of the groups and/or individuals affected by a decision, policy, operation, or the ethics standards of a firm or the accounting profession. Determine the obligations of the decision maker to each of the stakeholder groups.

4. Identify the accounting and auditing issues. Assuming that the case deals with whether the financial reports are accurate and reliable, an important step is to describe the accounting (GAAP) and auditing (GAAS) issues clearly. These might include revenue and expense recognition, asset valuation, disclosures, audit independence, due care, and gathering of sufficient audit evidence to warrant the expression of an opinion. In a tax matter, the principle that helps to establish ethical behavior is to judge a proposed tax position by the “realistic possibility of success” standard, which we will discuss in Chapter 4.

5. Identify the operational issues. Accounting decisions are not made in a vacuum; factors such as reporting responsibilities, the culture of an organization and its own ethics standards, internal controls, and the corporate governance system must be considered to highlight operational problems that should be corrected.

6. Identify the relevant accounting ethics standards involved in the situation. Identify the most important ethical values of the accounting profession that should be considered in evaluating the facts and alternative courses of action. Emphasis must be placed on the profession’s ethical standards (i.e., AICPA Principles and IMA Ethics Standards) because they provide the context within which ethical decision making takes place.

7. List all the possible alternatives that you can or cannot do. Most ethical issues are not black or white—there are shades of gray, and the alternatives should account for that uncertainty. Once you have examined the facts, identified the stakeholders, and described the operational and accounting issues, the next step is to consider the available alternatives. Creativity in identifying options, or “moral imagination,” helps distinguish good people who make ethically responsible decisions from good people who do not.

8. Compare and weigh the alternatives. • Is it legal; i.e., in conformity with SEC laws and Public Company Accounting Oversight

Board (PCAOB) rules? • Is it consistent with professional standards (AICPA Principles, IMA Ethics Standards and

IFAC standards; GAAP and GAAS)? • Is it consistent with in-house rules (firm policies and its own code of ethics)? • Is it right? • What are the potential harms and benefits to the stakeholders? • Is it fair to the stakeholders? • Is it consistent with virtue considerations? This is where the decision maker should form

a professional judgment after evaluating her moral intention and willingness to act in a principled manner, including having the courage to stand by what she knows is the right thing to do.

9. Decide on a course of action. After evaluating the ethics of the alternatives, select the one that best meets the ethical requirements of the situation.

10. Reflect on your decision. Before taking action, think about what you are about to do and why. Double-check the correctness of your proposed action by asking: How would I feel if my decision was made public and I had to defend it? Would I be proud if I had to explain my decision to my spouse or child?

EXHIBIT 2.2 Comprehensive Ethical Decision- Making Model

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Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting 71

4. Take action (ethical behavior) • Decide on a course of action consistent with one’s professional obligations. • How can virtue considerations support turning ethical intent into ethical action? • What steps can I take to strengthen my position and argument?

Application of the Model

The application of the integrated model in the case of Diem-Thi Le at DCAA follows. Our purpose is not to cover every aspect of the case, but to illustrate some of the more important considerations in dealing with the ethical conflict.

1. Ethical and Professional Issues • Inadequacy of accounting system at contractor that misallocated and mischarged

costs to the government • Change of audit opinion by supervisor without consultation—integrity issues • Altered work papers—due professional care issues • Sanctioning of contractor’s inappropriate accounting by top management—

objectivity and independence issues • Use of operating metrics to dictate audit procedures and findings—responsibility

issues • Failure to act in accordance with the public interest

2. Evaluation of Alternatives • Don’t take the matter to higher-ups: Violates laws and regulations; violates

accounting and auditing standards; inconsistent with professional obligations to protect the public interest; violates fiduciary obligation to the public

• Take the matter to higher-ups: Consistent with ethical and professional obligations; utilizes hot-line and whistleblowing procedures in place to protect the public interest; principled decision

• Find another solution: It’s always wise to consider another alternative that might achieve the goal of reversing the altered audit opinion and improve the culture of DCAA, such as enlisting the help of coworkers to bring this matter (i.e., systemwide internal control failure at the agency) that affects other audits and auditors out in the open

3. Reflection • Am I being true to myself and my personal and professional values if I take the

intended action? • Le understood the importance of objective audit decisions and independence from

contractors • Le struggled with her conscience and decided early on that she couldn’t stand idly

by and condone the fraudulent accounting and improper audit changes made by her supervisor

• Le understood her obligations to the public that expects government agencies to use resources efficiently and closely monitor those who do business with the agency

4. Take Action • What do I need to do to get my point across? • Who should I approach? • Can I elicit support from coworkers? • How can I convince higher-ups to support my position?

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72 Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting

Concluding Thoughts

We purposefully kept this chapter short to encourage students to think about the ethical decision- making process, how it might personally benefit them to use elements of it in daily life, and how to apply it to their professional obligations after joining the accounting profession. Ethical decision making requires both the ability to reason through alternative courses of action using moral reasoning methods and virtue in following one’s decisions with ethical behavior. In accounting, ethical decision making is required by the Principles of the AICPA Code of Professional Conduct and Ethical Standards of the IMA.

Ethical dilemmas in accounting occur when the rules are unclear or nonexistent, or rules are in conflict or inconsistent. To make matters worse, pressure may be imposed on accountants and auditors by supervisors to go along with materially false and misleading financial information. The environment of ethical decision making in accounting requires that the accounting professional must overcome those pressures through integrity and do the right thing: that is, make sure that the financial statements are accurate, reliable, and transparent. A decision-making model that integrates ethical judgment with ethical action helps to focus on the critical ethical and professional issues, stakehold- ers affected by alternative courses of action, technical and ethical standards in the profession specific to the dilemma, virtues that enable ethical action to occur, and reflection to consider carefully how best to carry out ethical action with intended ethical behavior.

In this book, we discuss several examples of unethical behavior by accountants and auditors and members of top management from CEOs and CFOs at Enron and WorldCom to financial scam artists like Bernie Madoff and a host of other fraudsters. We purposefully focused on examples of ethical behavior in the first two chapters to demonstrate that you can stand up for what you know is the right thing to do. You can withstand the pressure to compromise your values and ethics. You can follow the lead of Cynthia Cooper at WorldCom and Diem-Thi Le at the DCAA and be respected for your actions by your peers and the accounting profession.

Discussion Questions

The following story applies to questions 1 and 2: On October 15, 2009, in Fort Collins, Colorado, the parents of a six-year-old boy, Falcon Henne,

claimed that he had floated away in a homemade helium balloon that was shaped to resemble a sil- ver flying saucer. Some in the media referred to the incident as “Balloon Boy.” The authorities had closed down Denver International Airport, called in the National Guard, and a police pursuit ensued. After an hour-long flight that covered more than 50 miles across three counties, the empty balloon was found near the airport. It was later determined that the boy was hiding in the house all along in an incident that was a hoax and motivated by publicity that might lead to a reality television show. The authorities blamed the father, Richard, for the incident and decided to prosecute him. Richard Heene pleaded guilty on November 13, 2009, to the felony count of falsely influencing authorities. He pled to protect his wife, Mayumi, a Japanese citizen, who he believed may have been deported if Richard was convicted of a more serious crime. Richard also agreed to pay $36,000 in restitution.

1. Identify the stakeholders and how they were affected by Heene’s actions using ethical reasoning. 2. What stage of moral reasoning in Kohlberg’s model is exhibited by Richard Heene’s actions? Do you

believe the punishment fit the crime? In other words, was justice done in this case? Why or why not? 3. How do you assess at what stage of moral development in Kohlberg’s model you reason at in

making decisions? Are you satisfied with that stage? Do you believe there are factors or forces preventing you from reasoning at a higher level? If so, what are they?

4. Using the child abuse scandal at Penn State discussed in Chapter 1, explain the actions that would have been taken by Joe Paterno if he had been reasoning at each stage in Kohlberg’s model and why.

5. Aristotle believed that there was a definite relationship between having practical wisdom (i.e., knowledge or understanding that enables one to do the right thing) and having moral virtue, but these were not the same thing. Explain why. How do these virtues interact in Rest’s Four- Component Model of Ethical Decision Making?

6. In the text, we point out that Rest’s model is not linear in nature. An individual who demon- strates adequacy in one component may not necessarily be adequate in another, and moral failure

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Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting 73

can occur when there is a deficiency in any one component. Give an example in accounting when ethical intent may not be sufficient to produce ethical behavior and explain why that is the case.

7. In teaching about moral development, instructors often point out the threefold nature of moral- ity: It depends on emotional development (in the form of ability to feel guilt or shame), social development (manifested by the recognition of the group and the importance of moral behavior for the group’s existence), and cognitive development (especially the ability to adopt another’s perspective). How does this perspective of morality relate to ethical reasoning by accountants and auditors?

8. Some empirical research suggests that accountants and auditors may not achieve their higher levels of ethical reasoning. Why do you think this statement may be correct?

9. Do you agree with Carol Gilligan’s criticism of Kohlberg’s model that women reason differently than men and rely more on a care-and-response orientation? Why or why not? Do you believe Kohlberg’s model is culturally biased? Why or why not?

10. Arthur Andersen LLP was the auditor for Enron, WorldCom, Waste Management, and other companies that committed fraud. Andersen was forced to shut its doors forever after a U.S. Department of Justice lawsuit against it concluded that it had obstructed justice and lied to the government in the Enron case. One thing Andersen had done was to shred documents related to its audit of Enron before the government could get its hands on them. Some in the profes- sion thought that the government had gone too far given the facts and mediating circumstances (including top management’s deception); others believed that the punishment was unjustified because most accounting firms got caught up in similar situations during the late 1990s and early 2000s (pre–Sarbanes-Oxley). What do you believe? Use ethical reasoning to support your answer.

11. In this chapter, we discussed the role of Sherron Watkins in the Enron fraud. Evaluate Watkins’s thought process and actions from the perspective of Kohlberg’s model. Do you think she went far enough in bringing her concerns out in the open? Why or why not?

12. You are in charge of the checking account for a small business. One morning, your accounting supervisor enters your office and asks you for a check for $150 for expenses that he tells you he incurred entertaining a client last night. He submits receipts from a restaurant and lounge. Later, your supervisor’s girlfriend stops by to pick him up for lunch, and you overhear her telling the receptionist what a great time she had at dinner and dancing with your supervisor the night before. What would you do and why?

13. Do you believe that our beliefs trigger our actions, or do we act and then justify our actions by changing our beliefs? Explain.

14. Do you think Betty Vinson was a victim of “motivated blindness”? Why or why not?

15. In her case against the Defense Contract Audit Agency (DCAA) that resulted from actions against her for blowing the whistle on improper agency practices, Diem-Thi Le sought to pro- vide DCAA documents to the Office of Special Counsel (OSC) to back up her claims of retali- ation. DCAA provided Le with a memo that said she was “not permitted to access or copy or possess any Agency document for [her] private purposes, including preparation of complaints in any forum,” according to the OSC report, which directly quoted the memo. DCAA Assistant General Counsel John Greenlee drafted the template of the August 31, 2007 memo, which bore the signature of Sharon Kawamoto, one of Le’s supervising auditors.

Le wanted clarification. Kawamoto told Greenlee in a September 7, 2007, email that Le wanted to know if she could “access documents related to audits cited in her performance appraisals in order to prepare complaints to OSC and the Equal Employment Opportunity Office,” states the OSC report. Le wanted copies of her performance appraisals and related emails. Greenlee responded that Le “may not distribute or disclose those documents to anyone else—period—without asking permission. That permission will not be granted her.”

Do you think Le should have been provided access to her performance appraisals and related emails, given that some aspects of this information contained work-related matters and client information? Does she have an “ethical right” to such information? What ethical limitations might have existed for Le with respect to using this information, assuming that she was a mem- ber of the Institute of Management Accountants (IMA)?

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74 Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting

16. In this chapter, we discuss the study by Libby and Thorne of the association between auditors’ virtue and professional judgment by asking members of the Canadian Institute of Chartered Accountants to rate the importance of a variety of virtues. The most important virtues identified were truthful, independent, objective, and having integrity. The authors note that the inclusion of these virtues in professional codes of conduct (such as the Principles of the AICPA Code of Professional Conduct) may account for their perceived importance. 47 Explain how these virtues relate to an auditor’s intention to make ethical decisions.

17. Interpretation 102-4 of the AICPA Code of Professional Conduct, which was discussed in Chapter 1, provides that a CPA should not knowingly misrepresent facts or subordinate her judgment when performing professional services. Explain how Rest’s model of moral develop- ment influences the steps that a CPA should take to avoid subordinating professional judgment.

18. Explain what you think each of the following statements means in the context of moral development.

a. How far are you willing to go to do the right thing? b. How much are you willing to give up to do what you believe is right? c. We may say that we would do the right thing, but when it requires sacrifice, how much are we

willing to give up? 19. In a June 1997 paper published in the Journal of Business Ethics, Sharon Green and James

Weber reported the results of a study of moral reasoning of accounting students prior to and after taking an auditing course. The study also compared the results between accounting and nonac- counting students prior to the auditing course. The authors found that (1) accounting students, after taking an auditing course that emphasized the AICPA Code, reasoned at higher levels than students who had not taken the course; (2) there were no differences in moral reasoning levels when accounting and nonaccounting majors were compared prior to an auditing course; and (3) there was a significant relationship between the students’ levels of ethical development and the choice of an ethical versus unethical action. 48 Comment on the results of this study.

20. A major theme of this chapter is that our cognitive processes influence ethical decision making. Use the theme to comment on the following statement, which various religions claim as their own and has been attributed to Lao Tzu and some say the Dalai Lama:

“Watch your thoughts; they become your words. Watch your words; they become your actions. Watch your actions; they become your habits. Watch your habits; they become your character. Watch your character; it becomes your destiny.”

Endnotes 1. Max H. Bazerman and Ann E. Trebrunsel, Blind Spots: Why We Fail to Do What’s Right and What to Do About It (Princeton, NJ: Princeton University Press, 2011).

2. Wendy Zellner, “The Fall of Enron,” Business Week, December 17, 2001, p. 30. 3. Barbara Ley Toffler with Jennifer Reingold, Final Accounting: Ambition, Greed, and the Fall of

Arthur Andersen (New York: Broadway Books, 2003), p. 217. 4. Bethany McLean and Peter Elkind, The Smartest Guys in the Room: The Amazing Rise and

Scandalous Fall of Enron (New York: Penguin Group, 2003). 5. Paul M. Clikeman, Called to Account: Fourteen Financial Frauds That Shaped the American

Accounting Profession (New York: Routledge, 2009). 6. Daniel Edelman and Asgley Nicholson, “Arthur Andersen Auditors and Enron: What Happened

to Their Texas CPA Licenses?” Journal of Finance and Accountancy , manuscripts/11899.pdf .

7. Lawrence Kohlberg, “Stage and Sequence: The Cognitive Developmental Approach to Socialization,” in Handbook of Socialization Theory and Research, ed. D. A. Goslin (Chicago: Rand McNally, 1969), pp. 347–480.

8. Carol Gilligan, In a Different Voice: Psychological Theory and Women’s Development (Cambridge, MA: Harvard University Press, 1982).

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Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting 75

9. James R. Rest and Darcia Narvaez, Moral Development in the Professions: Psychology and Applied Ethics (New York: Psychology Press, 1994), p. 4.

10. Rest and Narvaez. 11. Rest and Narvaez. 12. Muriel J. Bebeau and S. J. Thoma, “‘Intermediate’ Concepts and the Connection to Moral

Education,” Educational Psychology Review 11, no. 4 (1999), p. 345. 13. O. C. Ferrell, John Fraedrich, and Linda Ferrell, Business Ethics: Ethical Decision Making and

Cases (Mason, OH: South-Western, Cengage Learning, 2009 Update), pp. 162–163. 14. Clare M. Pennino, “Is Decision Style Related to Moral Development Among Managers in the

U.S.?” Journal of Business Ethics 41 (December 2002), pp. 337–347. 15. William Crain, Theories of Development: Concepts and Applications, 6th ed. (Upper Saddle

River, NJ, 2010). 16. Lawrence A. Ponemon and David R. L. Gabhart, “Ethical Reasoning Research in the Accounting

and Auditing Professions,” in James R. Rest and Darcia Narvaez, Moral Development in the Professions: Psychology and Applied Ethics (New York: Psychology Press, 1994), pp. 101–120.

17. See Michael K. Shaub, “An Analysis of the Association of Traditional Demographic Variables with the Moral Reasoning of Auditing Students and Auditors,” Journal of Accounting Education (Winter 1994), pp. 1–26; and Lawrence A. Ponemon, “Ethical Reasoning and Selection Socialization in Accounting,” Accounting, Organizations, and Society 17 (1992), pp. 239–258.

18. David Arnold and Larry Ponemon, “Internal Auditors’ Perceptions of Whistle-blowing and the Influence of Moral Reasoning: An Experiment,” Auditing: A Journal of Practice and Theory (Fall 1991), pp. 1–15.

19. Larry Ponemon and David Gabhart, “Auditor Independence Judgments: A Cognitive Developmental Model and Experimental Evidence,” Contemporary Accounting Research (1990), pp. 227–251.

20. Larry Ponemon, “Auditor Underreporting of Time and Moral Reasoning: An Experimental-Lab Study,” Contemporary Accounting Research (1993), pp. 1–29.

21. Ponemon and Gabhart, 1994, p. 108. 22. James R. Rest, “Morality,” in Handbook of Child Psychology: Cognitive Development, Vol. 3,

series ed. P. H. Mussen and vol. ed. J. Flavell (New York: Wiley, 1983), pp. 556–629. 23. Lawrence Kohlberg, The Meaning and Measurement of Moral Development (Worcester, MA:

Clark University Press, 1979). 24. Rest and Narvaez, p. 24. 25. Steven Dellaportas, Beverley Jackling, Philomena Leung, Barry J. Cooper, “Developing an

Ethics Education Framework for Accounting,” Journal of Business Ethics Education 8, no. 1 (2011), pp. 63–82.

26. Marshall Schminke, Anke Arnaud, and Maribeth Kuenzi, “The Power of Ethical Work Climates,” Organizational Dynamics 35, no. 2 (January 2007), pp. 171 – 186.

27. Craig E. Johnson, Meeting the Ethical Challenges of Leadership, 3rd ed. (Thousand Oaks, CA: Sage Publications, Inc., 2009), p. 206.

28. Leon Festinger, A Theory of Cognitive Dissonance (Evanston, IL: Row & Peterson, 1957). 29. Penny Tompkins and James Lawley, “Cognitive Dissonance and Creative Tension—The Same

or Different?” and-Creative-Tension/Page0.html .

30. Mimi Swartz and S. Watkins, Power Failure: The Inside Story of the Collapse of Enron (New York: Doubleday, 2003).

31. Swartz and Watkins, pp. 350–351. 32. Theresa Libby and Linda Thorne, “While Virtue Is Back in Fashion, How Do You Define It and

Measure Its Importance to an Auditor’s Role?” CA Magazine, November 2003, www.camaga- .

33. Libby and Thorne.

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76 Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting

34. Edmund L. Pincoffs, Quandaries and Virtues Against Reductivism in Ethics (Lawrence: University Press of Kansas, 1986).

35. Michael Gibbins and Alister K. Mason, “Professional Judgment in Financial Reporting,” CICA Research Study (Toronto, Ontario, Canada: Canadian Institute of Chartered Accountants, 1988).

36. James C. Gaa, “Discussion of Auditors’ Ethical Decision Process,” Auditing: A Journal of Practice and Theory (1992), pp. 60–67.

37. Linda Thorne, “The Role of Virtue in Auditors’ Ethical Decision Making: An Integration of Cognitive-Developmental and Virtue Ethics Perspectives,” Research on Accounting Ethics, no. 4 (1998), pp. 293–294.

38. Mary Beth Armstrong, J. Edward Ketz, and Dwight Owsen, “Ethics Education in Accounting: Moving Toward Ethical Motivation and Ethical Behavior,” Journal of Accounting Education 21 (2003), pp. 1 – 16.

39. Statement of Diem-Thi Le, DCAA Auditor, Before the Senate Committee on Homeland Security and Governmental Affairs, September 10, 2008, .

40. Tony Saavedra, “The Whistleblower Saved You Money,” Orange County Register, November 3, 2011, .

41. Richard F. West and Keith Stanovich, “Individual Differences in Reasoning: Implications for the Rationality Debate,” Behavioral & Brain Sciences (2000), 23, pp. 645 – 665.

42. Daniel Kahneman, “A Perspective on Judgment and Choice: Mapping Bounded Rationality,” American Psychologist (2003), 58, pp. 697 – 720.

43. Courtney Clowes, “A Critical Examination of Ethical Decision Making Models,” www.aux .

44. Harold Q. Langenderfer and Joanee W. Rockness, “Integrating Ethics into the Accounting Curriculum: Issues, Problems, and Solutions,” Issues in Accounting Education 4 (Spring), pp. 58 – 69.

45. Mary Beth Armstrong, “Professional Ethics and Accounting Education: A Critique of the 8-Step Method,” Business & Professional Ethics Journal 9, nos. 1 & 2 (1990), pp. 181 – 191.

46. The phrase “IES standards” refers to International Education Standards issues by the International Federation of Accountants. IES 4 calls for ethics education to enhance and maintain professional values, ethics, and attitudes. The standards are consistent with those in the AICPA Code and IMA Ethical Standards. More will be said about IES 4 in Chapter 8.

47. Theresa Libby and Linda Thorne, “The Development of a Measure of Auditors’ Virtue,” Journal of Business Ethics 71 (2007), pp. 89–99.

48. Sharon Green and James Weber, “Influencing Ethical Development: Exposing Students to the AICPA Code of Conduct,” Journal of Business Ethics 16, no. 8 (June 1997), pp. 777–790.

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Chapter 2 Cases

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78 Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting

The WorldCom fraud was the largest in U.S. history, surpass- ing even that of Enron. Beginning modestly during mid-year 1999 and continuing at an accelerated pace through May 2002, the company, under the direction of Bernie Ebbers, the CEO, Scott Sullivan, the CFO, David Myers, the controller, and Buford Yates, the director of accounting, “cooked the books” to the tune of about $11 billion of misstated earnings. Investors collectively lost $30 billion as a result of the fraud.

The fraud was accomplished primarily in two ways:

1. Booking “line costs” for interconnectivity with other tele- communications companies as capital expenditures rather than operating expenses;

2. Inflating revenues with bogus accounting entries from “corporate unallocated revenue accounts.”

During 2002, Cynthia Cooper, the vice president of internal auditing, responded to a tip about improper accounting by having her team do an exhaustive hunt for the improperly recorded line costs that were also known as “prepaid capac- ity.” That name was designed to mask the true nature of the costs and treat them as capitalizable costs rather than as oper- ating expenses. The team worked tirelessly, often at night and secretly, to investigate and reveal $3.8 billion worth of fraud.

Soon thereafter, Cooper notified the company’s audit committee and board of directors of the fraud. The initial response was not to take action, but to look for explanations from Sullivan. Over time, Cooper realized that she needed to be persistent and not give in to pressure that Sullivan was putting on her to back off. Cooper even approached KPMG, the auditors that had replaced Arthur Andersen, to support her in the matter. Ultimately, Sullivan was dismissed, Myers resigned, Andersen withdrew its audit opinion for 2001, and the Securities and Exchange Commission (SEC) began an investigation into the fraud on June 26, 2002.

In an interview with David Katz and Julia Homer for CFO Magazine on February 1, 2008, Cynthia Cooper was asked about her whistleblower role in the WorldCom fraud. When asked when she first suspected something was amiss, Cooper said: “It was a process. My feelings changed from curiosity to discomfort to suspicion based on some of the accounting entries my team and I had identified, and also on the odd reac- tions I was getting from some of the finance executives.” 1

Cooper did exactly what is expected of a good auditor. She approached the investigation of line-cost accounting with a healthy dose of skepticism and maintained her integ- rity throughout, even as Sullivan was trying to bully her into dropping the investigation.

1 David K. Katz and Julia Homer, “WorldCom Whistle-blower Cynthia Cooper,” CFO Magazine, February 1, 2008. Available at: .

When asked whether there was anything about the cul- ture of WorldCom that contributed to the scandal, Cooper laid blame on Bernie Ebbers for his risk-taking approach that led to loading up the company with $40 billion in debt to fund one acquisition after another. He followed the same reckless strat- egy with his own investments, taking out loans and using his WorldCom stock as collateral. Cooper believed that Ebbers’s personal decisions then affected his business decisions; he ultimately saw his net worth disappear, and he was left owing WorldCom some $400 million for loans approved by the board. Ebbers was sentenced to 25 years in jail for his offenses.

Betty Vinson, the company’s former director of corporate reporting, was one of five former WorldCom executives who pleaded guilty to fraud. At the trial of Ebbers, Vinson said she was told to make improper accounting entries because Ebbers did not want to disappoint Wall Street. “I felt like if I didn’t make the entries, I wouldn’t be working there,” Vinson testified. She said that she even drafted a resignation letter in 2000, but ultimately she stayed with the company.

Vinson said that she took her concerns to Sullivan, who told her that Ebbers did not want to lower Wall Street expec- tations. Asked how she chose which accounts to alter, Vinson testified: “I just really pulled some out of the air. I used some spreadsheets.” 2

Her lawyer had urged the judge to sentence Vinson to probation, citing the pressure placed on her by Ebbers and Sullivan. “She expressed her concern about what she was being directed to do to upper management, and to Sullivan and Ebbers, who assured her and lulled her into believing that all was well,” he said. In the end, Vinson was sentenced to five months in prison and five months of house arrest.

Questions 1. What is the difference between accrual earnings and cash

earnings? In addition to the effect on accrual earnings of capitalizing the line costs, how might the treatment mask the true nature of operating cash flows?

2. Identify the stakeholders in the WorldCom case and how their interests were affected by the financial fraud.

3. Use ethical reasoning to compare the actions of Cynthia Cooper in the WorldCom case to those of Sherron Wat- kins in the Enron case, discussed earlier in this chapter.

2 Susan Pulliam, “Ordered to Commit Fraud, a Staffer Balked, Then Caved: Accountant Betty Vinson Helped Cook the Books at WorldCom,” The Wall Street Journal, June 23, 2003. Available at˜jstrawser/acct229h/Current%20 Readings/ Ordered%20to%20Commit%20Fraud,%20Balked.pdf .

Case 2-1


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Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting 79

Better Boston Beans is a coffee shop located in the Faneuil Hall Marketplace near the waterfront and Government Center in Boston. It specializes in exotic blends of coffee, including Sumatra Dark Roast Black, India Mysore “Gold Nuggets,” and Guatemala Antigua. It also serves a number of blended coffees, including Reggae Blend, Jamaican Blue Mountain Blend, and Marrakesh Blend. For those with more pedestrian tastes, the shop serves French Vanilla, Hazelnut, and Hawaiian Macadamia Nut varieties. The coffee of the day varies, but the most popular is Colombia Supremo. The coffee shop also serves a variety of cold-blended coffees.

Cindie Rosen has worked for Better Boston Beans for six months. She took the job right out of college because she wasn’t sure whether she wanted to go to graduate school before beginning a career in financial services. Cindie hoped that by taking a year off before starting her career or going on to graduate school, she would experience “the real world” and find out firsthand what it is like to work a 40-hour week. (She did not have a full-time job during her college years because her parents helped pay for the tuition.)

Because Cindie is the “new kid on the block,” she is often asked to work the late shift, from 4 p.m. to midnight. She works with one other person, Jeffrey Lyndell, who is the assis- tant shift supervisor. Lyndell has been with Boston Beans for three years but recently was demoted from shift supervisor.

For the past two weeks, Lyndell has been leaving before 11 p.m., after most of the stores in the Marketplace close, and he has asked Cindie to close up by herself. Cindie feels that this is wrong and it is starting to concern her, but she hasn’t spoken to Lyndell and has not informed the store manager either. However, something happened one night that is caus- ing Cindie to consider taking the next step.

At 11 p.m., 10 Japanese tourists came into the store for coffee. Cindie was alone and had to rush around and make five different cold-blended drinks and five different hot- blended coffees. While she was working, one of the Japanese tourists, who spoke English very well, approached her and said that he was shocked that such a famous American coffee shop would only have one worker in the store at any time dur- ing the workday. Cindie didn’t want to ignore the man’s com- ments, so she answered that her coworker had to go home early because he was sick. That seemed to satisfy the tourist.

It took Cindie almost 20 minutes to make all the drinks and also field two phone calls that came in during that time. After she closed for the night, Cindie reflected on the expe- rience. She realized that it could get worse before it gets better because Lyndell was now making it a habit to leave work early.

At this point, she realizes that she has to either approach Lyndell about it or speak with the store manager. She feels much more comfortable talking to the store manager. In fact, in Cindie’s own words, “Lyndell gives me the creeps.”

Questions 1. Consider Kohlberg’s six stages of moral development.

What would Cindie do and why if she reasoned at each of the six stages?

2. Assume that Cindie approached Lyndell about her con- cerns. Lyndell tells Cindie that he has an alcohol problem. Lately, it’s gotten to him real bad. That’s why he’s left early—to get a drink and calm his nerves. Lyndell also said that this is the real reason he was demoted. He had been warned that if one more incident occurred, the store manager would fire him. He pleaded with Cindie to work with him through these hard times. How would you react to Lyndell’s request if you were Cindie? Would you honor his request for confidentiality and support? Why or why not? What if Lyndell was a close personal friend—would that change your answer? Be sure to consider the implica- tions of your decision on other parties potentially affected by your actions.

3. Assume that Cindie keeps quiet. The following week, another incident occurred: Cindie got into a shouting match with a customer who became tired of waiting for his coffee after 10 minutes. Cindie felt terrible about it, apologized to the customer after serving his coffee, and left work that night wondering if it was time to apply to graduate school. The customer was so irate that he con- tacted the store manager and expressed his displeasure about both the service and Cindie’s attitude. What do you think the store manager should do? Support your answer with ethical reasoning.

Case 2-2

Better Boston Beans

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80 Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting

Brenda Sells sent the tax return that she prepared for the pres- ident of Purple Industries, Inc., Harry Kohn, to Vincent Dim, the manager of the tax department at her accounting firm. Dim asked Sells to come to his office at 9 a.m. on Friday, April 12, 2013. Sells had no idea why Dim wanted to speak to her. The only reason she could come up with was the tax return for Kohn.

“Brenda, come in,” Vincent said. “Thank you, Vincent,” Brenda responded. “Do you know why I asked to see you?” “I’m not sure. Does it have something to do with the tax

return for Mr. Kohn?” asked Brenda. “That’s right,” answered Vincent. “Is there a problem?” Brenda asked. “I just spoke with Kohn. I told him that you want to report

his winnings from the lottery. He was incensed.” “Why?” Brenda asked. “You and I both know that the tax

law is quite clear on this matter. When a taxpayer wins money by playing the lottery, then that amount must be reported as revenue. The taxpayer can offset lottery gains with lottery losses, if those are supportable. Of course, the losses can- not be higher than the amount of the gains. In the case of Mr. Kohn, the losses exceed the gains, so there is no net tax effect. I don’t see the problem.”

“Let me tell you the problem,” Vincent stated sharply. “It’s taken me years to gain Kohn’s trust. Our firm now audits his company’s books, prepares its annual tax return, prepares Kohn’s personal tax return, and provides financial planning services for both. Kohn and Purple Industries together are the largest clients in our office. I can’t afford to lose any of the busi- ness these clients provide for our firm. As you know, we are under increasing competition from larger regional firms that are

looking for new clients. If we don’t support Kohn, some other firm will step in and do it. Poof, there goes 20 percent of our revenues.”

Brenda didn’t know what to say. Vincent seemed to be tell- ing her the lottery amounts shouldn’t be reported. But that was against the law. She turned to Vincent and asked: “Are you telling me to forget about the lottery amounts on Mr. Kohn’s tax return?”

“I want you to go back to your office and think carefully about the situation. Consider that this is a one-time request and we value our staff members who are willing to be flex- ible in such situations. Let’s meet again in my office tomor- row at 9 a.m.”

Questions 1. Assume that Brenda has no reason to doubt Vincent’s ve-

racity with respect to the statement that it is “a one-time request.” Should that make a difference in what Brenda decides to do? Why or why not?

2. Analyze the alternatives available to Brenda using Kohlberg’s six stages of moral development. That is, what would Brenda’s position be when she meets with Vincent assuming that her judgment was influenced by relevant factors at each of the six different stages of moral development?

3. Assume that Brenda decides to go along with Vincent and omits the lottery losses and gains. Next year, the same situ- ation arises, but now it’s with gambling losses and gains. If you were Brenda, and Vincent asked you to do the same thing you did last year regarding omitting the lottery losses and gains, what would you do this second year? Why?

Case 2-3

The Tax Return

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Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting 81

Shifty Industries is a small business that sells home beauty products in the San Luis Obispo, California, area. The company has experienced a cash crunch and is unable to pay its bills on a timely basis. A great deal of pressure exists to minimize cash outflows such as income tax payments to the Internal Revenue Service (IRS) by interpreting income tax regulations as liber- ally as possible. You are the tax accountant at the company and report to the controller. You are concerned about the fact that

the controller approved the income statement shown here for the company at December 31, 2012, for financial reporting purposes. Your concern relates to the accounting treatment of depreciation in light of the IRS Section 179 depreciation regu- lations displayed in Exhibit 1. The depreciation relates to the purchase of one item of office machinery in 2012 for $40,000. The asset is expected to have a five-year useful life, with no salvage value, and the company uses the straight-line method

Case 2-4

Shifty Industries


Shifty Industries Income Statement

For the Year Ended December 31, 2012 Sales Revenue: Total Sales $137,460 Less: Sales Returns (2,060) Sales Discounts (5,190) Net Sales Revenue $130,210 Less: Cost of Goods Sold: Beginning Inventory $ 12,300 Add: Purchases 67,310 Freight-In 4,450 $ 84,060 Less: Purchase Discounts (3,900) Purchase Returns (1,000) (4,900) Less: Ending Inventory (16,170) Cost of Goods Sold 62,990 Gross Profit $67,220 Operating Expenses Selling Expenses: Freight-Out $6,150 Advertising Expense 5,790 Sales Commissions Expense 3,470 Administrative Expenses: Office Salaries Expense 18,510 Office Rent Expense 14,000 Office Supplies Expense 5,330 Depreciation of Office Machinery 40,000 Total Operating Expenses (93,250) Operating Loss $(26,030) Other Incomes and Expenses: Gains on Sale Equipment $2,430 Less: Loss on Sales of Investments (1,640) Interest Expense (930) (2,570) Net Other Incomes and Expenses (140) Net Loss ($26,170)

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82 Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting

of depreciation for all office machinery in its financial reports. You reviewed the income statement to help prepare the income tax return for the company that will be filed on April 30, 2013.

A special rule known as “expensing” lets small businesses write off the entire cost of certain depreciable assets in the year they are purchased.

In other words, you get to treat the cost as a business expense (hence “expensing”), such as salary paid or utilities, rather than an asset that has to be depreciated over a number of years. Property that qualifies for this tax break includes machinery, tools, furniture, fixtures, computers, software, and vehicles. (This special rule often goes by the alias “the Section 179 deduction” to give homage to the section of the tax law that allows it.)

This deduction is limited in several ways:

• Dollar limit. For assets placed in service in 2012, you can take a maximum expensing deduction of $500,000—a higher-than-normal level approved by Congress to help the struggling economy.

• Investment limit. As a way to focus this tax break on smaller businesses, firms whose investment in new property exceeds a threshold amount gradually lose the right to expensing. For 2012, the investment threshold is $2,000,000. For example, if you purchased $2,020,000 of otherwise eligible equipment in 2012, you can’t expense

more than $480,000 (the $500,000 expensing maximum minus the excess investment of $20,000).

• Taxable income limit. Your total first-year expensing deduction cannot exceed your business’s taxable income. Say, for example, that you bought $40,000 of property eligible for expensing in 2012, but your firm’s taxable income before taking expensing into account is just $20,000. That means your expensing deduction is limited to $20,000; you can carry over the disallowed $20,000 to 2013 and claim an expensing deduction then, assuming that you have sufficient business income.

Questions Consider the professional and ethical standards and ethical reasoning methods discussed in Chapters 1 and 2 in answer- ing the following questions. 1. Has the company properly handled the depreciation of

the one item of machinery reflected on its income state- ment for the year ended December 31, 2012? Why or why not?

2. How would you handle the depreciation deduction for in- come tax purposes?

3. How should the controller handle the matter, assuming that the financial reports have not been issued as yet, and that he reasons at stages 3, 4, and 5 in Kohlberg’s model?

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Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting 83

Assume that it is December 31, the last day of the fiscal year, and you are an internal accountant for Saturday Night Accessories, a privately owned company run by the Blues Brothers, that provides personal services to consumers. On that date, a $1.2 million major contract for one year of future services is received. You are instructed by your supervisor who reports to the “Brothers” to record the full amount of the $1.2 million as revenue on December 31. You know that management will receive a bonus for the boosted revenue and you will receive recognition in an upcoming performance review.

Questions 1. What is the proper way to account for the revenue in this

case? Why? 2. How might you go about convincing your supervisor of

the proper accounting? That is, what factors might enable you to get your point across, and what are disablers that might prevent you from achieving that result?

3. Under what circumstances might you consider going to the “Brothers” to discuss the matter?

Case 2-5

Blues Brothers

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84 Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting

Supreme Designs, Inc., is a small manufacturing com- pany located in Detroit, Michigan. The company has three stockholders—Gary Hoffman, Ed Webber, and John Sullivan. Hoffman manages the business, including the responsibil- ity for the financial statements. Webber and Sullivan do most of the sales work, and they cultivate potential customers for Supreme Designs.

Hoffman recently hired his daughter, Janet, to manage the office. Janet has successfully managed a small clothing bou- tique in downtown Detroit for the past eight years. She sold the shop to a regional department store that wanted to expand its operations. Gary Hoffman hopes that his daughter will take over as an owner in a few years when he reaches retire- ment age. Webber and Sullivan are significantly younger than Gary Hoffman.

Janet is given complete control over the payroll, and she approves disbursements, signs checks, and reconciles the general ledger cash account to the bank statement balance. Previously, the bookkeeper was the only employee with such authority. However, the bookkeeper recently left the com- pany, and Hoffman needed someone whom he could trust to be in charge of these sensitive operations. He did ask his daughter to hire someone as soon as possible to help with these and other accounting functions. Janet hired Kevin Greenberg shortly thereafter, based on a friend’s recommen- dation. Greenberg is a relatively inexperienced accountant, but he was willing to work for less than what the company had paid the former bookkeeper.

On April 29, 2013, about one year after hiring Greenberg, Janet discovers that she needs surgery. Even though the procedure is fairly common and the risks are minimal, she plans on spending five weeks in recovery because of related medical problems that could flare up if she returns to work too soon. She tells Greenberg to approve vouchers for pay- ment and present them to her father during this time, and her father will write the checks during her absence. Janet had previously discussed this plan with her father, and they both agreed that Greenberg was ready to assume the additional responsibilities. They did not, however, discuss the matter with either Webber or Sullivan.

The bank statement for April arrives on May 3, 2013. Janet did not tell Greenberg to reconcile the bank statements. In fact, she specifically told him to just put those aside until her return. However, Greenberg decides to reconcile the April bank statement as a favor to Janet and to lighten her workload after she returns.

Although everything appears to be in order, Greenberg is not sure what to make of his finding that Janet approved and signed five checks payable to herself, each for the same amount, during April 2013. Each check appears in correct numerical sequence, 1 check of every 10 checks written during the month. Greenberg was surprised because if these

were payroll checks (as he had suspected because they were for the same amount), it was highly unusual. This is because the payroll is processed once a month for all employees of Supreme Designs. In fact, he found only one canceled check for each of the other employees, including himself.

Curiosity gets the better of Greenberg, and he decides to trace the checks paid to Janet to the cash disbursements jour- nal. He looked for supporting documentation but couldn’t find any. He noticed that four of the five checks were coded to dif- ferent accounts: one each to supplies, travel and entertainment, and books and magazines, and two to miscellaneous expenses.

After considering what his findings might mean and whether he should contact Janet, Greenberg decided to expand his search. He reviewed the bank statements for January through March 2013. In all, there were 15 additional checks made payable to Janet, each for the same amount as the 5 in April. These 20 checks totaled $30,000. Greenberg still thought it was possible that these amounts represented Janet’s salary because he knows that her annual salary is $50,000. Perhaps she took out a little more this year.

Greenberg doesn’t know what to do. He could contact Janet, but he knows that she would be unhappy that he opened the bank statements and went so far as to reconcile cash for April even though she specifically told him not to. Perhaps he should contact the three stockholders. Then again, it may be best to keep quiet about the entire matter.

Questions 1. Do you think Greenberg did the “right” thing by opening

the April bank statement and reconciling it to the general ledger? Why or why not? What about the previous bank statements?

2. Explain what Greenberg should do if he reasons at each of the six stages of Kohlberg’s model of moral development. Be sure to consider stakeholder effects in your answer.

3. Evaluate what steps should be taken in each of the follow- ing independent situations: a. If you were Janet and Greenberg dropped by the hospi-

tal to tell you about his discovery, how would you react? b. Assume that Greenberg contacts Janet’s father because

he did not want to upset her after the surgery. Hoffman talks to his daughter, who informs him that she had a shortage in her personal funds and planned to repay the $30,000 after she returns. What would you do if you were Gary Hoffman? Why?

c. Assume that Hoffman does nothing because of his daughter’s explanation. Janet returns to work and fires Kevin Greenberg. What would you do if you were Greenberg? Why? How do you think his action (or inaction) might affect his opportunity for other jobs? Should that matter in terms of what he decides to do?

Case 2-6

Supreme Designs, Inc.

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Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting 85

Milton Manufacturing Company produces a variety of textiles for distribution to wholesale manufacturers of clothing prod- ucts. The company’s primary operations are located in Long Island City, New York, with branch factories and warehouses in several surrounding cities. Milton Manufacturing is a closely held company, and Irv Milton is the president. He started the business in 2002, and it grew in revenue from $500,000 to $5 million in 10 years. However, the revenues declined to $4.5 million in 2012. Net cash flows from all activities also were declining. The company was concerned because it planned to borrow $20 million from the credit markets in the fourth quarter of 2013.

Irv Milton met with Ann Plotkin, the chief accounting officer (CAO), on January 15, 2013, to discuss a proposal by Plotkin to control cash outflows. She was not overly concerned about the recent decline in net cash flows from operating activities because these amounts were expected to increase in 2013 as a result of projected higher levels of rev- enue and cash collections.

Plotkin knew that if overall capital expenditures contin- ued to increase at the rate of 26 percent per year, Milton Manufacturing probably would not be able to borrow the $20 million. Therefore, she suggested establishing a new policy to be instituted on a temporary basis. Each plant’s capital expenditures for 2013 would be limited to the level of capital expenditures in 2011. Irv Milton pointedly asked Plotkin about the possible negative effects of such a policy,

but in the end, he was convinced that it was necessary to initiate the policy immediately to stem the tide of increases in capital expenditures. A summary of cash flows appears in Exhibit 1 .

Sammie Markowicz is the plant manager at the head- quarters in Long Island City. He was informed of the new capital expenditure policy by Ira Sugofsky, the vice presi- dent for operations. Markowicz told Sugofsky that the new policy could negatively affect plant operations because cer- tain machinery and equipment, essential to the production process, had been breaking down more frequently during the past two years. The problem was primarily with the motors. New and better models with more efficient motors had been developed by an overseas supplier. These were expected to be available by April 2013. Markowicz planned to order 1,000 of these new motors for the Long Island City operation, and he expected that other plant managers would do the same. Sugofsky told Markowicz to delay the acquisition of new motors for one year, after which time the restrictive capital expenditure policy would be lifted. Markowicz reluctantly agreed.

Milton Manufacturing operated profitably during the first six months of 2013. Net cash inflows from investing activi- ties exceeded outflows by $250,000 during this time period. It was the first time in three years that there was a positive cash flow from investing activities. Production operations accelerated during the third quarter as a result of increased

Case 2-7

Milton Manufacturing Company


Summary of Cash Flows For the Years Ended December 31, 2012 and 2011 (000 omitted)

December 31, 2012 December 31, 2011

Cash Flows from Operating Activities

Net income $ 372 $ 542 Adjustments to reconcile net income to net cash provided by operating activities 1,350 1,383 Net cash provided by operating activities $ 1,722 $ 1,925

Cash Flows from Investing Activities

Capital expenditures $ (2,420) $ (1,918)

Other investing inflows (outflows) 176 84

Net cash used in investing activities $ (2,244) $ (1,834)

Cash Flows from Financing Activities

Net cash provided (used in) financing activities $ 168 $ (376)

Increase (decrease) in cash and cash equivalents $ (354) $ (285)

Cash and cash equivalents—beginning of the year $ 506 $ 791

Cash and cash equivalents—end of the year $ 152 $ 506

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86 Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting

demand for Milton’s textiles. An aggressive advertising campaign initiated in late 2012 seemed to bear fruit for the company. Unfortunately, the increased level of production put pressure on the machines, and the degree of breakdown was increasing. A big problem was that the motors wore out prematurely.

Markowicz was concerned about the machine breakdown and increasing delays in meeting customer demands for the shipment of the textile products. He met with the other branch plant managers, who complained bitterly to him about not being able to spend the money to acquire new motors. Markowicz was very sensitive to their needs. He informed them that the company’s regular supplier had recently announced a 25 percent price increase for the motors. Other suppliers followed suit, and Markowicz saw no choice but to buy the motors from the overseas supplier. That supplier’s price was lower, and the quality of the motors would signifi- cantly enhance the machines’ operating efficiency. However, the company’s restrictions on capital expenditures stood in the way of making the purchase.

Markowicz approached Sugofsky and told him about the machine breakdowns and the concerns of other plant manag- ers. Sugofsky seemed indifferent. He reminded Markowicz of the capital expenditure restrictions in place and that the Long Island City plant was committed to keep expenditures at the same level as it had in 2011. Markowicz argued that he was faced with an unusual situation and he had to act now. Sugofsky hurriedly left, but not before he said to Markowicz: “A policy is a policy.”

Markowicz reflected on the comment and his obliga- tions to Milton Manufacturing. He was conflicted because he viewed his primary responsibility and that of the other plant managers to ensure that the production process operated smoothly. The last thing the workers needed right now was a stoppage of production because of machine failure.

At this time, Markowicz learned of a 30-day promotional price offered by the overseas supplier to gain new customers by lowering the price for all motors by 25 percent. Coupled with the 25 percent increase in price by the company’s sup- plier, Markowicz knew he could save the company $1,500, or 50 percent of cost, on each motor purchased from the over- seas supplier.

After carefully considering the implications of his intended action, Markowicz contacted the other plant manag- ers and informed them that while they were not obligated to follow his lead because of the capital expenditure policy, he planned to purchase 1,000 motors from the overseas supplier for the headquarters plant in Long Island City.

Markowicz made the purchase in the fourth quarter of 2013 without informing Sugofsky. He convinced the plant accountant to record the $1.5 million expenditure as an operating (not capital) expenditure because he knew that the higher level of operating cash inflows would mask the effect of his expenditure. In fact, Markowicz was proud that he had “saved” the company $1.5 million, and he did what

was necessary to ensure that the Long Island City plant con- tinued to operate.

The acquisitions by Markowicz and the other plant managers enabled the company to keep up with the grow- ing demand for textiles, and the company finished the year with record high levels of net cash inflows from all activi- ties. Markowicz was lauded by his team for his leadership. The company successfully executed a loan agreement with Second Bankers Hours & Trust Co. The $20 million bor- rowed was received on January 3, 2014.

During the course of an internal audit on January 21, 2014, Beverly Wald, the chief internal auditor (and also a CPA), discovered that there was an unusually high number of motors in inventory. A complete check of the inventory deter- mined that $1 million worth of motors remained on hand.

Wald reported her findings to Ann Plotkin, and together they went to see Irv Milton. After being informed of the situ- ation, Milton called in Sugofsky. When Wald told him about her findings, Sugofsky’s face turned beet red. He paced the floor, poured a glass of water, drank it quickly, and then began his explanation. Sugofsky told them about his encoun- ter with Markowicz. Sugofsky stated in no uncertain terms that he had told Markowicz not to increase plant expenditures beyond the 2011 level. “I left the meeting believing that he understood the company’s policy. I knew nothing about the purchase,” he stated.

At this point, Wald joined in and explained to Sugofsky that the $1 million is accounted for as inventory, not as an operating cash outflow: “What we do in this case is transfer the motors out of inventory and into the machinery account once they are placed into operation because, according to the documentation, the motors added significant value to the asset.” Sugofsky had a perplexed look on his face. Finally, Irv Milton took control of the accounting lesson by asking: “What’s the difference? Isn’t the main issue that Markowicz did not follow company policy?” The three officers in the room shook their head simultaneously, perhaps in gratitude for being saved the additional lecturing. Milton then said he wanted the three of them to brainstorm some alternatives on how best to deal with the Markowicz situation and present the choices to him in one week.

Questions Use the Integrated Ethical Decision-Making Process explained in this chapter to help you assess the following: 1. Identify the ethical and professional issues of concern to

Beverly Wald in this case. 2. Identify and evaluate the alternative courses of action for

Wald, Plotkin, and Sugofsky to present in their meeting with Milton.

3. How do virtue considerations influence the alternatives presented?

4. If you were in Milton’s place, which of the alternatives would you choose and why?

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Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting 87

“I’m sorry, Lucy. That’s the way it is,” Ricardo Rikey said. “I just don’t know if I can go along with it, Rikey,” Lucy

replied. “We have no choice. Juggyfroot is our biggest client,

Lucy. They’ve warned us that they will put the engagement up for bid if we refuse to go along with the reclassification of marketable securities,” Rikey explained.

“Have you spoken to Fred and Ethel about this?” Lucy asked.

“Are you kidding? They’re the ones who made the deci- sion to go along with Juggyfroot,” Rikey responded.

The previous scene took place in the office of Deziloo LLP, a large CPA firm in Beverly Hills, California. Lucy Spheroid is the partner on the engagement of Juggyfroot, a publicly owned global manufacturer of pots and pans and other household items. Ricardo Rikey is the managing part- ner of the office. Fred and Ethel are the two members of the firm that make final judgments on difficult accounting issues, especially when there is a difference of opinion with the cli- ent. All four are CPAs.

Ricardo Rikey is preparing for a meeting with Norman Baitz, the CEO of Juggyfroot. Rikey knows that the company expects to borrow $5 million next quarter and it wants to put the best possible face on its financial statements to impress the banks. That would explain why the company reclassified a $2 million market loss on a trading investment to the available- for-sale category so that the “loss” would now show up in

stockholder’s equity, not as a charge against current income. The result was to increase earnings in 2013 by 8 percent. Rikey also knows that without the change, the earnings would have declined by 2 percent and the company’s stock price would have taken a hit.

In the meeting, Rikey points out to Baitz that the invest- ment in question was marketable, and in the past, the com- pany had sold similar investments in less than one year. Rikey adds there is no justification under generally accepted accounting principles (GAAP) to change the classification from trading to available-for-sale.

Questions 1. Explain the rules in accounting to determine whether an

investment in a marketable security should be accounted for as trading, available-for-sale, or held-to-maturity. In- clude in your discussion how such classification affects the financial statements.

2. Who are the stakeholders in this case? What expectations should they have, and what are the ethical obligations of Deziloo and its CPAs to the stakeholders? Use ethical rea- soning to answer this question.

3. Using the AICPA Code of Professional Conduct as a refer- ence, what ethical issues exist for Rikey, Lucy, Fred, Ethel, and Deziloo LLP in this matter? What role does auditor virtue play in determining what to do in this case?

Case 2-8


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88 Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting

Case 2-9


The Dilemma

The story of Phar-Mor shows how quickly a company that built its earnings on fraudulent transactions can dissolve like an Alka-Seltzer.

One day, Stan Cherelstein, the controller of Phar- Mor, discovered cabinets stuffed with held checks totaling $10 million. Phar-Mor couldn’t release the checks to vendors because it did not have enough cash in the bank to cover the amount. Cherelstein wondered what he should do.


Phar-Mor was a chain of discount drugstores, based in Youngstown, Ohio, and founded in 1982 by Michael Monus and David Shapira. In less than 10 years, the company grew from 15 to 310 stores and had 25,000 employees. According to Litigation Release No. 14716 issued by the SEC, 1 Phar-Mor had cumulatively overstated income by $290 million between 1987 and 1991. In 1992, prior to disclosure of the fraud, the company overstated income by an additional $238 million.

The Cast of Characters

Mickey Monus personifies the hard-driving entrepreneur who is bound and determined to make it big whatever the cost. He served as the president and chief operating officer (COO) of Phar-Mor from its inception until a corporate restructuring was announced on July 28, 1992.

David Shapira was the CEO of both Phar-Mor and Giant Eagle, Phar-Mor’s parent company and majority stockholder. Giant Eagle also owned Tamco, which was one of Phar-Mor’s major suppliers. Shapira left day-to-day operations of Phar- Mor to Monus until the fraud became too large and persistent to ignore.

Patrick Finn was the CFO of Phar-Mor from 1988 to 1992. Finn, who holds the Certified Management Accountant (CMA) certification, initially brought Monus the bad news that following a number of years of eroding profits, the com- pany faced millions in losses in 1989.

John Anderson was the accounting manager at Phar-Mor. Hired after completing a college degree in accounting at Youngstown State University, Anderson became a part of the fraud.

Coopers & Lybrand, prior to its merger with Price Waterhouse, were the auditors of Phar-Mor. The firm failed to detect the fraud as it was unfolding.

How It Started

The facts of this case are taken from the SEC filing and a PBS Frontline episode called “How to Steal $500 Million.” The interpretation of the facts is consistent with reports, but some literary license has been taken to add intrigue to the case.

Finn approached Monus with the bad news. Monus took out his pen, crossed off the losses, and then wrote in higher numbers to show a profit. Monus couldn’t bear the thought of his hot growth company that had been sizzling for five years suddenly flaming out. In the beginning, it was to be a short- term fix to buy time while the company improved efficiency, put the heat on suppliers for lower prices, and turned a profit. Finn believed in Monus’s ability to turn things around, so he went along with the fraud. Finn prepared the reports, and Monus changed the numbers for four months before turn- ing the task over to Finn. These reports with the false num- bers were faxed to Shapira and given to Phar-Mor’s board. Basically, the company was lying to its owners.

The fraud occurred by dumping the losses into a “bucket account” and then reallocating the sums to one of the com- pany’s hundreds of stores in the form of increases in inven- tory amounts. Phar-Mor issued fake invoices for merchandise purchases and made phony journal entries to increase inven- tory and decrease cost of sales. The company overcounted and double-counted merchandise in inventory.

The fraud was helped by the fact that the auditors from Coopers observed inventory in only 4 out of 300 stores, and that allowed the finance department at Phar-Mor to conceal the shortages. Moreover, Coopers informed Phar-Mor in advance which stores they would visit. Phar-Mor executives fully stocked the 4 selected stores but allocated the phony inventory increases to the other 296 stores. Regardless of the accounting tricks, Phar-Mor was heading for collapse and its suppliers threatened to cut off the company for nonpayment of bills.

Stan Cherelstein’s Role

Cherelstein, a CPA, was hired to be the controller of Phar-Mor in 1991, long after the fraud had begun. One day, Anderson, Phar-Mor’s accounting manager, called Cherelstein into his office and explained that the company had been keeping two sets of books—one that showed the true state of the company with the losses and the other, called the “subledger,” that showed the falsified numbers that were presented to the auditors.

1 Securities and Exchange Commission, Litigation Release No. 14716, November 9, 1995, SEC v. Michael Monus, Patrick Finn, John Anderson and Jeffrey Walley, Case No. 4:95, CV 975 (N.D. OH, filed May 2, 1995), lr14716.txt .

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Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting 89

Cherelstein and Anderson discussed what to do about the fraud. Cherelstein was not happy about it at all and demanded to meet with Monus. Cherelstein did get Monus to agree to repay the company for the losses from Monus’s (personal) investment of company funds into the World Basketball League (WBL). But Monus never kept his word. In the begin- ning, Cherelstein felt compelled to give Monus some time to turn things around through increased efficiencies and by using a device called “exclusivity fees,” which vendors paid to get Phar-Mor to stock their products. Over time, Cherelstein became more and more uncomfortable as the suppliers called more and more frequently, demanding payment on their invoices.

Accounting Fraud Misappropriation of Assets The unfortunate reality of the Phar-Mor saga was that it involved not only bogus inventory but also the diversion of company funds to feed Monus’s personal habits. One exam- ple was the movement of $10 million in company funds to help start the WBL.

False Financial Statements According to the ruling by the U.S. Court of Appeals that heard Monus’s appeal of his conviction on all 109 counts of fraud, the company submitted false financial statements to Pittsburgh National Bank, which increased a revolving credit line for Phar-Mor from $435 million to $600 million in March 1992. It also defrauded Corporate Partners, an investment group that bought $200 million in Phar-Mor stock in June 1991. The list goes on, including the defraud- ing of Chemical Bank, which served as the placing agent for $155 million in 10-year senior secured notes issued to Phar- Mor; Westinghouse Credit Corporation, which had executed a $50 million loan commitment to Phar-Mor in 1987; and Westminster National Bank, which served as the placing agent for $112 million in Phar-Mor stock sold to various financial institutions in 1991.

Tamco Relationship The early financial troubles experienced by Phar-Mor in 1988 can be attributed to at least two transactions. The first was that the company provided deep discounts to retailers to stock its stores with product. There was concern early on that the margins were too thin. The second was that its supplier, Tamco, was shipping partial orders to Phar-Mor while billing for full orders. Phar-Mor had no way of knowing this because it was not logging in shipments from Tamco.

After the deficiency was discovered, Giant Eagle agreed to pay Phar-Mor $7 million in 1988 on behalf of Tamco. Phar-Mor later bought Tamco from Giant Eagle in an addi- tional effort to solve the inventory and billing problems. However, the losses just kept on coming.

Back to the Dilemma Cherelstein looked out the window at the driving rain. He thought about the fact that he didn’t start the fraud or engage in the cover-up. Still, he knows about it now and feels com- pelled to do something. Cherelstein thought about the persis- tent complaints by vendors that they were not being paid and their threats to cut off shipments to Phar-Mor. Cherelstein knows that without any product in Phar-Mor stores, the com- pany could not last much longer.

Questions 1. How do you assess blame for the fraud? That is, to what

extent was it caused by Finn’s willingness to go along with the actions of Monus? What about Shapira’s lax oversight? Should all the blame go to Monus? What role did Coopers & Lybrand play with respect to its professional judgment?

2. Assume Cherelstein decides to use Rest’s Model of Morality to reason out what the right thing to do is and how to carry out the action. Apply the logic of the model to Cherelstein’s decision-making process. What do you think he should do at this point and why?

3. What is the ethical message of Phar-Mor? That is, explain what you think is the moral of this story.

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90 Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting

Troy just returned from a business trip for health care admin- istrators in Orlando. Kristen, a relatively new employee who reports to him, also attended the conference. Troy works for Gateway Hospital, a for-profit hospital in the St. Louis area. The Orlando conference included training in the newest regula- tions over health care, networking with other hospital adminis- trators, and reports on upcoming legislation in health care. The conference was in early March and coincided with Troy’s kids school spring break, so the entire family traveled to Orlando.

The hospital’s expense reimbursement policy is very clear on the need for receipts for all reimbursements. Meals are covered for those not included in the conference, but only within a pre-set range. Troy has never had a problem follow- ing those guidelines. However, the trip to Orlando was more expensive than Troy expected. He did not attend all sessions of the conference to enjoy time with his family. Upon return to St. Louis, Troy’s wife suggested that Troy submit three meals and one extra night at the hotel as business expenses, even though they were personal expenses. Her rationale was that the hospital policies would not totally cover the business costs of the trip. Troy often has to travel and misses family time that cannot be recovered or replaced. Troy also knows that his boss has a reputation of signing forms without read- ing or careful examination.

Kristen is approached by the head of the accounting department about Troy’s expenses, which seem high and not quite right. Kirsten is asked about the extra night because she did not ask for reimbursement for that time. Kristen knows it can be easily explained by saying Troy had to stay an extra day for additional meetings, a common occurrence for admin- istrators, although that was not the case. She also knows that the hospital has poor controls and a culture of “not rocking the boat,” and that other employees have routinely inflated expense reports in the past. Assume that you are in Kristen’s position. How would you respond to the inquiry of the head of the accounting department? In considering your response, address the following issues.

Questions 1. What is at stake for the key parties? What is at stake for

you [Kristen]? 2. What are the main arguments that you are trying to coun-

ter, assuming that you know Troy’s position on the mat- ter, and what are the reasons and rationalizations that you need to address?

3. What should Kristen do and what ethical considerations should influence her decision?

Case 2-10

Gateway Hospital

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3 Creating an Ethical Organization Environment and Effective Corporate Governance Systems


THE CHALLENGER SHUTTLE DISASTER The culture of an organization can affect the behavior of employees, as occurred at Penn State and Enron. As we learned in Chapters 1 and 2, even if your attitudes and beliefs conform to your intended actions, there may be obstacles within the organization that constrain those actions. This may be caused by ethical fading , a process by which the ethical dimensions are eliminated from a deci- sion and replaced by considerations such as avoiding bad publicity or making the deal at all costs. In Chapter 2, we learned that cognitive dissonance occurs because how we think we should behave differs from how we decide to behave, so we adjust our beliefs to fit our behavior. Both factors were in play at the National Aeronautics and Space Administration (NASA) in the Challenger shuttle launch on January 28, 1986, when the solid rocket booster seals failed on takeoff, and 75 seconds after the launch, the space craft erupted into flames killing all aboard includ- ing schoolteacher Christa McAuliffe, America’s first private citizen in space.

On January 27, the night before the launch, engineers and managers from NASA and from shuttle craft contrac- tor Morton Thiokol met to discuss whether it was safe to launch the Challenger at a low temperature. In 7 of the shuttle program’s 24 previous launches, problems with the O-rings that kept the seals intact had been detected. Now, under intense time pressure by management, Morton Thiokol engineers quickly put together a presentation that led to their recommendation not to launch because at low temperatures (it was 27°F at launch time), the likelihood of O-ring failure increased.

During a teleconference call, NASA personnel reacted to the engineers’ recommendation not to launch with hos- tility, according to Roger Boisjoly, a Morton Thiokol engi- neer who participated in the meeting. NASA had already scrubbed the launching twice, and the entire public was watching to see the first “average citizen” in space. Morton Thiokol manager Joe Kilminster asked for a five- minute, offline caucus to reevaluate the data, and as soon as the  mute button was pressed, according to Boisjoly,

Ethics Reflection


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“our general manager, Jerry Mason, said in a soft voice, ‘We have to make a management decision.’ “Boisjoly con- cluded that it was obvious that management was going to change the decision to a launch decision to accommodate the company’s major customer.

The general manager of Thiokol turned to his three senior managers and asked what they wanted to do. Two agreed to go to a launch recommendation, and one refused. “So he [the general manager] turns to him and said ‘take off your engineering hat and put on your man- agement hat’—and that’s exactly what happened,” said Boisjoly. “He changed his hat and changed his vote, just 30 minutes after he was the one to give the recommenda- tion not to launch. I didn’t agree with one single statement made on the recommendations given by the managers.’ ”

The teleconference resumed, and NASA heard that Thiokol had changed its decision and gave a recommenda- tion to launch. NASA did not ask why.

“I went home, opened the door and didn’t say a word to my wife,” added Boisjoly. “She asked me what was wrong and I told her, ‘Oh nothing, honey, it was a great day, we just had a meeting to go launch tomorrow and kill the astro- nauts, but outside of that, it was a great day.’“

How should we evaluate Boisjoly’s behavior in the Challenger disaster? Unlike Betty Vinson in the WorldCom accounting fraud, Boisjoly did not actively do anything to

bring about the failure. However, he did have the techni- cal expertise to know the launch was fraught with danger. According to Johnson, he recognized the ethical problem of launching the shuttle in cold weather but failed to generate a “creative strategy” for preventing the launch. He stopped objecting and deferred to management. “Boisjoly made no effort to go outside the chain of command to express his concerns to the agency director or to the press.” 1

In analyzing the decision-making process in the Challenger disaster, Bazerman and Trebrunsel point out that an organization’s ethical gap is more than just the sum of the individual gaps of its employees. Group work, the build- ing block of organizations, creates additional ethical gaps. Groupthink—the tendency for cohesive groups to avoid a realistic appraisal of alternative courses of action in favor of unanimity—can prevent groups from challenging ques- tionable decisions, as was the case with NASA’s decision to launch the Challenger. Morton Thiokol’s decision to treat the dilemma as a management decision led to the fading of the ethical dimensions of the problem under consideration, as if it were possible to ignore the human lives at stake. 2

As you read this chapter, reflect on the following ques- tions: (1) How does organization culture influence ethical decisionmaking? (2) What are the components of a strong system of corporate governance? (3) When should an employee consider blowing the whistle on wrongdoing?

Ethics Reflection (Concluded)

“ The thing I have learned at IBM is that culture is everything. Underneath all the sophisticated processes, there is always the company’s sense of values and identity.” Louis V. Gerstner , Jr. former CEO IBM

This statement by former IBM chief executive officer (CEO) Louis Gerstner highlights one of the themes of this chapter that the culture of an organization establishes the boundaries within which ethical decisions must be made. As we learned from previous chapters, it is one thing to know that you should behave in a certain way, but it is quite another to do it (or even want to do it) given the pressures that may exist from within the organization.

Seven Signs of Ethical Collapse

In her book The Seven Signs of Ethical Collapse, Marianne Jennings analyzes the indica- tors of possible ethical collapse in companies and provides advice how to avoid impend- ing disaster. She starts with a description of ethical collapse, saying that it “occurs when any organization has drifted from the basic principles of right and wrong,” and she uses

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Chapter 3 Creating an Ethical Organization Environment and Effective Corporate Governance Systems 93

financial reporting standards and accounting rules as one area where this might occur. She points out that “not all companies that have drifted ethically have violated any laws.” 3 Enron did not necessarily violate generally accepted accounting principles (GAAP) in treating the effects of some of its transactions with special-purpose entities off-balance- sheet. However, the company ignored conflicts of interest of Andy Fastow who managed some of the entities while wearing a second hat as CFO of Enron during the time the two entities had mutual dealings.

According to Jennings, “When an organization collapses ethically, it means that those in the organization have drifted into rationalizations and legalisms, and all for the purpose of getting the results they want and need at almost any cost.” The Challenger shuttle disaster is a case in point. Putting the management hat on and taking the engineer’s hat off was just a way of rationalizing the launch decision. Jennings links the rationalizations and legalisms to a culture that leads to behavior based on the notion “Everybody does this” and “It’s not a question of should we do it.” It is a culture of “Can we do it legally?” This mentality occurs because of the combination of the seven factors working together to cloud judgment. 4

Jennings identifies seven common ethical signs of moral meltdowns in companies that have experienced ethical collapse. The common threads she found that make good people at companies do really dumb things include (1) pressure to maintain numbers; (2) fear and silence; (3) young ’uns and a bigger-than-life CEO (i.e., loyalty to the boss); (4) weak board of directors; (5) conflicts of interest overlooked or unaddressed; (6) innovation like no other company; and (7) goodness in some areas atones for evil in others. 5 We briefly address the signs here and elaborate on some of them later on.

Pressure to Maintain the Numbers Jennings points out that the tension between ethics and the bottom line will always be present. The first sign of a culture at risk for ethical collapse occurs when there is not just a focus on numbers and results, but an unreasonable and unrealistic obsession with meeting quantitative goals. This “financial results at all costs” approach was a common ethical problem at both Enron and WorldCom. At WorldCom, the mantra was that financial results had to improve in every quarter, and the shifting of operating expenses to capitalized costs was used to accomplish the goal regardless of the propriety of the accounting treatment. It was an “ends justifies means” culture that sanctioned wrongdoing in the name of earn- ings. Accountants like Betty Vinson got caught up in the culture and did not know how to extricate themselves from the situation.

Fear of Reprisals Fear and silence characterizes a culture where employees are reluctant to raise issues of ethical concern because they may be ignored, treated badly, transferred, or worse. It underlies the whistleblowing process in many organizations where ethical employees want to blow the whistle but fear reprisals, so they stay silent. One aspect of such a culture is a “kill the messenger syndrome,” whereby an employee brings bad news to higher-ups with the best intentions of having the organization correct the matter, but instead the messenger is treated as an outcast.

Loyalty to the Boss Dennis Kozlowski was the dominant, larger-then-life CEO of Tyco International, who had an appetite for a lavish style of living. He surrounded himself with young people who were taken by his stature and would not question his actions. Kozlowski, who once spent $6,000 on a shower curtain for an apartment paid for by the company, made sure these “young ’uns” received all the trappings of success so they would be reluctant to speak up when ethical and legal issues existed for fear of losing their expensive homes, boats, and cars and

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the prestige that comes along with financial success at a young age. They were selected by the CEO for their positions based on their inexperience, possible conflicts of interest, and unlikelihood to question the boss’s decisions. Of course, not all bigger-than-life CEO’s are unethical (e.g., Steve Jobs and Warren Buffet).

Weak Board of Directors A weak board of directors characterizes virtually all the companies with major account- ing frauds in the early part of the 2000s. One example is HealthSouth, one of the largest healthcare providers in the United States specializing in patient rehabilitation services, Richard Scrushy surrounded himself with a weak board so that when he made decisions as CEO at HealthSouth that contributed to an accounting scandal where the company’s earnings were falsely inflated by $1.4 billion, the board would go along, in part because of their interrelationships with Scrushy and HealthSouth that created conflicts of interest. Jennings identifies the following conflicts of interest: 6

• One director earned $250,000 per year from a consulting contract with HealthSouth over a seven-year period.

• Another director had a joint investment venture with Scrushy on a $395,000 investment property.

• Another director’s company was awarded a $5.6 million contract to install glass at a hospital being built by HealthSouth.

• MedCenter District, a hospital-supply company that was run online, did business with HealthSouth and was owned by Scrushy, six directors, and the wife of one of those directors.

• The same three directors had served on both the audit committee and the compensation committee for several years.

• Two of the directors had served on the board for 18 years. • One director received a $425,000 donation to his favorite charity from HealthSouth just

prior to his going on the board.

A Culture of Conflicting Interests

A good example of a culture of conflicts is the dual relationship between financial ana- lysts and investment bankers. Conflicts of interest occur in the financial services industry because of the dual tasks performed by investment banks. On the one hand, they research and conduct financial analysis on corporations issuing securities such as in an initial public offering (IPO); on the other hand, the firms hope to be chosen as the investment banker to underwrite these securities by selling them to the public on behalf of the issuing corpora- tion. Investment banks often combine research and underwriting because the information that is produced for one task is also useful for another task. These relationships are not unlike the conflict that might exist when an audit firm also conducts a financial informa- tion systems design and installation engagement for the same client. Doing both for the same client places the firm in the position of having to examine its own work in the course of gathering data to help render an opinion on the client’s financial statements.

A conflict of interest arises between research and underwriting because the investment bank attempts to serve the needs of two client groups—the firms for which it is issuing the securities and the investors to whom it sells these securities. These client groups have different information needs: Issuers benefit from optimistic research, whereas investors desire unbiased research. Due to economies of scope, however, both groups will receive the same information.

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When the potential revenues from underwriting greatly exceed brokerage commissions, the investment bank has a strong incentive to alter the information provided to both types of clients so as to favor the issuing firms’ needs. If the information provided is not favor- able to the issuing firm, it might take its business to a competitor that is willing to put out more positive information and thereby entice more people to buy the newly issued stock. For example, an internal Morgan Stanley memo excerpted in The Wall Street Journal on July 14, 1992, stated: “Our objective . . . is to adopt a policy, fully understood by the entire firm, including the Research Department, that we do not make negative or controversial comments about our clients as a matter of sound business practice.” 7 Because of directives like this one, analysts in investment banks might be persuaded to distort their research to please the underwriting department of their bank and the corporations issuing the securi- ties, and indeed, this seems to have happened during the technology boom of the 1990s. Of course, such actions undermine the reliability of the information that investors use to make their financial decisions and, as a result, diminish the efficiency of securities markets.

Innovation and Ethics Sanjay Kumar, the former CEO of Computer Associates (CA), was sentenced to 12 years in prison on August 13, 2007, for his conviction of securities fraud, obstruction of justice, and false statements. A jury found that Kumar presided over a scheme to inflate CA’s quarterly sales numbers falsely by adopting a 35-day month internally. Along with the imprisonment, Kumar was ordered to pay an $8 million fine and to make restitution for up to $800 million in losses suffered by investors who lost money as a result of his accounting fraud scheme. Jennings points out that Kumar had an attitude that the company was above the fray because it was so innovative. He is quoted as saying: “Standard accounting rules [were] not the best way to measure [Computer Associate’s] results because it had changed to a new business model offering its clients more flexibility.” 8

Community Involvement and Ethics Should companies that act ethically in one aspect of their operations be judged less harshly when they violate ethical norms in other areas? This question came up when it was revealed that John Rigas, founder of Adelphia Communications, was convicted on July 8, 2004, of conspiracy, bank fraud, and securities fraud for looting the cable company and duping its investors. Rigas became fond of using the company’s money as his personal piggy bank. Most people in the small town of Coudersport, Pennsylvania, where the company was headquartered, were shocked to learn what Rigas had done. He was known for his generos- ity in supporting people in financial need in the community and in financially supporting projects that enhanced the image of the town.

Jennings sums it up quite well in her book by saying that remedies for the good/evil bal- ancing act include rethinking the popular notions of social responsibility and business and rethinking company activities, perceptions, and realities. “Be very skeptical about ‘doing well by doing good.’ Instead, companies need to rely on virtue ethics and simplicity: truth, honesty, fairness, and egalitarianism.” 9

Organizational Influence on Ethical Decision Making The previous examples illustrate how the ethics of an organization can influence decision making through the culture established by those at the very top. Those who work for an organization need to understand the culture and limitations that it creates. This includes accountants and auditors who work for the company and must meet their responsibilities given that culture. Decisions are not made in a vacuum, but in the context of organizational relationships and expectations for behavior.

Thomas Jones developed an explanatory model that merged Rest’s four-step moral reasoning model with Fiske and Taylor’s 10 work on social cognition to illustrate the ethical

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decision-making process of an individual who encounters an ethical dilemma within the context of work. Of particular importance is the role that moral intensity plays in recogniz- ing moral issues. Recall that in Rest’s model, ethical perception is the first stage in the decision-making process. Jones argues that the characteristics of the moral issue, what he collectively termed moral intensity, influence ethical decision making. Moral issues of high intensity will be more salient because the magnitude of consequences is greater, their effects stand out, and their effects involve significant others (greater social, cultural, psychological, or physical proximity). 11

Individual-Organization Interchange While Jones’s model illustrates the impact that moral intensity has on ethical choices and behavior and acknowledges that organizational factors influence the establishment of moral intent and behavior—the last two steps in Rest’s model—the model fails to address what Burchard calls the cyclical, ongoing dynamic exchange between the individual and organization, which affects the development and sustaining of one’s code of conduct in the organizational context. 12 It was left to Jones and Hiltebeitel to fill the gap when they conducted a study of organizational influence on moral decisions and proposed a model that demonstrated organizational influence on the moral decision-making process. As Jones had done with his previous model, Jones and Hiltebeitel based their model on Rest’s moral reasoning and Kohlberg’s moral development theory. 13

The Jones-Hiltebeitel model looks at the role of one’s personal code of conduct in ethical behavior within an organization. When an employee is called upon to perform routine tasks—those with no internal conflict or cognitive dissonance—the actions taken were almost automatic. However, when those tasks diverged from the routine, the employee would refer to her personal code of conduct for ethical cues. 14 The implica- tions for ethical behavior within the organization are significant because an unethical individual might act dishonestly in one case, while a virtuous person acts in a truthful, trustworthy manner.

According to the model, when one’s personal code is insufficient to make the necessary moral decision, the individual will look at the factors that influenced the formation of the code, including professional and organizational influences to resolve the conflict. The influences that are strongest are the ones that determine the reformation of the individual’s code of conduct. The implications for the culture of an organization are significant because an organization that values profits above all else might elicit one kind of response, such as to go along with improper accounting, while an organization that values integrity above all else might lead to questioning improper accounting and doing what one can to reverse false and misleading financial results.

Ethical Dissonance Model Burchard points out that the Jones-Hiltebeitel model and others like it pay too little atten- tion to the examination of ethical person-organization fit upon the person-organization exchange, within each of the four potential fit options. Burchard presents what he calls “the Ethical Dissonance Model” to illustrate the interaction between the individual and the organization, based on the person-organization ethical fit at various stages of the contractual relationship in each potential ethical fit scenario. 15 The model is complex, so we restrict our coverage to the basics of the person-organization interchange and its implications for ethical behavior within organizations. This is an important consideration because the ethics of an individual influences the values that one brings to the workplace and decision making, while the ethics (through its culture) of an organization influences that behavior. To keep it simple, we adopt the idea that there can be a dissonance between what is considered ethical and what may actually be “best” for the subject inviting ethical consideration.

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Of the four potential fit options, two possess high person-organization fit: (1) high organizational ethics, high individual ethics (High-High), and (2) low organizational ethics, low individual ethics (Low-Low); and two possess low person-organization fit: (1) high organizational ethics, low individual ethics (High-Low) and (2) low organizational ethics, high individual ethics (Low-High). 16

Let’s pause for a moment and consider the practical implications of this model. Imagine that you are interviewing for a position with a mid-sized company in your town. You can easily find out information about the company on the Internet to prepare for the interview, such as the scope of its operations, products and services, customer base, and geographical locations. However, it is less easy to find out about its reputation for ethics, although reports in the media about specific events might be of some use. Now, let’s assume that you knew (and understood) what is meant by organizational fit and in this case the fit is Low-High. Would that affect whether you interview with the company? Might you ask questions to better understand why that fit exists? Would it affect your final decision whether to work for the company? The information you might gather during the process could be invaluable when you face ethical dilemmas in the workplace.

In two of the fit options (High-High and Low-Low), no ethical dissonance exists. Person-organization fit is optimal, and the organization is highly effective, either to con- structive or destructive ends. The other two (High-Low and Low-High) demonstrate a lack of person-organization fit in the realm of ethics and values. 17

High Organizational Ethics, High Individual Ethics (High-High) 18 Assume that you know your values and beliefs are an ethical match for the company you work for. You are likely to continue to stay employed in the organization. The issue for us is how you might assess organizational ethics. Koh and Boo identified three distinct measures of organizational ethics: support for ethical behavior from top management, the ethical climate of the organization, and the connection between career success and ethical behavior. 19 These three factors relate to the culture of the organization and may have implications for actions such as whistleblowing, as will be discussed later in this chapter. Koh and Boo found that positive ethical culture and climate produces favorable organizational outcomes by setting down the ethical philosophy and rules of conduct and practices (i.e., code of ethics).

Low Organizational Ethics, Low Individual Ethics (Low-Low) 20 When both the individual and organization possess low moral and ethical development, the fit is there, but it is turns in a negative direction. A culture of corruption is difficult to change, and for the employee, it takes more conscious effort to stop the corruption than to participate in it. You might say that the employee adopts the attitude of going along to get along. Padilla et al. contend that “dysfunctional leader behaviors and suscep- tible followers interacting in the context of a contributing environment produce negative organizational outcomes in which ‘followers must consent to, or be unable to resist, a destructive leader.’ ” 21 Imagine if Diem-Thi Le, whose story was discussed in Chapter 2, had low individual ethics in the low organization ethical environment at Defense Contract Audit Agency (DCAA). It is hard to imagine her taking the steps that she did to stop the misallocation and mischarging of contractor costs to the government.

High Organizational Ethics, Low Individual Ethics (High-Low) 22 According to Kelman and Hamilton, if the individual possesses lower ethics than that which is held by the organization, the discovery of an individual’s lack of person-organization fit is often pointed out by socialized members within the ethical organization. 23 Those assimi- lated members of the organization may attempt to socialize the individual to the ways of the organization to alleviate the ethical dissonance. Once this dissonance is discovered, the likelihood that the mismatched employee will leave the company rises. The more the

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individual’s personal decisions are seen to be in conflict with the ethical decisions that are perceived to be encouraged by the organization, the greater the discomfort of the individ- ual. Imagine, for example, a newly hired employee thought there was nothing wrong with accepting free gifts from contractors doing business with one’s employer, but the employer has a code of ethics forbidding such practices. The culture of the organization conflicts with the individual’s low ethical standards in this instance, and others in the organization that identify with organizational values may attempt to resolve the dissonance and alter the employee’s behavior. If the employee’s behavior does not change, the employee may be let go for cause or insubordination.

Low Organizational Ethics, High Individual Ethics (Low-High) A reduction in job satisfaction is likely if an employee striving to be ethical perceives little top management support for ethical behavior, an unfavorable ethical climate in the organization, and/or little association between ethical behavior and job success. 24 Once this ethical dissonance is discovered, the likelihood of employee turnover rises. Sims and Keon found a significant relationship between the ethical rift between one’s personal decisions and the perceived unwritten/informal policies of the organization, and the indi- vidual’s level of comfort within the organization. The greater the difference between the decisions that the individual made and the decisions perceived as expected and reinforced by the organization, the greater levels of discomfort the individual would feel, and the more likely the individual would be to report these feelings of discomfort. 25 The case of Cynthia Cooper, discussed in Chapter 1, illustrates the low organizational, high individual ethics environment. Cooper reported her concerns to top management, and once she was convinced that nothing would be done to address the improper accounting for capitalized costs, she blew the whistle by going to the audit committee and external auditors.

Business Ethics

There are many definitions of business ethics . The one we adopt is by Ferrell, Fraedrich, and Ferrell (referred to as just Ferrell et al. in the text) because of its simplicity. These authors define business ethics as comprising the principles, values, and standards that guide behavior in the world of business.

Guiding Principles The principles are specific and pervasive boundaries for behavior that are universal and absolute. 26 For example, the guiding principles of Starbucks, 27 shown in Exhibit 3.1 , are part of the company’s mission statement and establish a tone that defines what Starbucks stands for.

Establish Starbucks as the premier purveyor of the finest coffee in the world while maintaining our uncompromising principles while we grow.

The following six guiding principles will help us measure the appropriateness of our decisions:

1. Provide a great work environment and treat each other with respect and dignity. 2. Embrace diversity as an essential component in the way we do business. 3. Apply the highest standards of excellence to the purchasing, roasting and fresh delivery of

our coffee. 4. Develop enthusiastically satisfied customers all of the time. 5. Contribute positively to our communities and our environment. 6. Recognize that profitability is essential to our future success.

EXHIBIT 3.1 Starbucks Mission Statement and Guiding Principles

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Notice how profitability is at the bottom of this list, which implies that profits will occur if members of the Starbucks community live by the guiding principles. Clearly, issues of responsibility, trust, and work environment are key fundamentals that Starbucks views as critical to its success. The results speak for themselves: Starbucks has been named one of “The World’s Most Ethical Companies” 28 for six years in a row by Ethisphere, a well- respected organization that promotes sound business ethics principles. No other company has been on the list longer than Starbucks.

Values Values are beliefs or convictions that guide behavior and support the overall organization vision. Values help define or describe the desired culture; further, they communicate what is important to the organization, as well as what key practices and behaviors will be recognized and rewarded. Johnson points out that if a mission statement identifies the final destination of a company, then the values that it adopts serve as a moral compass to guide the journey. Values provide a frame of reference, helping a company to set priorities and to determine right from wrong .29 For example, if a company values diversity, then it will do what it can to hire people with a mix of abilities, experiences, knowledge, and personal attributes.

Values give the means to the end, such as the financial goals of an organization. According to Jennings, just meeting numbers does not define an organization’s values. Values determine what the organization will and will not do to get to the numbers. 30 At WorldCom, the goal was to show a continuing trend of earnings increase over time to satisfy financial analysts and investors. Russ McGuire, a former WorldCom employee, who left after two months because of concerns about the environment at the company, writes about the culture that Bernie Ebbers nurtured at WorldCom as follows: “During my brief stay at WorldCom, the company’s priorities were clearly communicated. Each department within the company had firm financial goals to meet. Whenever possible, indi- viduals had specific financial goals. If you missed your goals for 1 month, you were put on warning. If you missed them for 3 months, you were gone. It was as simple as that. These requirements were always discussed within the context of creating shareholder value.” 31 WorldCom valued growth above or else, and employees were expected to do whatever it took, including manipulate the numbers, to achieve that goal.

Ethical Standards The principles of behavior are sometimes considered the organization’s ethical standards. Generally, these would be principles that when followed, promote values such as trust, good behavior, fairness, and caring. There is not one consistent set of standards that all companies follow, but each company has the right to develop the standards that are mean- ingful for their organization. Ethical standards are not always easily enforceable, as they are frequently vaguely defined and somewhat open to interpretation. For example, “Treat the customer with respect and kindness.”

In accounting, the ethical standards for the profession are embodied in its codes of conduct. We have already discussed the codes of the American Institute of Certified Public Accountants (AICPA) and Institute of Management Accountants (IMA) in Chapter 1. Exhibit 3.2 32 presents the code of the Institute of Internal Auditors (IIA). The IIA repre- sents about 170,000 members, many of whom hold the designation of certified internal auditor (CIA).

The IIA Code of Ethics states the principles and expectations governing the behav- ior of individuals and organizations in the conduct of internal auditing. It describes the minimum requirements for conduct and lists behavioral expectations rather than specific activities. The purpose of the IIA Code is to promote an ethical culture in the profession of internal auditing.

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Principles Internal auditors are expected to apply and uphold the following principles:

1. Integrity The integrity of internal auditors establishes trust and thus provides the basis for reliance on their judgment.

2. Objectivity Internal auditors exhibit the highest level of professional objectivity in gathering, evaluating, and communicating information about the activity or process being examined. Internal auditors make a balanced assessment of all the relevant circumstances and are not unduly influenced by their own interests or by others in forming judgments.

3. Confidentiality Internal auditors respect the value and ownership of information they receive and do not disclose information without appropriate authority unless there is a legal or professional obligation to do so.

4. Competency Internal auditors apply the knowledge, skills, and experience needed in the performance of internal audit services.

Rules of Conduct

1. Integrity Internal auditors:

• 1.1. Shall perform their work with honesty, diligence, and responsibility. • 1.2. Shall observe the law and make disclosures expected by the law and the profession. • 1.3. Shall not knowingly be a party to any illegal activity, or engage in acts that are discreditable to the profession of

internal auditing or to the organization. • 1.4. Shall respect and contribute to the legitimate and ethical objectives of the organization.

2. Objectivity Internal auditors:

• 2.1. Shall not participate in any activity or relationship that may impair or be presumed to impair their unbiased assessment. This participation includes those activities or relationships that may be in conflict with the interests of the organization.

• 2.2. Shall not accept anything that may impair or be presumed to impair their professional judgment. • 2.3. Shall disclose all material facts known to them that, if not disclosed, may distort the reporting of activities under


3. Confidentiality Internal auditors:

• 3.1. Shall be prudent in the use and protection of information acquired in the course of their duties. • 3.2. Shall not use information for any personal gain or in any manner that would be contrary to the law or

detrimental to the legitimate and ethical objectives of the organization.

4. Competency Internal auditors:

• 4.1. Shall engage only in those services for which they have the necessary knowledge, skills, and experience.

• 4.2. Shall perform internal audit services in accordance with the International Standards for the Professional Practice of Internal Auditing.

• 4.3. Shall continually improve their proficiency and the effectiveness and quality of their services.

Notice how similar the IIA standards are to those of the AICPA and IMA. In particular, integrity, objectivity, and competency (due care) appear in all three codes. We refer to elements of the IIA code in this chapter because of the role of the internal auditor in estab- lishing an ethical organization environment, as will be discussed later.

Business Ethics versus Personal Ethics While many definitions and characterizations of business ethics exist, one important issue to discuss at this point is whether there is a difference between business and personal ethics.

EXHIBIT 3.2 The IIA Code of Ethics

Source: Republished with permission of The Institute of Internal Auditors Research Foundation, The IIA Code of Ethics. Permission conveyed through Copyright Clearance Center, Inc.

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John Maxwell contends there is no such thing as “business” ethics. Maxwell believes that a single standard of ethics applies to both our business and to our personal lives. Maxwell identifies the standard as the Golden Rule. He says in making ethical decisions, we should ask the question: How would I like to be treated in a particular situation? To Maxwell, the Golden Rule is an integrity guideline for all situations. 33 Maxwell’s perspective implies that we should treat others the way that we would like to be treated. His view is consistent with Kant’s notion of universality; that is, we should act in ways that we would want others to act in similar situations for similar reasons. Imagine, for example, your boss asks you to charge his personal travel expenses to the company for reimbursement because he is short of funds this month. Absent a low-low organizational fit, we can assume you would not cheat in such a way in your personal life or with your own business expenses, so you should act consistently and refuse to do so for your boss. Predictability and consistency of behavior enhances one’s ethical judgments and makes them more understandable to outsiders. In business, it is an important element of trust. In this situation, ethical dissonance occurs because you know that it is wrong to “fudge” an expense report of your boss, but it is presented to you as being in the boss’s best interest.

Many people seem to have a different standard of behavior in the workplace than in their personal lives. The following example illustrates how dangerous this can be. You arrive home one night and see your daughter working on an art project. She has a variety of markers on the table to help with the project. Now, you know that there are no such markers in the house, so you ask your daughter where they came from. She admits taking them from the classroom to help with the project. You lecture her on how wrong it was to do that. She says to you: “But Mommy, you take supplies from your office and use them at home all the time.” Remember, ethics involves consistent behavior based on underlying ethical principles. What kind of example do you set for your daughter if you do improper things in business while touting ethical behavior at home in your personal life? Recall that the last step of the comprehensive decision-making model discussed in Chapter 2 provides for a final reflection before taking action that considers how you would feel if your child knew what you were about to do.

Ends versus Means While most people recognize that business must earn a profit to survive, it is the steps taken in business dealings and financial reporting to make the profit that concern ethicists. As Kant points out, the ends do not justify the means. If they did, then businesses could rationalize accelerating the recording of revenue into an earlier period to inflate profit. A company places its own self-interests (perhaps in the guise of maximizing shareholder wealth) ahead of the interests of society if it decides to inflate revenue and earnings artificially.

A good example of ends versus means can be seen in the actions of commercial and investment banks during the financial crisis of 2007–2008, to transfer risk to others by making risky home mortgage loans, group dozens of them into securitized financial instruments, and then selling the instruments to investment banks. The investment banks proceeded to sell the financial instruments to unsuspecting investors, who trusted that these investments were based on solid financial analysis. The goal of the banks was to transfer risk to others. The means to accomplish the goal was to sell off the instruments to outside investors, most of whom did not fully understand the instruments and were misled into thinking that a high level of returns would be forthcoming.

Trust in Business Trust in business is the cornerstone of relationships with customers, suppliers, employ- ees, and others who have dealings with an organization. Trust means to be reliable and

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carry through words with deeds. Looking back at Rest’s model, trust is gained when an employee follows through ethical intent with ethical action. Trust becomes pervasive only if the organization’s values are followed and supported by top management. By modeling the organization’s values, senior leaders provide a benchmark for all employees.

A good example of building trust in an organization is from Paul O’Neill, former CEO at Alcoa Inc., the world’s third-largest producer of aluminum. O’Neill created a reputation for trust among his employees by setting strict ethical standards and carrying through with them. In an interview with PBS Newshour on July 9, 2002, O’Neill was asked by reporter Jim Lehrer why Alcoa was able to avoid the accounting scandals that infected so many companies in the late 1990s and early 2000s. He responded with the following statement: “When I went there [to Alcoa], I called the chief financial officer and the controller and I said to them, ‘I don’t want to ever be accused of or guilty of managing earnings,’ that is to say making earnings that really aren’t as a consequence of operations.” 34 O’Neill went on to express in the interview his dismay at the number of cases where employees of a company were told that these are the company’s values, and then senior management totally ignored those same values.

Alcoa stands as an example of a company that walks the talk of ethics. Alcoa’s values statement, which appears in Exhibit 3.3 , was recognized in the 2011 Covalence Ethical Ranking, a global ranking organization headquartered in Geneva, Switzerland, which listed Alcoa number 1 in the basic resources sector and the only basic resources company among the top-ranked companies for ethics. Alcoa also was recognized by the Dow Jones Sustainability Indexes for North America and the World, which also rank Alcoa number 1 among aluminum companies.

Trust can be lost, even if once gained in the eyes of the public, if an organization no longer follows the guiding principles that helped to create its reputation for trust. A good example is what has happened with Johnson & Johnson. The company was a model of ethical behavior during the Tylenol incident but has come under intense scrutiny lately over questions about the safety of its other products.

Our Vision Alcoa. Advancing each generation.

Since 1888, the people of Alcoa have partnered to create innovative and sustainable solutions that move the world forward.

Our Values We live our Values every day, everywhere, collaborating for the benefit of our customers, investors, employees, communities, and partners.

Integrity We are open, honest, and accountable.

Environment, Health, & Safety We work safely, promote wellness, and protect the environment.

Innovation We creatively transform ideas into value.

Respect We treat all people with dignity and provide a diverse, inclusive work environment.

Excellence We relentlessly pursue outstanding and sustainable results.

EXHIBIT 3.3 Alcoa Values and Vision Statement

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Chapter 3 Creating an Ethical Organization Environment and Effective Corporate Governance Systems 103

Johnson & Johnson: A Case of Dr. Jekyll and Mr. Hyde? In addition to a statement of values, standards of business practices, and a code of ethics, some companies use a credo to instill virtue. A credo is an aspirational statement that encourages employees to internalize the values of the company. A good example of a corporate credo is that of Johnson & Johnson, which appears in Exhibit 3.4 . 35

The Johnson & Johnson credo clearly sets a positive ethical tone. Notice how it empha- sizes the company’s primary obligations to those who use and rely on the safety of its products. The Johnson & Johnson credo implies that shareholders will earn a fair return if the company operates in accordance with its ethical values. Johnson & Johnson was

We believe our first responsibility is to the doctors, nurses, and patients, to mothers and fathers and all others who use our products and services.

In meeting their needs, everything we do must be of high quality. We must constantly strive to reduce our costs

in order to maintain reasonable prices. Customers’ orders must be serviced promptly and accurately.

Our suppliers and distributors must have an opportunity to make a fair profit.

We are responsible to our employees, the men and women who work with us throughout the world.

Everyone must be considered as an individual. We must respect their dignity and recognize their merit.

They must have a sense of security in their jobs. Compensation must be fair and adequate,

and working conditions clean, orderly, and safe. We must be mindful of ways to help our employees fulfill

their family responsibilities. Employees must feel free to make suggestions and complaints.

There must be equal opportunity for employment, development, and advancement for those qualified.

We must provide competent management, and their actions must be just and ethical.

We are responsible to the communities in which we live and work, and to the world community as well.

We must be good citizens—support good works and charities and bear our fair share of taxes.

We must encourage civic improvements and better health and education. We must maintain in good order

the property we are privileged to use, protecting the environment and natural resources.

Our final responsibility is to our stockholders. Business must make a sound profit.

We must experiment with new ideas. Research must be carried on, innovative programs developed,

and mistakes paid for. New equipment must be purchased, new facilities provided,

and new products launched. Reserves must be created to provide for adverse times.

When we operate according to these principles, the stockholders should realize a fair return.

EXHIBIT 3.4 Johnson & Johnson Credo

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credited with being an ethical organization in part because of the way it handled the Tylenol poisoning incidents in 1982. However, more recent events bring into question whether the company is suffering from a “Dr. Jekyll and Mr. Hyde” syndrome.

Tylenol Poisoning In the fall of 1982, seven people in the Chicago area collapsed suddenly and died after taking Tylenol capsules that had been laced with cyanide. These five women and two men became the first victims ever to die from what came to be known as “product tampering.”

McNeil Consumer Products, a subsidiary of Johnson & Johnson, was confronted with a crisis when it was determined that each of the seven people had ingested an Extra-Strength Tylenol capsule laced with cyanide. The news of this incident traveled quickly and was the cause of a massive, nationwide panic.

Tamara Kaplan, a professor at Penn State University, contends that Johnson & Johnson used the Tylenol poisonings to launch a public relations program immediately to preserve the integrity of both their product and their corporation as a whole. We find this to be a vacu- ous position, however. By Kaplan’s own admission, “Johnson & Johnson’s top manage- ment put customer safety first, before they worried about their company’s profit and other financial concerns.” 36 This hardly sounds like a company that used a catastrophic event to boost its image in the eyes of the public.

Johnson & Johnson’s stock price dropped precipitously after the initial incident was made public. In the end, the stock price recovered because the company’s actions gained the support and confidence of the public. Johnson & Johnson acted swiftly to remove all the product from the shelves of supermarkets, provide free replacements of Tylenol cap- sules with the tablet form of the product, and make public statements of assurance that the company would not sell an unsafe product. To claim that the company was motivated by a public relations agenda (even though in the end, its actions did provide a public relations boon for the company) is to ignore a basic point that Johnson & Johnson’s management may have known all along. That is, good ethics is good business. But don’t be fooled by this expression. It is good for the company if it benefits as a result of an ethical action. However, the main reason to make ethical decisions, as did Johnson & Johnson, is that it is the proper way to act. Much like Alcoa, Johnson & Johnson’s credo instills a sense of pride for what the company stands for.

Appendix 1 of this chapter presents an analysis of Johnson & Johnson’s actions from the perspective of the comprehensive ethical decision-making model starting from the first public disclosure of the poisoning and how the company should have (and did) act in response. We provide the analysis to help students gain proficiency in using the model and identifying the ethical issues and stakeholders that provide the basis for making ethical judgments.

Johnson & Johnson Records a $3.3 Billion Charge for Product Liability Johnson & Johnson announced in January 2012 that it recorded pretax charges and special items totaling $3.3 billion for the fourth quarter of 2011 in order to provide a reserve for probable losses from product liability lawsuits. The pending lawsuits are attributable to misleading marketing practices and manufacturing-quality lapses.

On August 2, 2012, the company disclosed in a securities filing that it had reached an agreement in principle with the U.S. Justice Department and some states on settling inves- tigations into marketing practices, including the illegal promotion of the antipsychotic Risperdal. One of the company’s operating units paid state officials to get Risperdal on approved drug lists, marketed it for unapproved uses to children and the elderly, and lied about its safety and effectiveness. The company did not give a dollar amount of its liability, which The Wall Street Journal has said could be as much as $2.2 billion, depending on how many of the states suing the company join in the lawsuit. 37

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Chapter 3 Creating an Ethical Organization Environment and Effective Corporate Governance Systems 105

Unfortunately, the problems for Johnson & Johnson go further back. Here is a brief summary of the investigations against the company:

1. On December 21, 2011, it was announced that Johnson & Johnson must defend a lawsuit claiming that it misled investors about quality control failures at manufacturing plants that led to recalls of the popular over-the-counter drug Motrin. Allegedly, top executives made misleading statements about details of the recalls, leading to stock losses after the true reasons for the recalls became public.

2. Earlier in 2011, a lawsuit filed by a group of consumers alleging that Johnson & Johnson’s baby shampoo includes potentially cancer-causing chemicals was allowed to go forward after evidence came out that the product contained a chemical ingredient called methylene chloride, which is banned by the U.S. Food and Drug Administration (FDA) for use in cosmetics.

3. In January 2011, it was announced that Johnson & Johnson might have to pay up to $1 billion for lawsuits concerning its subsidiary DePuy Orthopaedics, which sold metal-on-metal hip implants that were found to shed minute metal particles into a patient’s bloodstream over time. Lawsuits over the implants have piled up across the country, accusing DePuy of manufacturing a defective product, failing to warn patients and doctors of problems with the implant, and negligence in designing, manufacturing, and selling the product.

It is worth noting that Johnson & Johnson raised its product-liability reserves to $570 million at the end of 2010 and allotted $280 million for medical costs of patients directly affected by the recalled hip implants.

4. Women who have suffered serious injury and disfiguration filed lawsuits in 2012 against Johnson & Johnson subsidiary Ethicon, claiming that vaginal mesh manufactured by Ethicon caused them life-altering complications. Upon investigation, a number of doctors and scientists concluded that the Ethicon vaginal mesh and bladder slings did not meet reasonable safety standards. The FDA issued Public Health Notifications regarding the use of vaginal mesh products to treat pelvic organ prolapse and stress urinary incontinence in October 2008, in February 2009, and in July 2011.

Some might say that Johnson & Johnson made withdrawals from its “trust” bank in recent years. They reacted slowly to a variety of crises, at first failing to admit any culpabil- ity and disclaiming financial liability. We can’t escape the logical conclusion that “where there is smoke, there is fire.” The disappointing fact is that these instances occurred as a result of management and internal actions and reflect a culture that has changed dramati- cally from the days of the Tylenol poisoning. Perhaps Johnson & Johnson is learning the hard way that it takes a long time to build a reputation for trust, but not very long to tear it down.

Employees Perceptions of Ethics in the Workplace Given the organization-person fit and values that provide part of the culture for ethical decision making in the workplace, it is important to understand how employees view the ethics of the organizations they work for, in part to better understand corporate gover- nance systems and whistleblowing, which are discussed later in this chapter. The 2011 National Business Ethics Survey (NBES) conducted by the Ethics Resource Center pro- vides interesting data about ethics in the workplace. The report is the seventh in a series. The 2011 survey provides information on the views of 4,683 respondents that represent a broad array of employees in the for-profit sector. 38 Exhibit 3.5 summarizes some of the survey results.

The results of the NBES survey are mixed. On the one hand, the percentage of employees who witnessed misconduct at work has declined by 10 percent from 2007 to 2011, and those reporting misconduct increased by 7 percent. On the other hand, pressure to compromise

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106 Chapter 3 Creating an Ethical Organization Environment and Effective Corporate Governance Systems

ethical standards trended upwards in 2011, after a decline between 2007 and 2009. The same is true of the view of a weak ethical culture. A troubling result is retaliation against employee whistleblowers almost doubled. When employees were asked whether they could question management without fear of retaliation, 19 percent said it was not safe to do so.

The five most frequently observed types of misconduct reported in 2011 were (1) misuse of company time (33 percent); (2) abusive behavior (21 percent); (3) and (4) company resource abuse and lying to employees (20 percent each); and (5) violating company Internet use policies (16 percent). The latter is a growing problem, with more and more employees turning to social networking while on the job. Most of the active networkers who reported misconduct in the workplace say that they experienced retaliation as a result: 56 percent, compared to just 18 percent of less active social networkers and non-networkers. These results may indicate that a company turns more quickly on an employee who reports wrong- doing if that employee also uses social networking at work. The NBES survey also indicates that active social networkers show a higher tolerance for certain activities that could be considered questionable. For example, among active social networkers, half believe that it is acceptable to keep copies of confidential work documents in case they need them in their next job, compared to only 15 percent of their colleagues. 40

We have already discussed common ways to improve the ethical culture of an organi- zation, including values-based decision making and having a code of conduct. The NBES survey reports that ethics and compliance programs have grown since the establishment of the U.S. Federal Sentencing Guidelines for Organizations (FSGO). The U.S. Congress passed the FSGO in 1991 to create an incentive for organizations to develop and imple- ment programs designed to foster ethical and legal compliance. These guidelines, which were developed by the U.S. Sentencing Commission, apply to all felonies and class A misdemeanors committed by employees in association with their work. As an incen- tive, organizations that demonstrated due diligence in developing effective compliance programs to discourage unethical and illegal conduct may be subject to reduced organi- zational penalties if an employee commits a crime. The essence of the law is that legal violations can be prevented through organizational values and a commitment to ethical conduct. Some have called the law the “good parenting statute.” 41 In 2011, organizations subject to the law had the following ethical measures in place as part of their culture.

EXHIBIT 3.5 Views of Employees on Ethics in the Workplace from the 2011 National Business Ethics Survey 39

Item 2011 2009 2007 Pressure to compromise ethical standards 13% 8% 10%

Weak/weak-leaning ethical culture 42% 35% 39%

Negative view of supervisors’ ethics 34% 24% 26%

Observed misconduct 45% 49% 55%

Reported observed misconduct 65% 63% 58%

Experienced retaliation after reporting (i.e., whistleblowing)

22% 15% 12%

Disciplining of employees who violate the standards of the organization or the law 85%

Written standards for ethical conduct 82%

Provision of a mechanism of reporting misconduct anonymously 77%

Training on company standards of ethical workplace conduct 76%

Provision of a mechanism for seeking ethics-related advice or information 68%

Assessment of ethical conduct as a part of employee performance evaluations 67%

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Chapter 3 Creating an Ethical Organization Environment and Effective Corporate Governance Systems 107

Stakeholder Perspective

The well-known ethicist Archie Carroll points out that questions of right, wrong, fairness, and justice permeate an organization’s activities as it attempts to interact successfully with major stakeholder groups, including investors and creditors, employees, customers, government, and society at large. He believes that the principal task of management is not only to deal with the various stakeholder groups in an ethical fashion, but also to reconcile the conflicts of interest that occur between the organization and the stakeholder groups. 42

Ferrell et al. state that the degree to which an organization understands and addresses stakeholder demands can be referred to as a stakeholder orientation. 43 This orientation comprises three sets of activities: (1) the organization-wide generation of data about stake- holder groups and assessment of the firm’s effects on these groups, (2) the distribution of this information throughout the firms, and (3) the responsiveness of the organization as a whole to this information. 44

Generating data about stakeholders begins with identifying the stakeholders that are relevant to the firm followed by the concerns about the organization’s conduct that each relevant stakeholder group shares. At this stage, the values and standards of behavior are used to evaluate stakeholder interests and concerns from an ethical perspective. The ethical reasoning methods previously discussed help to make the necessary judgments.

Stakeholder management requires that an individual consider issues from a variety of perspectives other than one’s own or that of the organization. The case of the Ford Pinto illus- trates how important stakeholder concerns can be left out of the decision-making process.

The Case of the Ford Pinto The case of the Ford Pinto illustrates a classic example of how a company can make a fatal mistake in its decision making by failing to consider the interests of the stakehold- ers adequately. The failure was due to total reliance on utilitarian thinking instead of the universality perspective of rights theory, to the detriment of the driving public and society in general.

The Pinto was Ford Motor Company’s first domestic North American subcompact auto- mobile, marketed beginning on September 11, 1970. It competed with the AMC Gremlin and Chevrolet Vega, along with imports from makes such as Volkswagen, Datsun, and Toyota. The Pinto was popular in sales, with 100,000 units delivered by January 1971, and was also offered as a wagon and Runabout hatchback. Its reputation suffered over time, however, especially from a controversy surrounding the safety of its gas tank.

The public was shocked to find out that if the Pinto cars experienced an impact at speeds of only 30 miles per hour or less, they might become engulfed in flames, and passengers could be burned or even die. Ford faced an ethical dilemma: what to do about the appar- ently unsafe gas tanks that seemed to be the cause of these incidents. At the time, the gas tanks were routinely placed behind the license plate, so a rear-end collision was more likely to cause an explosion (whereas today’s gas tanks are placed on the side of the vehicle). However, the federal safety standards at the time did not address this issue, so Ford was in compliance with the law. Ford’s initial response was based on ethical legalism—the company complied with all the laws and safety problems, so it was under no obligation to take any action.

Eventually, Ford did use ethical analysis to develop a response. It used a risk-benefit analysis to aid decision making. This was done because the National Highway Traffic Safety Administration (NHTSA) excused a defendant from being penalized if the mon- etary costs of making a production change were greater than the “societal benefit” of that change. The analysis followed the same approach modeled after Judge Learned Hand’s ruling in United States v. Carroll Towing in 1947 that boiled the theory of negligence down

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to the following: If the expected harm exceeded the cost to prevent it, the defendant was obligated to take the precaution, and if he (or it, in the case of a company) did not, liability would result. But if the cost was larger than the expected harm, the defendant was not expected to take the precaution. If there was an accident, the defendant would not be found guilty. 45 A summary of the Ford analysis follows.

Ford’s Risk-Benefit Analysis 46

Benefits of Fixing the Pintos Savings: 180 burn deaths, 180 serious burn injuries, 2,100 burned vehicles Unit cost: $200,000 per death (figure provided by the government); $67,000 per burn injury and $700 to repair a burned vehicle (company estimates) Total benefits: 180 3 ($200,000) 1 180 3 ($67,000) 1 2,100 3 ($700) 5 $49.5 million

Costs of Fixing the Pintos Sales: 11 million cars, 1.5 million light trucks Unit cost: $11 per car, $11 per light truck Total cost: 11,000,000 3 ($11) 1 1,500,000 3 ($11) 5 $137 million

Based on this analysis and other considerations, including not being required by law to change its product design, Ford decided not to change the placement of the fuel tank. Ford relied on ethical legalism reasoning to justify (rationalize) its actions.

In 2009, Toyota encountered a problem with some of its models when news broke that there may be a sudden unintended acceleration on certain models. Toyota was hesitant at first to do anything, but after being forced to explain its actions to the U.S. Congress, the company did take corrective action. You might say that Toyota was nudged by con- gressional and public opinion to see that the rights of the driving public outweighed any benefits of inaction. Toyota’s fix was to first cut the length of the accelerator pedals until replacement pedal assemblies become available and to install a brake-to-idle algorithm on affected models. In December 2012, the company agreed to pay about $1.1 billion to settle a class-action lawsuit stemming from complaints about the unintended acceleration.

Returning to the Pinto problem, Ford decided to do a risk-benefit analysis relying only on act-utilitarian reasoning that focused only on costs and benefits, an approach that ignores the rights of various stakeholders. A rule-utilitarian approach might have led Ford to follow the rule “Never sacrifice public safety.” A rights theory approach would have led to the same conclusion, based on the reasoning that the driving public has an ethical right to expect that their cars will not blow up if there is a crash at low speeds.

The other danger of utilitarian reasoning is that an important factor may be omitted from the analysis. Ford did not include as a potential cost the lawsuit judgments that might be awarded to the plaintiffs and against the company. For example, in May 1972, Lily Gray was traveling with 13-year-old Richard Grimshaw when their Pinto was struck by another car traveling approximately 30 miles per hour. The impact ignited a fire in the Pinto, which killed Gray and left Grimshaw with devastating injuries. A judgment was rendered against Ford, and the jury awarded the Gray family $560,000 and Matthew Grimshaw, the father of Richard Grimshaw, $2.5 million in compensatory damages. The surprise came when the jury also awarded $125 million in punitive damages. This was subsequently reduced to $3.5 million. 47

In the aftermath of the scandal, it is interesting to consider whether any of the Ford executives who were involved in the decision-making process would have predicted in advance that they would have made such an unethical choice. Dennis Gioia, who was in charge of recalling defective automobiles at Ford, did not advocate ordering a recall. Gioia eventually came to view his decision not to recall the Pinto as a moral failure—what

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Chapter 3 Creating an Ethical Organization Environment and Effective Corporate Governance Systems 109

De Cremer and Tenbrunsel call a failure to think outside his prevailing background narrative or script at the point of decision. “My own schematized (scripted) knowledge influenced me to perceive recall issues in terms of the prevailing decision environment and to uncon- sciously overlook key features of the Pinto case . . . mainly because they did not fit an exist- ing script.” While personal morality was very important to Gioia, he admits that the framing narrative of his workplace “did not include ethical dimension.” 48 The moral mistake was that there were other, better choices that he could have made—albeit ones outside the pur- view of Gioai’s framing narrative. The Pinto situation is much like the Challenger disaster discussed earlier in the chapter. The decisionmakers in each case made the same mistake of viewing the decision as a business decision rather than an ethical decision. The result, as previously noted, was ethical fading, where the ethical dimensions of the problem disappear from consideration and issues of costs and benefits and image take center stage.

Fraud in Organizations

Fraud can be defined as a deliberate misrepresentation to gain an advantage over another party. Fraud comes in many different forms, including fraud in financial statements, the misappropriation of assets (theft) and subsequent cover-up, and disclosure fraud. We discuss fraud in the financial statements more fully in Chapter 5. In this chapter, we will look at the results of the 2012 Global Fraud Survey: Report to the Nations on Occupational Fraud and Abuse, conducted by the Association of Certified Fraud Examiners (ACFE).

Fraudulent Business Practices Fraudulent business practices occur when an organization purposefully engages in an act that harms another person, such as a customer. A good example is that of Sears. The Sears case illustrates what can happen when the culture of an organization allows for deceptive business practices. One way to prevent this from happening is to establish an ethical tone at the top that sends the message to employees that such practices will not be tolerated. Sears violated its obligations to its most important stakeholder—its customers, and the company’s reputation was tarnished as a result of these events. In the end, Sears had to shut down its auto-repair operation.

In 1992, Sears paid $15 million to settle accusations in 41 states that auto-repair sales representatives were finding problems where none existed to get commissions on repair work. This was not an example of a few rogue employees acting alone to line their pockets with money they didn’t rightfully earn. The company had instilled a culture of overcharg- ing hundreds of customers at its auto-repair centers for performing four-wheel alignments, even though only the front wheels can be aligned on many vehicles. Mechanics at Sears also told customers they would conduct a “free” vehicle inspection, but then went on to charge for unauthorized repairs supposedly discovered during the inspections. Sears’s actions were repeated over and over again. In New Jersey alone, there were at least 350 instances of the alleged overcharges for wheel alignments at 19 separate Sears stores. This wasn’t the first time Sears has faced lawsuits because of its fraudulent business practices. In 1992, Sears agreed to pay as much as $20 million to settle 19 class action lawsuits that stemmed from charges that it bilked auto-repair customers by recommending unneeded repairs. California state authorities sent in undercover investigators for simple brake jobs that Sears had advertised. The government subsequently charged that about half of the 72 auto centers had recommended unnecessary replacement of such parts. Under the terms of the settlement, Sears offered a coupon worth $50 to some 933,000 customers nationwide who had the various (unnecessary) services performed at a Sears auto center from August 1, 1990, through January 31, 1992. There was a persistent and pervasive pattern of

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fraud and deception, according to the lawsuits. The unassailable conclusion is that Sears was responsible for a moral erosion of business ethics in its auto-repair business. One has to wonder whether unethical behavior fed into other business lines of Sears as well.

Occupational Fraud The 2012 ACFE survey is a follow-up to its 2010 Global Fraud Study and its 2008 Report to the Nation on Occupational Fraud and Abuse. The survey took on a distinctly interna- tional flavor in 2010 and 2012. The 2012 survey reports on 1,388 cases of occupational fraud that were reported by the Certified Fraud Examiners (CFEs) who investigated them. These offenses occurred in nearly 100 countries on six continents. 49

As previously discussed, trust is the basis of business relationships, and it is essential for companies to entrust their employees with resources and responsibilities. The ACFE report focuses on occupational fraud schemes in which an employee abuses the trust placed in him by an employer for personal gain. The ACFE defines occupational fraud as “the use of one’s occupation for personal enrichment through the deliberate misuse or misapplication of the employing organization’s resources or assets.” 50 A summary of the findings follows:

• Survey participants estimated that the typical organization loses 5 percent of its rev- enues to fraud each year.

• The median loss caused by the occupational fraud cases studied was $140,000. • The frauds reported lasted a median of 18 months before being detected. • Asset misappropriation schemes were the most common type of occupational fraud,

comprising 87 percent of the reported cases. • Financial statement fraud schemes made up just 8 percent of the cases, but caused the

greatest median loss at $1 million. • Occupational fraud is more likely to be detected by a tip than by any other method. • Corruption and billing schemes pose the greatest risks to organizations throughout the

world. • The presence of anti-fraud controls is correlated with significant decreases in the cost

and duration of occupational fraud schemes. • Perpetrators with higher levels of authority tend to cause much larger losses. • The longer a perpetrator has worked for an organization, the higher fraud losses tend to be. • In 81 percent of the cases, the fraudster displayed one or more behavioral red flags that

are often associated with fraudulent activities. • Nearly half of the victim organizations do not recover any losses they suffer due to fraud.

A variety of observations from the results are discussed below given the focus in this chapter on ethics in organizations and creating an ethical culture.

How Occupational Fraud Is Committed and Detected Asset misappropriation schemes include when an employee steals or misuses resources, such as charging personal expenses to the company while traveling on business trips. Corruption schemes include misusing one’s position or influence in an organization for personal gain, something that Dennis Kozlowski, the former CEO at Tyco, was known for doing. Kozlowski and chief financial officer (CFO) Mark Swartz were convicted on June 21, 2005, of taking bonuses worth more than $120 million without the approval of Tyco’s directors, abusing an employee loan program, and misrepresenting the company’s financial condition to investors to boost the stock price while selling $575 million in stock. Perhaps the most egregious offense by Kozlowski was to charge the company for half the cost of a birthday party thrown for his wife on the Italian island of Sardinia, claiming that business was conducted during the weeklong event.

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A surprising result is that a “tip” was the most common way of detecting fraud, at 43.3 percent in 2012. According to the ACFE report, detection by tip has been the most common method of initial detection since the first survey in 2002. It could be that tips are primarily provided by whistleblowers, but the study does not reach that conclusion. Exhibit 3.6 shows the frequency of detection methods as reported by survey respondents.

An important conclusion from these results is that controls such as management reviews and internal audits account for a significant percentage of detection methods (29 percent) and the external audit does not seem to be a reliable method to detect fraud at only 3.3 percent. These results have implications for our discussion of corporate gov- ernance later on.

Red-Flag Warnings of Fraud The ACFE study found that most occupational fraudsters’ crimes are motivated at least in part by some kind of financial pressure. In addition, while committing a fraud, an individual will frequently display certain behavioral traits associated with stress or a fear of being caught. 51 These warning signs should alert internal auditors that trouble may lie ahead with respect to actual fraud. Exhibit 3.7 shows the fraud indicators identified in the study.

The results of the survey clearly indicate that internal auditors should have their “eyes wide open” with respect to whether senior officers have adopted a lavish living style that creates the incentive to “cook the books” in a way that provides financial results to support their lifestyle. If earnings go up, stock prices often rise as well. Top managers typically own stock in their companies, so an incentive exists to boost earnings sometimes at any cost. A good example is the former CEO of HealthSouth, Richard Scrushy. Recall that we earlier identified the company as one that showed signs of ethical collapse because of its weak board of directors. Scrushy was behind the $2.7 billion earnings overstatement at HealthSouth.

Scrushy allegedly received $226 million in compensation over seven years, while HealthSouth was losing $1.8 billion during the same period. A skeptical auditor would have asked where all that money was going and would have looked for warnings that Scrushy might have been living beyond his means. Scrushy was charged with knowingly engaging in financial transactions using criminally derived property, including the purchase of land, aircraft, boats, cars, artwork, jewelry, and other items. At his trial, it become known that he had used money from his compensation for several residences in the state of Alabama and property in Palm Beach, Florida; a 92-foot Tarrab yacht called Chez Soiree, a 38-foot Intrepid Walkaround watercraft and a 42-foot Lightning boat; a 1998 Cessna Caravan

Detection Method Percentage Reported Median Loss

Tip 43.3% $144,000

Management Review 14.6% $123,000

Internal Audit 14.4% $81,000

By Accident 7.0% $166,000

Account Reconciliation 4.8% $124,000

Document Examination 4.1% $105,000

External Audit 3.3% $370,000

Notified by Police 3.0% $1,000,000

Surveillance/Monitoring 1.9% N/A

Confession 1.5% $225,000

IT Controls 1.1% $110,000

Other 1.1% $378,000

EXHIBIT 3.6 Initial Detection of Occupational Frauds from the ACFE 2012 Global Survey: 2012 Report to the Nations on Occupational Fraud and Abuse

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675, together with amphibious floats and other equipment, and a 2001 Cessna Citation 525 aircraft; diamond jewelry; several luxury automobiles, including a 2003 Lamborghini Murcielago, a 2000 Rolls Royce Corniche, and two 2002 Cadillac Escalades; and paintings by Pablo Picasso, Marc Chagall, Pierre-August Renoir, among others.

It is not just the internal auditors who wore blinders and the board that looked the other way. The external auditors did not detect the fraud either.

Financial Statement Fraud Financial statement fraud schemes occur because an employee—typically a member of top management—causes a misstatement or omission of material information in the orga- nization’s financial reports. Examples include recording fictitious revenues, understating reported expenses, artificially inflating reported assets, and failing to accrue expenses at the end of the year, such as what occurred in the DigitPrint case in Chapter 1.

A report by Ernst & Young, Detecting Financial Statement Fraud: What Every Manager Needs to Know, 52 provides examples of common methods to overstate revenue, under- state expenses, and make improper asset valuations. Revenue overstatements include the following:

• Recording gross, rather than net, revenue • Recording revenues of other companies when acting as a “middleman” • Recording sales that never took place • Recording future sales in the current period • Recording sales of products that are out on consignment

Common methods of understating expenses include the following:

• Reporting cost of sales as a non-operating expense so that it does not negatively affect gross margin

• Capitalizing operating costs, recording them as assets on the balance sheet instead of as expenses on the income statement (i.e., WorldCom)

• Not recording some expenses at all, or not recording expenses in the proper period

Behavioral Indicators of Fraud Percentage Reported Living Beyond Means 35.6%

Financial Difficulties 27.1%

Unusually Close Association with Vendor/Customer 19.2%

Control Issues, Unwillingness to Share Duties 18.2%

Divorce/Family Problems 14.8%

Wheeler-Dealer Attitude 14.8%

Instability, Suspiciousness or Defensiveness 12.6%

Addiction Problems 8.4%

Past Employment-Related Problems 8.1%

Complained About Inadequate Pay 7.9%

Refusal to Take Vacations 6.5%

Excessive Pressure Within Organization 6.5%

Past Legal Problems 5.3%

Complained About Lack of Authority 4.8%

Excessive Family/Peer Pressure for Success 4.7%

Instability in Life Circumstance 4.1%

EXHIBIT 3.7 Behavioral Red Flags of Fraudsters from the ACFE 2012 Global Survey: 2012 Report to the Nations on Occupational Fraud and Abuse

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Chapter 3 Creating an Ethical Organization Environment and Effective Corporate Governance Systems 113

Examples of improper asset valuations include the following:

• Manipulating reserves • Changing the useful lives of assets • Failing to take a write-down when needed • Manipulating estimates of fair market value

One of the most bizarre examples of financial statement fraud involved Miniscribe, a manufacturer of computer hard drive disks that committed inventory fraud in the 1980s in the amount of $15 million. This was a mere pittance compared to the $11 billion fraud at WorldCom some 15 years later, but the efforts of Miniscribe’s management to cover up the fraud were as audacious as any ever seen. Exhibit 3.8 summarizes this fraud. Of particular note is the unethical behavior at the highest levels of management that created a culture of blindness to what was right and wrong and led to the perpetuation of the fraud. An important point in the Miniscribe fraud is that top management committed the fraud and overrode internal controls in the process. The corporate governance system at Miniscribe failed because the company lacked independent members on its board of directors to serve as a check against excessive management behavior.

Miniscribe was a Colorado-based manufacturer of computer hard disk drives whose top officers were convicted of management fraud by covering up a multimillion-dollar inventory overstatement between December 1986 and January 1989, which falsely inflated Miniscribe’s profits and accelerated its descent into bankruptcy.

Patrick Schleibaum was the former CFO and vice president of Miniscribe. Quentin T. Wiles was the former chairman of the board and CEO of Miniscribe. Both Schleibaum and Wiles were convicted of making false statements to the government and securities fraud.

Miniscribe began operations in 1981 in Longmont, Colorado. Miniscribe was then a privately owned company manufacturing computer disk drives operating out of the basement of its founder, Terry Johnson. Miniscribe went public in 1983, but it soon grew beyond its capacity. In 1985, a venture capital group, Hambrecht & Quist, invested $20 million in Miniscribe and gained control of its management. By 1986, Miniscribe was a profitable, publicly owned corporation with operations in Colorado, Hong Kong, and Singapore. Miniscribe, whose common stock was traded on the NASDAQ exchange, was subject to the Securities Exchange Act of 1934, as well as the rules and regulations of the Securities and Exchange Commission (SEC).

Following its change in management, Wiles headed Miniscribe from his office in Sherman Oaks, California. Wiles had a reputation as a successful, demanding executive who expected performance. Salaries and bonuses at Miniscribe often depended upon Miniscribe “making the numbers.”

Assisting Wiles was a management team consisting largely of certified public accountants (CPAs). Schleibaum initially served as Miniscribe’s CFO.

Despite reported growth and profitability, Miniscribe’s financial position began to deteriorate early in 1987. In January 1987, Miniscribe conducted its annual inventory count to determine the value of inventory on hand. The accuracy of the inventory count was critical to the proper preparation of Miniscribe’s 1986 year-end financial statements.

Management retained the independent accounting firm of Coopers & Lybrand to audit Miniscribe and verify the accuracy of its inventory count. The standard procedure for verifying a company’s inventory count is through a test count—an inventory sampling deemed representative of the entire inventory. Problems arose when, unbeknownst to the auditors, management detected an inventory hole of between $2 million and $4 million. This inventory hole appeared because the actual inventory count, and thus dollar value of the inventory, was less than the value of the inventory recorded on Miniscribe’s books. The overstatement of inventory led to the understatement of cost of goods sold and inflated earnings equal to the amount of the inventory overstatement.

At this point, Wiles was unaware of the inventory hole. Schleibaum properly decided to charge a portion of the hole against an emergency fund known as “inventory reserves.” The remainder of the hole also should have been charged off or expensed as a cost of goods sold, with a corresponding reduction in profits. But when the division manager, Warren Perry, suggested this approach, Schleibaum balked. Instead, Schleibaum directed his subordinates to conceal the remainder of the inventory hole through improper means so that Miniscribe could continue to “make the numbers.”

EXHIBIT 3.8 Miniscribe Fraud 53


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With Schleibaum’s knowledge and approval, Perry and operations controllers Kenneth A. Huff and Steven Wolfe decided to cover the inventory hole by falsely inflating the inventory count. To hide the false count from the auditors, Wolfe and Perry broke into the auditors’ work trunks at Miniscribe after business hours and altered the test count to match the inflated inventory count. The inflated numbers were then entered into Miniscribe’s computer system and reflected as additional inventory. Schleibaum signed a management representation letter to the auditors indicating that Miniscribe’s financial statements were accurate, including its inventory valuation. Miniscribe cleared the 1986 audit.

Miniscribe reported the false profits resulting from concealment of the inventory hole on its 1986 income statement and 1987 first-quarter earnings statement. Miniscribe disseminated this information to the public through its 1986 annual report and 1987 first-quarter financial report. Schleibaum signed the 1986 10-K report (annual report to the SEC) and 1987 first-quarter 10-Q report, which contained Miniscribe’s false financial statements. Miniscribe filed the 10-K and 10-Q reports with the SEC as required by law. Miniscribe’s reported success allowed the company to raise funds through a $97 million issue of debentures early in 1987.

In the spring of 1987, Wiles became concerned about Miniscribe’s internal controls and financial strength. He worried that if an inventory problem actually existed, Miniscribe and its officers might be liable to those investors purchasing the debentures on the basis of the company’s reported financial strength. Ultimately, a $15 million hole in inventory was discovered. Wiles had decided that Miniscribe could not afford to write off the inventory hole in 1987; instead, it had to cover it up to maintain investor confidence. Wiles planned to write off the inventory hole over six quarters, beginning with the first quarter of 1988.

In December 1987, independent auditors began preparing for Miniscribe’s 1987 year-end audit. Miniscribe again faced the problem of clearing the independent audit. In mid-December, Miniscribe’s management, with Wiles’s approval and Schleibaum’s assistance, engaged in an extensive cover-up, which included recording the shipment of bricks as in-transit inventory. To implement the plan, Miniscribe employees first rented an empty warehouse in Boulder, Colorado, and procured 10 exclusive-use trailers. They then purchased 26,000 bricks from the Colorado Brick Company.

On Saturday, December 18, 1987, Schleibaum and others gathered at the warehouse. Wiles did not attend. From early morning to late afternoon, those present loaded the bricks onto pallets, shrink-wrapped the pallets, and boxed them. The weight of each brick pallet approximated the weight of a pallet of disk drives. The brick pallets then were loaded onto the trailers and taken to a farm in Larimer County, Colorado.

Miniscribe’s books, however, showed the bricks as in-transit inventory worth approximately $4 million. Employees at two of Miniscribe’s buyers, CompuAdd and CalAbco, agreed to refuse fictitious inventory shipments from Miniscribe totaling $4 million. Miniscribe then added the fictitious inventory shipments to the company’s inventory records.

Additionally, the officers employed other means to cover the inventory hole, including (1) recording the shipment of nonexistent inventory from Colorado to the Far East, (2) packaging scrap as inventory, (3) double-counting inventory, and (4) failing to record payables upon the receipt of materials. These various means distributed the inventory hole throughout Miniscribe’s three facilities, making the problem more difficult for the independent auditors to detect.

Again, Schleibaum signed a management representation letter to the auditors stating that Miniscribe’s 1987 financial reports were accurate and truthful, and Miniscribe cleared the independent audit. The result of the cover-up was that Miniscribe’s book inventory and reported profits for 1987 were overstated by approximately $15 million and $22 million, respectively. These figures represented 17 percent of Miniscribe’s inventory and 70 percent of its profits for the year.

Eventually, Miniscribe got caught up in its own fraud, as it became more and more difficult to cover the inventory hole and questions were asked about its accounting. The sharp decline in the stock market in October 1987 hastened the day when the house of cards that was Miniscribe collapsed. The company finally declared bankruptcy in 1990.

EXHIBIT 3.8 (Continued)

Foundations of Corporate Governance Systems

An essential part of creating an ethical organization environment is to put in place effective corporate governance systems that establish control mechanisms to ensure that organiza- tional values guide decision making and that ethical standards are being followed. The char- acteristics of such systems include accountability, oversight, and control. Accountability refers to the relationship between workplace decisions, strategic direction, and compliance with legal and ethical considerations. Oversight provides a system of checks and balances that limit employees’ and managers’ opportunities to deviate from established policies

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Chapter 3 Creating an Ethical Organization Environment and Effective Corporate Governance Systems 115

and strategies aimed at preventing unethical and illegal activities. Control is the process of auditing and improving organizational decisions and actions, which relies on internal audit and internal control processes. 54

Defining Corporate Governance There is no single, accepted definition of corporate governance. A fairly narrow definition given by Shleifer and Vishny emphasizes the separation of ownership and control in corpo- rations. They define corporate governance as dealing with “the ways in which the suppliers of finance to corporations assure themselves of getting a return on their investment.” 55 Parkinson defines it as a process of supervision and control intended to ensure that the company’s management acts in accordance with the interests of shareholders. 56

A corporate governance regime typically includes mechanisms to ensure that the agent (management) runs the firm for the benefit of one or more principals (shareholders, creditors, suppliers, clients, employees, and other parties with whom the firm conducts its business). The mechanisms include internal ones, such as the board of directors, its committees, executive compensation policies, and internal controls, and external mea- sures, which include monitoring by large shareholders and creditors (in particular banks), external auditors, and the regulatory framework of a securities exchange commission, the corporate law regime, and stock exchange listing requirements and oversight.

The definition of corporate governance that we like the best is by Tricker, who says that governance is not concerned with running the business of the company per se, but with giving overall direction to the enterprise, with overseeing and controlling the execu- tive actions of management, and with satisfying legitimate expectations of accountability and regulation by interests beyond the corporate boundaries. 57 In this regard, corporate governance can be seen as a set of rules that define the relationship between stakeholders, management, and board of directors of a company and influence how that company is operating. At its most basic level, corporate governance deals with issues that result from the separation of ownership and control. But corporate governance goes beyond simply establishing a clear relationship between shareholders and managers.

Views of Corporate Governance Differences exist about the role of corporate governance in business. Some organizations take the view that so long as they are maximizing shareholder wealth and profitability, they are fulfilling their core responsibilities. Other firms take a broader view based on the stakeholder perspective.

The shareholder model of corporate governance is founded on classic economic pre- cepts, including maximizing wealth for investors and creditors. In a public corporation, firm decisions should be oriented toward serving the best interests of investors. Underlying these decisions is a classic agency problem, in which ownership (investors) and control (man- agers) are separate. Managers act as the agents of the investors (principals), who expect those decisions to increase the value of the stock they own. 58 However, managers may have motivations beyond stockholder value such as increasing market share, or more personal ones including maximizing executive compensation. In these instances, decisions may be based on an egoist approach to ethical decision making that ignores the interests of others.

Because shareholder owners of public companies are not normally involved in the daily operations, the board of directors oversee the companies, and CEOs and other members of top management run them. Albrecht points out that the principal-agent relationship involves a transfer of trust and duty to the agent, while also assuming that the agent is opportunistic and will pursue interests that are in conflict with those of the principal, thereby creating an “agency problem.” 59 Because of these potential differences, corporate governance mechanisms are needed to align investor and management interests.

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116 Chapter 3 Creating an Ethical Organization Environment and Effective Corporate Governance Systems

One traditional approach is for shareholders to give the CEO shares or options of stock that vest over time, thus inducing long-term behavior and deterring short-term actions that can harm future company value. When the interests of top management are brought in line with interests of shareholders, agency theory argues that management will fulfill its duty to shareholders, not so much out of any sense of moral duty to shareholders, but because doing what shareholders have provided incentives for maximizes their own utility. 60

Jensen and Meckling demonstrate how investors in publicly traded corporations incur (agency) costs in monitoring managerial performance. In general, agency costs arise whenever there is an “information asymmetry” between the corporation and outsiders because insiders (the corporation) know more about a company and its future prospects than do outsiders (investors). 61

Agency costs can occur if the board of directors fails to exercise due care in its oversight role of management. Enron’s board of directors did not monitor the company’s incentive compensation plans properly, thereby allowing top executives to “hype” the company’s stock so that employees would add it to their 401(k) retirement plans. While the hyping occurred, often through positive statements about the company made by CEO Ken Lay, Lay himself sold about 2.3 million shares for $123.4 million.

The agency problem can never be perfectly solved, and shareholders may experience a loss of wealth due to divergent behavior of managers. Investigations by the SEC and U.S. Department of Justice of 20 corporate frauds during the Enron-WorldCom era indicate that $236 billion in shareholder value was lost between the time the public first learned of the first fraud and September 3, 2002, the measurement date.

An alternative to agency theory that has been proposed in recent years is stewardship theory. In this theory, managers are viewed as stewards of their companies, predominately motivated to act in the best interests of the shareholders. The theory holds that as stewards, managers will choose the interests of shareholders, perhaps psychologically identified as the best interests of “the company,” over self-interests, regardless of personal motivations or incentives. 62

Unlike agency theory, stewardship theory focuses on enabling managers rather than controlling them because they can be trusted to act in the best interests of the shareholders. The board provides feedback on intended actions of managers rather than controlling them. The steward recognizes the trust placed in him or her and is motivated to act accordingly. 63 Under this theory, the steward-CEO can best act when he or she is also the chairperson of the board; the dual roles are enablers, whereas they would be viewed as a violation of control mechanisms under agency theory. Looking back at the discussion of cultural variables in Chapter 1, the culture of agency theory reflects high individualism and high power distance, whereas collectivism and low power distance are characteristic of steward- ship approaches to management. 64

Other theories of management exist, including the “power perspective theory” and “resource dependency.” However, our goal is not to address all such theories but to provide the framework within which control mechanisms exist to enhance behavior in accordance with laws and ethics.

The Importance of Good Governance The presence of strong governance standards provides better access to capital and aids economic growth. Various survey results in the decade of the 2000s indicate that the invest- ment community is willing to pay more for a company with strong and effective corporate governance policies. A 2005 survey of institutional investors conducted by the Economist Intelligence Unit, which polled 136 senior executives and 65 institutional investors in

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October 2004, indicates that transparency of corporate dealings is the most important element of investment decisions (68 percent) followed by high standards of corporate governance (62 percent) and ethical behavior of staff (46 percent). 65

The survey found that corporate responsibility is a “central” or “important” consider- ation in business decisions: 85 percent ranked corporate responsibility as central or impor- tant, compared with 44 percent in 2000. According to the report, corporate governance has become a mainstream business concern. The increased presence of corporate responsibility in daily business operations is being driven by a variety of factors, such as the erosion of trust in large companies. 66 There is no doubt that in the United States, the Sarbanes-Oxley Act (SOX) that was passed by Congress in 2002 and follow-up SEC regulations is largely responsible for the increased emphasis on good governance.

Executive Compensation One of the most common approaches to the agency problem is to link managerial com- pensation to the financial performance of the corporation in general and the performance of the company’s shares. Typically, this occurs by creating long-term compensation pack- ages and stock option plans that tie executive wealth to an increase in the corporation’s stock price. These incentives aim to encourage managers to maximize the market value of shares. One of the biggest issues that corporate boards of directors face is executive compensation. It has been found that most boards spend more time deciding how much to compensate top executives than they do ensuring the integrity of the company’s financial reporting systems. 67

Excessive Pay Packages A problem arises when top management purposefully manipulates earnings amounts to drive up the price of stock so they can cash in more lucrative stock options. During the financial crisis, Congress charged executives at some of the nation’s largest companies with gaining pay packages in the millions while their companies suffered losses, and they may have even accepted funds from the government to keep them liquid. The Obama administration named a “compensation czar,” Kenneth Feinberg, to set salaries and bonuses at some of the biggest firms at the heart of the economic crisis, as part of a broader govern- ment campaign to reshape pay practices across corporate America. The initiative reflected public uproar over executive compensation at companies such as American International Group (AIG) that received a $180 billion bailout from the government and decided to pay $165 million in bonuses to executives.

A study conducted by a professor at Purdue University in 2009 that used a new type of theoretical analysis found that chief executives in 35 of the top Fortune 500 companies were overpaid by 129 times their “ideal salaries” in 2008. The authors noted that the ratio of CEO pay to the lowest employee salary has gone up from about 40:1 in the 1970s to as high as 344:1 in recent years in the United States. At the same time, the ratio remained around 20:1 in Europe and 11:1 in Japan. 68 Other studies have found that compensation for big-company CEOs was more than 400 times the pay for average workers in past years.

We do not know whether CEOs at top American companies are overpaid. After all, they have the daunting task of running multibillion-dollar companies in an increasingly globalized, competitive environment. However, it does give us pause when we read that in 2011, the chief executives of the 500 biggest companies in the United States (as measured by a composite ranking of sales, profits, assets, and market value) got a collective pay raise of 16 percent that year, to $5.2 billion. This compares with a 3 percent pay raise for the average American worker. 69

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Backdating Stock Options An executive compensation scandal erupted in 2006 when it was discovered that some companies had changed the grant dates of their options to coincide with a dip in the stock price, making the options worth more because less money would be needed to exercise them and buy stock. Although backdating was legal, it must be expensed and disclosed properly in the financial statements. Legalities aside, it is difficult to justify such a practice from an ethical perspective because it purposefully manipulates the option criteria that determine their value.

In the wake of this scandal, hundreds of companies conducted internal probes and the SEC launched investigations into more than 140 firms. The agency filed charges against 24 companies and 66 individuals for backdating-related offenses, and at least 15 people have been convicted of criminal conduct. An interesting case is that of Nancy Heinen, Apple Computer’s general counsel until she left in 2006. She was investigated by the SEC for receiving backdated options and wound up agreeing to pay $2.2 million in disgorge- ment (return of ill-gotten gains), interest, and penalties. Steve Jobs, the former CEO of Apple, apologized on behalf of the company, stating that he did not understand the relevant accounting laws. Of course, ignorance of the law is no excuse for violating it—at least in spirit—especially by someone like Jobs, who presumably had dozens of accountants on staff to advise on these matters. Notably, SOX includes stricter reporting requirements that are supposed to cut down on such practices.

Clawbacks Clawbacks have been on the regulatory radar screen in a big way since 2002, when SOX gave the SEC power to recover compensation and stock profits from CEOs and CFOs of public companies in the event of financial restatements caused by misconduct. The Dodd- Frank Act that is discussed in greater detail below requires that publicly listed companies themselves recover the compensation. Clawback policies among Fortune 100 companies were already on the rise before the financial crisis, jumping from 17.6 percent in 2006 to 42.1 percent in 2007. In 2010, the year Dodd-Frank was passed, 82.1 percent of the Fortune 100 had them. In 2012, 86.5 percent of the Fortune 100 firms had adopted publicly disclosed policies. The ethical justification for clawbacks is the breach of fiduciary duty owed by top management to shareholders and inequities when they benefit from their own wrongful acts.

Say on Pay The Dodd-Frank Wall Street Reform and Consumer Protection Act (H.R. 4173) 70 was signed into federal law by President Barack Obama on July 21, 2010. Passed as a response to the late-2000s recession, it brought the most significant changes to financial regulation in the United States since the regulatory reform that followed the Great Depression. It made changes in the American financial regulatory environment that affect all federal financial regulatory agencies and almost every part of the nation’s financial services industry today.

Two areas where Dodd-Frank relates to corporate governance are in executive compensation and whistleblowing procedures that will be discussed later on. The Act includes “say-on-pay” provisions (Section 951) that require SEC-registered issu- ers to provide shareholders at least once every three calendar years with a separate nonbinding say-on-pay vote regarding the compensation of the company’s named executive officers (i.e., CEO and CFO), and the company’s three other most highly compensated officers. Although the vote on compensation is nonbinding, the company must include a statement in the “Compensation Discussion and Analysis” of the proxy statement whether and, if so, how its compensation policies and decisions have taken into account the results of the shareholder-say-on-pay vote. The idea is for the vote

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of the shareholders to be taken seriously not only by the company, but also by other companies in the same marketplace.

In perhaps the most widely followed shareholder action, in April 2012, 55 percent of Citigroup’s shareholders voted against CEO Vikram Pandit’s $15 million compensation package for 2011, a year when the bank’s stock tumbled. At the time of the vote, Pandit had received nearly $7 million in cash for 2011, with the remainder to be paid in restricted stock and cash over the next few years (and thus subject to possible restructuring by the board). Citigroup’s shareholders expressed concerns that the compensation package lacked significant and important goals to provide incentives for improvement in the shareholder value of the institution. Soon after the vote, a shareholder filed a derivative lawsuit against the CEO, the board of directors, and other directors and executives for allegedly awarding excessive pay to its senior officers.

Questions raised by shareholders and others about the size of executive compensa- tion packages and say-on-pay votes are designed to build equity into the compensation system. Issues with respect to whether CEOs are overpaid, as many have said, do bring up questions of fairness and justice. Over the long haul, the question is whether these nonbinding referendums are likely to have any impact on the potential civil liability of directors for approving allegedly excessive executive compensation that the shareholders reject. According to Robert Scully, who analyzes the law in the January 2011 The Federal Lawyer, the answer is probably not. Scully maintains that Dodd-Frank does not preempt state fiduciary law or entirely occupy the field of director liability for excessive compensa- tion. Instead, the act focuses on the process by which public company executive compen- sation is set, thereby enforcing the primacy of the business judgment rule in determining executive compensation. 71

Corporate Governance Mechanisms

In his book Corporate Governance and Ethics, Zabihollah Rezaee points out that cor- porate governance is shaped by internal and external mechanisms, as well as policy interventions through regulations. Internal mechanisms help manage, direct, and monitor corporate governance activities to create sustainable stakeholder value. Examples include the board of directors, particularly independent directors; the audit committee; manage- ment; internal controls; and the internal audit function. External mechanisms are intended to monitor the company’s activities, affairs, and performance to ensure that the interests of insiders (management, directors, and officers) are aligned with the interests of outsid- ers (shareholders and other stakeholders). Examples of external mechanisms include the financial markets, state and federal statutes, court decisions, and shareholder proposals. 72 Two points of note include (1) independent directors enhance governance accountability and (2) separate meetings between the audit committee and external auditors strengthen control mechanisms.

The Role of the Board of Directors For public corporations, boards of directors hold the ultimate responsibility for their firms’ success or failure, as well as for the ethics of their own actions. The members of the board are legally responsible for the firm’s resources and decisions, and they appoint its top executive officers.

The directors and officers of a corporation are responsible for managing and directing the business and affairs of the corporation. They often face difficult questions concerning whether to acquire other businesses, sell assets, expand into other areas of business, or issue stocks and dividends. They may also face potential hostile takeovers by other businesses. To help directors and officers meet these challenges without fear of liability, courts have given substantial deference to the decisions the directors and officers must make. Under the

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business judgment rule, the officers and directors of a corporation are immune from liability to the corporation for losses incurred in corporate transactions within their authority, so long as the transactions are made in good faith and with reasonable skill and prudence.

Board members have a fiduciary duty to safeguard corporate assets and make decisions that promote shareholder interests. They owe a duty of care in carrying out their respon- sibilities, which means to act in the best interests of the shareholders. This is typically defined as a level of care expected of a reasonable person under the same circumstances (notice the universality dimension). The board exercises diligence by performing vigilant oversight of the company’s business and financial affairs, ensuring that reliable financial information is reported, and monitoring compliance with applicable laws, rules, and regulations. Failure to adhere to these obligations may constitute a breach of the fiduciary duty of care that is expected of directors. A good example is the accounting fraud at Waste Management, where Andersen auditors developed a plan called “Summary of Action Steps” to correct for the company’s past misstatements in its financial reports. The idea was to correct for past adjustments by spreading out their effects over a number of years in the future, a practice that did not conform to GAAP. Rather than insist on immediate recognition of the full amount of the adjustment as required by GAAP, all members of top management agreed to the plan. The board failed in its fiduciary role by accepting the plan without questioning its appropriateness.

Despite the fact that board members have been given greater responsibilities under SOX and SEC regulations, there is scant evidence that they have been held more account- able for their own misconduct. The SEC does not usually pursue corporate directors for misconduct unless it can be proved that they acted in bad faith. One example is the civil charges brought against three directors of DHB Industries for allegedly ignoring red flags indicating misconduct in the company. According to the accusations, these directors tried to hide the fraud by hiring two separate firms to perform audits, perhaps in the hope that at least one of the firms would sign off on the financial statements. Because the SEC saw indications of corruption within the board, it filed a lawsuit against the directors. However, this type of action tends to be the exception rather than the norm. 73

Audit Committee In the aftermath of accounting scandals at companies such as Enron and WorldCom, Congress passed SOX in 2002 74 to strengthen corporate governance mechanisms. One important requirement is for the audit committee of the board of directors to be completely independent of management. National stock exchanges such as the New York Stock Exchange (NYSE) adopted listing requirements that a majority of directors must be inde- pendent of management. In the accounting scandals, the audit committee either didn’t know about the fraud or chose to look the other way. A conscientious and diligent committee is an essential ingredient of an effective corporate governance system—one that takes its role in financial statement oversight to heart and follows basic principles of responsibility, accountability, and transparency.

The Audit Committee Institute at the international accounting firm KPMG, issued “Ten To-Do’s for Audit Committees in 2011.” The most important of these are (1) focus on financial reporting and strong internal controls, (2) review the company’s whistleblower processes and compliance program, (3) understand the significance of risks to the com- pany’s operations and financial reporting, (4) consider whether the company’s disclosures provide investors with the information needed to understand the state of the business, (5) set clear expectations for the internal audit function and communication with the exter- nal auditors, and (6) understand the audit committee’s role in information technology. 75

Traditionally, the audit committee’s primary role has been to monitor the integrity of the financial statements produced by management. Deloitte and Touche LLP elaborates on the

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role of audit committees in financial reporting and provides helpful advice for audit com- mittees to discharge their expanded responsibilities under SOX, including the following: 76

• Audit committees should be aware of the universe of corporate reporting and its various financial and nonfinancial components.

• Audit committees should review the financial statements, Management Discussion & Analysis (MD&A) and related news releases as a single package of information.

• The effectiveness of the audit committee’s review of earnings news releases, financial statements, and MD&A depends not only on its understanding of accounting standards and regulations, but to a great extent on its knowledge of the company’s business and the industries in which the company operates.

• In addition to approving the financial statements, MD&A and earnings news release, the audit committee must understand and agree with the process by which these docu- ments were prepared.

• The audit committee should seek assurances from the CEO and CFO as part of the CEO/ CFO financial statement certification process that they have put in place and effective disclosure controls and procedures to ensure that all reports have been prepared and filed properly with the appropriate authorities in accordance with applicable requirements.

• Audit committees should review their oversight responsibilities regularly to determine whether they should include additional financial and/or nonfinancial disclosures.

There can be no doubt that financial reports would be more reliable if audit committees adhered to these guidelines. The goal should be to establish an ethical corporate culture that supports good corporate governance. In addition to a watchful audit committee, an organization must establish effective internal controls to ferret out fraud, a strong internal audit oversight role to deal with fraud, diligent members of the board of directors to over- see management, and a management group that recognizes its primary responsibility is to conduct business operations in a responsible manner and report financial information in accordance with established accounting rules. Organizations that create such an environ- ment are better prepared to deal with the challenges of maintaining an effective corporate governance system.

Following the passage of SOX, the audit committee was seen as the one body that was (or at least should be) capable of preventing identified fraudulent financial reporting. The audit committee has an oversight responsibility for the financial statements. The internal auditors should have direct and unrestricted access to the audit committee so that they can take any matters of concern directly to that group without having to go through top management. The external auditors rely on the support and actions of the audit committee to resolve differ- ences with management over proper financial reporting. Section 401 of SOX amended the Securities Exchange Act of 1934 to include the requirement that each financial statement filed with the SEC should reflect all material correcting adjustments that have been identified by the audit firm in accordance with GAAP and the rules and regulations of the commission. Even though the fraud at Waste Management preceded passage of the Act, it is clear that the law would have been violated by writing off material adjustments over a period of time in the future rather than charging them against retained earnings.

An effective device to ensure audit committee independence is for the committee to meet separately with the senior executives, the internal auditors, and the external auditors. The perception of internal auditors as the “eyes and ears” of the audit committee suggests that the head of the internal audit department attend all audit committee meetings. 77 Recall the role of Cynthia Cooper at WorldCom. She informed the audit committee every step of the way as her department uncovered the fraud, and ultimately she gained the support of the external auditors.

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122 Chapter 3 Creating an Ethical Organization Environment and Effective Corporate Governance Systems

Internal Controls as a Monitoring Device The internal controls that are established by management should help prevent and detect fraud, including materially false and misleading financial reports, asset misappropria- tions, and inadequate disclosures in the financial statements. These controls are designed to ensure that management policies are followed, laws are strictly adhered to, and ethical systems are built into corporate governance. However, even the best internal controls can be overridden by top management. For example, top executives at Tyco and Adelphia used corporate resources for their own benefit without getting proper authority from the board of directors, thereby violating their fiduciary duty and duty of care to the stockholders. The board at each company claimed to have been uninformed about the use of hundreds of millions of dollars from interest-free loans for personal purposes. We can assume that each company had a series of internal controls in place to prevent such an occurrence. Still, the CEOs circumvented their own controls to accomplish their self- interest-oriented goals. The tone at the top of these organizations apparently was that employees should do what the CEO says, not what she does. It creates a cynical attitude on the part of employees who may come to view the organization as not following its own ethical standards, while at the same time expecting its employees to adhere to those standards.

The risk that internal controls will not help prevent or detect a material misstatement in the financial statements is a critical evaluation to provide reasonable assurance that the financial statements are free from material misstatement. Auditing Standard No. 5 issued by the Public Company Accounting Oversight Board (PCAOB) establishes requirements and provides direction that applies when an auditor is engaged to perform an audit of management’s assessment of the effectiveness of internal control over financial reporting that is integrated with an audit of the financial statements, a requirement of SOX. These standards are discussed in Chapter 5.

The system of internal controls and whether it operates as intended enables the auditor to either gain confidence about the internal processing of transactions or create doubt for the auditor that should be pursued. Internal Control—Integrated Framework, published by the Committee of Sponsoring Organizations (COSO) of the Treadway Commission in 1992, establishes a framework that defines internal control as a process, effected by an entity’s board of directors, management, and other personnel, designed to provide reason- able assurance regarding the achievement of the following objectives: (a) effectiveness and efficiency of operations; (b) reliability of financial reporting; and (c) compliance with applicable laws and regulations. 78

The COSO report states that management should enact five components related to these objectives as part of the framework including: (1) the control environment; (2) risk assess- ment; (3) control activities; (4) monitoring; and (5) information and communication.

1. The control environment sets the tone of an organization, influencing the control con- sciousness of its people. It is the foundation for all aspects of internal control, providing discipline and structure.

2. Risk assessment is the entity’s identification and evaluation of how risk might affect the achievement of objectives.

3. Control activities are the strategic actions established by management to ensure that its directives are carried out.

4. Monitoring is a process that assesses the efficiency and effectiveness of internal controls over time.

5. Information and communication systems provide the information in a form and at a time that enables people to carry out their responsibilities.

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Chapter 3 Creating an Ethical Organization Environment and Effective Corporate Governance Systems 123

The COSO framework emphasizes the roles and responsibilities of management, the board of directors, internal auditors, and other personnel in creating an environment that supports the objectives of internal control. One important contribution of COSO is in the area of corporate governance. COSO notes that if members of the board and audit com- mittee do not take their responsibilities seriously, then the system will likely break down as occurred in Enron and WorldCom. The COSO Integrated Framework is the foundation for control assessment of internal financial reporting required by SOX under Section 404. More will be said about the framework in Chapter 5.

The results for a company can be devastating when internal controls fail or are over- ridden by management. A good example is what happened to Groupon after it announced a restatement in its financial statements on March 30, 2012, that resulted from a material weakness in its internal controls with respect to the inadequacy of its reserve for coupon returns. Exhibit 3.9 presents a summary of the facts surrounding the restatement. There can be no doubt that the company’s fortunes changed on a dime after the announcement as its IPO share price close of $26.11 on March 30, 2012, trended downward and continued going in the wrong direction declining to $4.14 as of November 30, 2012. The stock has since rebounded somewhat to $7.69 as of June 1, 2013.

Internal Auditors Internal auditors interact with top management, and as such, should assist them to fulfill their role in developing accurate and reliable financial statements and compliance with

Groupon, Inc., offers online retail services and provides daily deals on things to do, eat, see, and buy in more than 500 markets in 44 countries. It has offices across North America, Europe, Latin America, Asia, and other parts of the world.

On November 5, 2011, Groupon took its company public in an IPO with a buy-in price set at $20 per share. Groupon shares rose from their IPO price of $20 by 40 percent in early trading on NASDAQ and ended at the 4 p.m. market close at $26.11, up 31 percent. The closing price valued Groupon at $16.6 billion, making it more valuable than companies such as Adobe Systems and nearly the size of Yahoo.

Groupon employees broke out the champagne, as did Silicon Valley and Wall Street, as financial analysts took Groupon’s stock market debut as a sign that investors are still willing to make risky bets on fast-growing but unprofitable young Internet companies, even as the IPO environment had shifted downward since the financial troubles that started in 2007.

At a size of up to $805 million, Groupon ranked as the third-largest Internet IPO sold in the United States in 2011, after a $1.4 billion issue by Russian search-engine operator Yandex NV in May and a $855 million issue by China social networking platform Renren, according to Dealogic. It was the ninth-largest ever, on a list topped by the $1.9 billion sale by Google in 2004.

Less than five months later, on March 30, 2012, Groupon announced that it had revised its financial results, an unexpected restatement that deepened losses and raised questions about its accounting practices. As part of the revision, Groupon disclosed a “material weakness” in its internal controls, saying that it had failed to set aside enough money to cover customer refunds. The accounting issue increased the company’s losses in the fourth quarter to $64.9 million from $42.3 million. The news that day sent shares of Groupon tumbling 6 percent, to $17.29. Shares of Groupon had fallen by 30 percent since it went public.

In its announcement of the restatement, Groupon explained that it had encountered problems related to certain assumptions and forecasts the company used to calculate its results. In particular, the company said that it underestimated customer refunds for higher- priced offers, such as laser eye surgery. Groupon collects more revenue on such deals, but it also sees a higher number of refunds. The company honors customer refunds for the life of its

EXHIBIT 3.9 Internal Control Disaster at Groupon


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124 Chapter 3 Creating an Ethical Organization Environment and Effective Corporate Governance Systems

laws and regulations. Exhibit 3.10 presents the framework of financial reporting that sup- ports a strong control environment identified in the Treadway Commission Report titled Report of the National Commission on Fraudulent Financial Reporting.80 Notice how the internal auditors should have direct and unrestricted access to the audit committee. One problem for Cynthia Cooper as she struggled to get WorldCom to act on the fraudulent capitalization of line costs was periodic interference by Scott Sullivan, the CFO and mas- termind of the fraud. But Cooper didn’t let that stop her dogged pursuit of the truth about the causes of the fraud.

Internal auditors have a crucial role to play in risk management. PricewaterhouseCoopers (PwC) released a study, 2012 PwC State of the Internal Audit Profession, that indicates risks are increasing because of global economic uncertainty. It topped the list as the biggest perceived risk to companies that year, according to nearly three-quarters of the chief audit executives (CAEs) and other poll respondents. 81

The survey indicated that other significant risks have emerged, and businesses are ask- ing internal auditing to play a bigger role in helping companies navigate the changing risk landscape. While concerns about further economic uncertainty continue to be the main ones for business leaders, issues such as fraud and ethics, mergers and acquisitions, large programs, new product introductions, and business continuity were identified among the top risks affecting businesses.

The single most requested area for increased internal audit focus was data privacy and security, with 46 percent of stakeholders asking for added capabilities in this area. With regulations escalating and evolving, the second-largest requested area for increased focus involves regulations and government policies, with 32 percent of stakeholders asking internal auditing to get more involved in supporting the business in understanding and

coupons, so these payments can affect its financials at various times. Groupon deducts refunds within 60 days from receiving revenue; after that, the company has to take an additional accounting charge related to the payments.

As Groupon prepared its financial statements for 2011, its independent auditor, Ernst & Young, determined that the company did not account accurately for the possibility of higher refunds. By the firm’s assessment, that constituted a “material weakness.” Groupon said in its annual report, “We did not maintain effective controls to provide reasonable assurance that accounts were complete and accurate.”

In an interesting twist, in response to the conclusion that the company’s internal controls contained a material weakness, Groupon blamed Ernst & Young in part for not identifying the weakness. The auditors were at fault for not identifying problems with the financial controls earlier, said Herman Leung, a financial analyst at Susquehanna Financial Group in San Francisco. “This should have been highlighted by the auditors. The business is growing so fast that it sounds like they don’t have the proper financial controls to deal with the growth.” 79 In fact, it was management’s assessment of the material weakness in internal controls over financial reporting that led to the disclosure. Ernst & Young had signed the fourth-quarter audit report included in Groupon’s annual report, giving a clean (unmodified) opinion.

In a related issue, on April 3, 2012, a shareholder lawsuit was brought against Groupon, accusing the company of misleading investors about its financial prospects in its IPO and concealing weak internal controls. According to the complaint, the company overstated revenue, issued materially false and misleading financial results, and concealed how its business was not growing as fast and was not nearly as resistant to competition, such as from LivingSocial and Amazon, as it had suggested.

These claims bring up a gap in the sections of SOX that deal with companies’ internal controls. There is no requirement to disclose a control weakness in a company’s IPO prospectus. Groupon had no obligation to disclose the problem until it filed its first quarterly or annual report as a public company—which is what it did.

EXHIBIT 3.9 (Continued)

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Chapter 3 Creating an Ethical Organization Environment and Effective Corporate Governance Systems 125

EXHIBIT 3.10 Internal Control Environment— “Corporate Culture”

Audit Committee of the

Board of Directors Board of Directors

Chief Executive Officer

• Chief Financial Officer • Controller • Accounting Department

Internal Accounting Controls Accounting System

• Legal Department

• Internal Audit Function

Financial Reports

managing this risk. Survey respondents also indicated that they were concerned about areas such as fraud and ethics.

The report found that internal audit groups at leading companies provide stakeholders with advice on risks and controls rather than just reporting on gaps. A total of 78 percent of the survey respondents whose companies were better at managing risk said their CAEs played a more active role during executive meetings, compared to only 61 percent of companies that were not as well managed. In addition, the better managed companies take into consideration the organization’s enterprise risk management process and adapt their approach quickly when changes are needed.

Audited Financial Statements The Securities and Exchange Act of 1934 established mandatory independent audits of publicly traded companies in order to give third parties confidence that the compa- nies’ books could be trusted. The financial statements prepared by management report the financial results in accordance with GAAP. The audit involves an examination of those statements in accordance with generally accepted auditing standards (GAAS) and the rendering of the opinion about whether the financials conform to GAAP. Because the purpose of an audit is to provide “reasonable assurance” to investors and creditors that the financial statements are free of material misstatement, the audit plays an important role in corporate governance. The audit function will be discussed in greater detail in Chapter 5.

NYSE Listing Requirements Corporate governance provisions in the United States establish benchmark standards by which publicly owned companies should measure their practices. Control procedures required by the New York Stock Exchange (NYSE) provide a blueprint of good gover- nance practices. While there is no required formal report on corporate governance, as in many other countries outside the United States, listed companies in the United States must adopt and disclose corporate governance guidelines and CEOs must certify compliance.

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126 Chapter 3 Creating an Ethical Organization Environment and Effective Corporate Governance Systems

Non-U.S. companies listed on the NYSE must follow U.S. corporate governance provi- sions so that the listing requirements should be used as part of the comparative analysis. What follows are the final corporate governance rules of the NYSE (2003) approved by the SEC. Companies listed on the exchange must comply with standards regarding corporate governance as codified in Section 303A.

1. Listed companies must have a majority of independent directors. 2. To empower non-management directors to serve as a more effective check on manage-

ment, they must meet at regularly scheduled executive sessions without management. “Non-management” directors are those who are not company officers and include directors who are not independent by virtue of a material relationship, former status or family membership, or for any other reason.

3. Listed companies must have an audit committee with a minimum of three members, all of whom are independent of management and the entity.

4. From time to time, the audit committee should meet separately with management, internal auditors (or other personnel responsible for the internal audit function), and independent auditors.

5. The audit committee should review with the independent auditor any audit problems or difficulties and management’s response.

6. The audit committee should report regularly to the board of directors. 7. Each listed company must have an internal audit function. 8. Each listed company CEO must certify to the NYSE each year that he or she is not aware

of any violation by the company of NYSE corporate governance listing standards. 9. Listed companies must adopt and disclose corporate governance guidelines. 10. Listed foreign private issuers must disclose any significant ways in which their corporate

governance practices differ from those followed by domestic companies under NYSE listing standards.

On December 14, 2009, the NYSE amended its corporate governance listing standards and they were approved by the SEC. 82 Some of the amendments relate to our discussions of corporate governance mechanisms and include the following new requirements:

• Enhanced Notification Requirements . A company’s CEO must notify NYSE after an executive officer becomes aware of any noncompliance with NYSE corporate gover- nance listing standards, regardless of its materiality.

• Communications with Directors . The amendments clarify that a company must disclose a method for all interested parties, not only shareholders, to communicate with the presiding director or the non-management or independent directors as a group.

• Disclosure of Business Conduct and Ethics Waivers . The amended listing standards clarify that companies must disclose any waivers of their codes of conduct and ethics granted to executive officers and directors within four business days, the same time frame required by the SEC, either through a press release, on the company’s website or on a Form 8-K.

• Executive Sessions. A company can hold regular executive sessions of independent directors as an alternative to executive sessions of non-management directors.

These amendments should improve corporate governance disclosures of deviations from accepted governance standards because there no longer can be a materiality evalua- tion. In addition, it accelerates the reporting by listed companies of waivers from the code of ethics granted to executive officers and directors. Recall that this was an area creating a conflict of interest at Enron when the CFO, Andy Fastow, who also managed some of the special-purpose-entities, was given a waiver from the company’s code of ethics

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Chapter 3 Creating an Ethical Organization Environment and Effective Corporate Governance Systems 127

that prohibited such related-party relationships. There was no disclosure at the time to members of the board or the outside auditors.

Code of Ethics for CEOs and CFOs In virtually all the frauds of the late 1990s and early 2000s, the CEOs and CFOs knew about the company’s materially misstated financial statements. One important provision of SOX that helps protect the public against fraudulent financial statements is the requirement of Section 302 that the CEO and CFO must certify that to the best of their knowledge, there are no material misstatements in the financial statements. Another requirement of SOX is that public companies must have a code of ethics for its CEO and principal finan- cial officers. This code must be separate from the company’s code of ethics. An excellent example of such a code is the code for finance professionals of Microsoft which appears in Appendix 2 of this chapter. Notice how the code includes many provisions that are part of an ethical culture, reliance on virtues to instill the desired standards of behavior, and links to corporate governance. You know that a company takes its ethical obligations seriously when it establishes a series of steps for employees to follow when reporting violations of the standards of business practice (whistleblowing) and concerns about questionable accounting or auditing practices.

A valid question, now that SOX is more than 10 years old, is whether its promise of holding CEOs and CFOs criminally responsible for fraud has been a success. The law states that if top corporate executives knowingly sign off on a false financial report, they’re subject to a prison term of up to 10 years and a fine of up to $1 million, with penalties escalating to 20 years and $5 million if their misconduct is willful. In practice, very few defendants have even been charged with false certification, and fewer still have been convicted.

As previously discussed, Richard Scrushy, the former HealthSouth Corporation CEO, falsely certified the financial statements of the company but was not sent to jail for that crime. On the other hand, CFO Weston L. Smith was sentenced in 2005 to 27 months in prison for his role in the company’s $2.7 billion accounting fraud. Smith had pleaded guilty to one count each of conspiracy to commit wire and securities fraud, falsely certify- ing a financial report, and falsifying a report to the SEC.

In 2007, the former CFO of a medical equipment financing company called DVI pleaded guilty to mail fraud and false certification and was sentenced to 30 months in prison. In a more recent case, a SOX false certification charge against former Vitesse CEO Louis Tomasetta was dismissed.

What about using SOX to prosecute bank executives for their role in the mortgage crisis? Frankel points out that there has been renewed interest in SOX as a potential tool in investigations of companies involved in the financial meltdown of 2007–2008, including J.P. Morgan Chase that engaged in risky credit default swap trading.

So, the question in the end is, why have there not been more prosecutions under Section 302? Frankel believes that the answer may lie partly in how corporations have responded to SOX. Most major corporations have implemented internal compliance sys- tems that make it very difficult to show that the CEO or CFO knowingly signed a false certification. And when prosecutors have enough evidence to show that those internal systems failed and top executives knowingly engaged in wrongdoing, they often prefer, for strategic reasons, to charge crimes other than false certification. 83

The jury is still out on whether SOX serves as an adequate deterrent to financial fraud. We should not be surprised if the answer is “no” because laws do not necessarily lead to ethical behavior. Any law—including SOX—establishes the rules of the game and how violators will be punished. As we have learned throughout these first three chapters, ethical behavior comes from within; it comes from a desire to do the right thing, not because we may be punished if we do not. In the end, it is a post-conventional mindset that guides ethical reasoning when

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the chips are down, not a conventional one. Laws are needed, but they serve as only a mini- mum standard of ethical conduct. Codes of ethics are needed because they help to establish an ethical organization environment. But it is virtuous behavior that should guide corporate officers through the minefield of conflicts and pressures that exist in decision making.

Compliance Function The Ethics and Compliance Officer Association (ECOA) has recognized its increased responsibilities resulting from SOX. The mission of the ECOA is to promote “ethical busi- ness practices and [serve] as a global forum for the exchange of information and strategies among organizations and individuals responsible for ethics, compliance, and business conduct programs.” 84 An important step in encouraging the reporting of wrongdoing is to appoint a trusted member of the management team to be the organization’s ethics officer. This person should take the lead in ensuring that the organization is in compliance with the laws and regulations, including SEC securities laws, SOX, and Dodd-Frank. A chief compliance officer (CCO) should serve as a sounding board for management to try out new ideas to see if it passes the ethics “smell” test. The ethics officer plays a critical role in helping create a positive ethical tone in organizations.

The 2012 State of Compliance study conducted by PwC found that oversight of the compliance function has been changing. Fewer compliance officers report to the general counsel on a daily basis (35 percent in 2012, compared to 41 percent in 2011), although the number reporting on a daily basis to the CEO held steady at 32 percent. On a formal basis, 32 percent of respondents report to the audit committee, almost as many as who report to the general counsel (33 percent) and much more than those reporting to the CEO. This falls in line with the FSGO revisions from 2010, which favor an independent compliance function that preferably reports to the audit committee and board. 85

Over the past decade, heightened regulations related to SOX and Dodd-Frank have elevated the importance and visibility of the chief compliance officer role. Now an official member of the c-suite, compliance leaders are tasked with building comprehensive and robust programs that not only address existing requirements, but also anticipate regulatory changes and their likely impact.

Bernie Madoff’s Ponzi Scheme

A Ponzi scheme is an investment fraud that involves the payment of purported returns to existing investors from funds contributed by new investors.86 Ponzi scheme organizers often solicit new investors by promising to invest funds in opportunities claimed to gen- erate high returns with little or no risk. In many Ponzi schemes, the fraudsters focus on attracting new money to make promised payments to earlier-stage investors and to use for personal expenses instead of engaging in any legitimate investment activity. With little or no legitimate earnings, the schemes require a consistent flow of money from new investors to continue. Ponzi schemes tend to collapse when it becomes difficult to recruit new investors or when a large number of investors ask to cash out.

The case of Bernie Madoff illustrates what can happen in a Ponzi scheme when regula- tors ignore warnings by whistleblowers. 87

Madoff was a trusted investment adviser. He had served as chair of the board of direc- tors and served on the board of governors of the National Association of Securities Dealers (NASDAQ), a self-regulator securities industry organization. He had personal relation- ships with his investors and was a pillar of the community. Madoff used his reputation to gain favor with his investors and assure them about the promised level of returns.

As the stock market tanked in the period between 2007 and 2009, many Madoff inves- tors asked to have their funds returned. Madoff could return some of the money, typi- cally to favored investors, but he couldn’t meet most of the claims. By the time the dust

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Chapter 3 Creating an Ethical Organization Environment and Effective Corporate Governance Systems 129

had settled, Madoff had perpetrated a $65 billion fraud. Two of his sons involved in the business, Andrew and Mark, notified the federal authorities on December 11, 2008, and Madoff was arrested. He was sentenced to serve a 150-year sentence on June 16, 2009, and $170 billion of his ill-gotten gains is supposed to be restored to the victims of his crime.

The trustee assigned to handle repayments is Irving Picard, who has been bringing lawsuits against former investors who benefited disproportionately when Madoff did return money. The recovery actions are facilitated through “clawback” lawsuits to recover some of the money. In December 2010, Picard and Preet Bharara, U.S. Attorney for the Southern District of New York, cleared a major hurdle in dealing with Madoff’s mess. They announced a $7.2 billion settlement with Barbara Picower, the widow of Jeffrey Picower, considered the biggest beneficiary of Madoff’s scheme. According to the trustee, Picower had withdrawn $7.8 billion from Madoff’s firm since the 1970s, even though he only deposited $619 million. His widow agreed to hand over the difference, $7.2 billion, to benefit Madoff’s victims, many of whom were left destitute in the wake of his fraud. On March 19, 2012, a settlement was reached with the best-known Madoff investors in the clawback actions. Picard had filed suit against the owners of the New York Mets, Fred Wilpon and Saul Katz. He initially sought $1 billion, claiming that they enriched themselves over many years of profitable investing with Madoff while ignoring repeated warnings that he might have been a fraud. The owners agreed to pay $162 million, but that figure is likely to be reduced or wiped out altogether as the complex bankruptcy litigation involving Madoff’s investment operation plays out.

The SEC brought an action against Madoff’s auditors, Friehling & Horowitz, claiming that the firm enabled Madoff’s conduct by falsely representing to investors that Bernard L. Madoff Investment Securities (BMIS) LLC was financially sound and that the firm employed independent auditors who conducted audits of BMIS each year. In documents that the firm knew were distributed or submitted to investors and the SEC, Friehling know- ingly or with reckless disregard falsely stated the following: 88

• The firm audited BMIS’s financial statements pursuant to GAAS, including the require- ments to maintain auditor independence, and to perform audit procedures regarding custody of securities.

• BMIS’s financial statements were presented in conformity with GAAP. • Friehling & Horowitz had reviewed the internal control environment at BMIS, includ-

ing internal controls over the custody of securities, and found no material inadequacies.

According to the SEC, all of these statements were materially false because Friehling & Horowitz did not perform anything remotely resembling an audit of BMIS and, critically, did not perform procedures to confirm the securities that BMIS purportedly held on behalf of its customers even existed. Instead, the firm merely pretended to conduct minimal audit procedures of certain accounts to make it seem as though it were conducting an audit, and even then, it failed to document its purported findings and conclusions as required under GAAS. If properly stated, those financial statements, along with BMIS’s related disclosures regarding reserve requirements, would have shown that BMIS owed tens of billions of dollars in additional liabilities to its customers and thus was insolvent. Similarly, Friehling & Horowitz did not conduct any procedures with respect to BMIS’s internal con- trols, or it knew or recklessly disregarded that it had absolutely no basis to represent that BMIS had adequate internal controls. On November 3, 2009, Friehling & Horowitz agreed not to contest the SEC’s findings and consented to a partial judgment without admitting or denying the allegations of the SEC’s complaint.

A sad part of the Bernie Madoff story is what happened to his family in the aftermath of the public disclosure of the Ponzi scheme. No longer able to deal with the hatred against his family and his own role in the scandal, on December 11, 2010 (the two-year anniversary of his father’s downfall), Mark Madoff killed himself. On June 20, 2012, another son,

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Peter, pleaded guilty to one count of conspiracy to commit securities fraud and one count of falsifying records. Prosecutors said Peter Madoff will agree to forfeit $143.1 billion, a staggering amount based on the total funds that passed through the Madoff firm during his tenure. On December 20, 2012, Peter was sentenced to a ten-year jail term for crimes including conspiracy to commit securities fraud. Peter was the chief compliance officer of the firm. It is hard to feel sorry for him because he either did know about the fraud or should have known as the compliance officer. No charges had been filed against Andrew Madoff in the fraud. Bernie Madoff’s wife, Ruth, disclaimed any knowledge of the fraud and denied any guilt for the fraud in a 60 Minutes interview with Morley Safer in October 2011.

Who is to blame for the fraud at Madoff? Clearly, Madoff himself violated every stan- dard of ethical behavior and acted strictly in his own self-interests. He even ignored the interests of his family, claiming that they knew nothing of the fraud (which is somewhat hard to believe in the light of subsequent evidence) and left them to pick up the pieces of their smashed lives. Friehling & Horowitz shares the blame with Madoff for failing to live up to its ethical obligations as a CPA firm. Perhaps most important was the benign role played by the SEC in acting on tips that it had received by an external whistleblower, Harry Markopolos, an investment adviser who was skeptical of Madoff’s approach to earning the purported large returns for his investors.

Markopolos testified in February 2009, in hearings held by the U.S. House of Represen- tatives, that the SEC ignored his repeated warnings about Madoff’s dealings. Markopolos asserted that he had submitted warnings about Madoff since 2000 and he assailed the agency for ignoring his warnings or brushing them aside. “Nothing was done,” he declared. “There was an abject failure by the regulatory agencies we entrust as our watchdog.” Markopolos stated publicly that his experience with most SEC officials “proved to be a systemic disap- pointment, and lead me to conclude that the SEC securities lawyers, if only through their investigative ineptitude and financial illiteracy, colluded to maintain large frauds such as the one to which Madoff later confessed.”

Markopolos said he began his investigation of Madoff after his superior at Rampart Investment Management asked him to try to match the returns of Madoff’s firm. Markopolos said his analysis showed it was impossible for Madoff to outperform the markets and other managers consistently, as he was claiming. He described Madoff as “one of the most powerful men on Wall Street” and said there was “great danger” in raising questions about him. During his years of investigation, “my team and I surmised that if Madoff gained knowledge of our activities, he may have felt threatened enough to seek to stifle us.” He also said, “I became fearful for the safety of my family until the SEC finally acknowledged, after Madoff had been arrested, that it had received credible evidence of Madoff’s Ponzi scheme several years earlier.”

In the wake of the Madoff fraud, the SEC’s office of the inspector general launched an internal investigation in December 2008 to determine why the agency did not detect the scheme. The SEC initiated a variety of actions to prevent such a regulatory failure from occurring in the future. Some of the more relevant steps affecting the accounting profession include: 89

• Require all investment advisers who control or have custody of their clients’ assets to hire an independent public accountant to conduct an annual “surprise exam” to verify that those assets actually exist.

• Require all investment advisers who do not use independent firms to maintain their clients’ assets to obtain a third-party written report assessing the safeguards that protect the clients’ assets. The report—prepared by an accountant registered and inspected by the PCAOB—would, among other things, describe the controls that are in place to protect the assets, the tests performed on the controls, and the results of those tests.

The SEC is advocating for expanded authority from Congress to reward whistleblowers who bring forward substantial evidence to the agency about significant federal securities

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violations. It proposed legislation that a fund would be established to pay whistleblowers using money collected from wrongdoers that is not otherwise distributed to investors. The SEC got its way on August 12, 2011, when a rule 90 was adopted under the Dodd-Frank Act to establish a whistleblower program that requires the commission to pay an award, under regulations prescribed by the commission and subject to certain limitations, to eligible whistleblowers who voluntarily provide it with original information about a violation of the federal securities laws that leads to the successful enforcement of a covered judicial or administrative action, or a related action. Dodd-Frank also prohibits retaliation by employ- ers against individuals who provide the commission with information about possible securities violations.


There is no one set definition of whistleblowing, although most definitions characterize the practice as disclosing to others in an organization (internal whistleblowing) an action that violates organizational norms or the law. External whistleblowing entails going to an organization outside the employer to report wrongdoing. Near and Miceli take a broad view of whistleblowing as “the disclosure by organization members (former or current) of illegal, immoral, or illegitimate practices under the control of their employers, to per- sons or organizations that may be able to effect action.” They identify four elements of the whistleblowing process: the whistleblower, the whistleblowing act or complaint, the party to whom the complaint is made, and the organization against which the complaint is lodged. In discussing the act itself, they label it as an act of “dissidence” somewhat analogous to civil disobedience. 91 The term organizational dissidence fits in with our discussion of cognitive dissonance in Chapter 2, which emphasized the difference between our thoughts, beliefs or attitudes, and behavior.

Detection, Reporting, and Retaliation Ferrell et al. define whistleblowing as exposing an employer’s wrongdoing to outsiders such as the media or government regulatory agencies. They acknowledge that the term is some- times used to refer to corporate internal acts but prefer to label them as form of reporting. For example, reporting of misconduct to management, especially through anonymous reporting mechanisms, often involving hotlines. 92 The ACFE study of global fraud identi- fied hotlines as one of 16 anti-fraud controls used in organizations to report wrongdoing.

Recall the discussion about Sherron Watkins’s role as an internal whistleblower in the Enron case in Chapter 2. Watkins initially wrote a letter to Ken Lay, the CEO of the com- pany, questioning the potential effects on the company of improper accounting practices once they are discovered. She did not go any further than reporting it to Lay, and no further action was taken. She became an external whistleblower only after investigations of Enron by the federal government were underway and she testified before Congress.

The evidence shows that nearly all whistleblowers who use external channels to report wrongdoing do so after first using internal channels; they may go outside because the wrongdoing was not corrected after the internal report, because they experienced retalia- tion, or because the nature of the wrongdoing required it (e.g., some types of wrongdoing, such as fraud or workplace violence, must be reported to authorities). 93

Retaliation refers to an undesirable action taken against a whistleblower in direct response to his or her action. This might include being viewed as an outcast by others in the organization, being written up for poor performance even though the evidence indicates otherwise, demotion, and being passed over for a deserved promotion. In Chapter 2, we discussed the case of Diem-Thi Le, who blew the whistle on illegal practices at the DCAA and experienced virtually all these forms of retaliation.

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A study by the Ethics Resource Center (ERC), Inside the Mind of a Whistleblower, indicates that the top five reasons given by whistleblowers for coming forward are (1) the belief that corrective action would take place (79 percent); (2) support of management (75 percent); (3) support of coworkers (72 percent); (4) the fact that they could report anonymously (63 percent); and (5) their belief that no one else would (49 percent). The top reasons for not reporting include (1) the conviction that no corrective action would take place; (2) fear of retaliation; (3) fear that they wouldn’t remain anonymous; and (4) the assumption that someone else would do it. 94

The notion that an employee might not engage in whistleblowing because she believes someone else would raises the issue of “bystander apathy.” In a post on the Corporate Social Responsibility Newswire, Kristy Mathewson refers to “the bystander effect” as situ- ations where passersby don’t offer assistance when other parties are present. Mathewson raises a number of questions with respect to why passersby don’t act, including whether there may be an assumption that others will help or that if no one is helping, why should I? Studies have shown that the greater number of parties present, the fewer the incidents of assistance; we take our cues from the behavior of others, and it is, after all, less stress and hassle to ourselves to assume that others will intervene. 95

There may be implications for reporting corporate fraud if the bystander effect carries over to whistleblowing. The ERC study indicates that employees may go outside their company to report wrongdoing. They may do so because they do not trust the company to handle the matter appropriately or because they are angry or frustrated after their attempts at internal reporting proved to be futile. However, while almost all whistleblowers make some effort to root out wrongdoing internally before going outside the organization, only 2 percent of employees go solely outside their companies to report misconduct. The bystander effect may account for some of that reluctance. A bystander may be concerned that if others have remained silent, then why should he go out on a limb?

Compliance officers have an important role to play in managing the risks of wrong-doing and encouraging reporting. The results of the ERC study on whistleblowing clearly indi- cate that an ethical organization environment enhances the likelihood the wrongdoings will be reported, while a weak environment or culture of indifference often works against reporting. Compliance officers can help to set an ethical tone that treats whistleblowers with respect rather than derision. The ERC study highlights the toll that whistleblowing can take on employees, as 11 percent of all whistleblowers said they planned to leave their company within one year and an additional 23 percent who reported misconduct and then experienced retaliation planned to leave within one year. The study also indicates that 62 percent who experienced retaliation would be willing to go to the federal government with their concerns, even if their job was at risk. 96

Legal Protection for Whistleblowers Legal protection for whistleblowers exists to encourage reporting of misconduct. Whistle- blower laws have provisions against retaliation and are enforced by a number of govern- ment agencies. For example, under SOX, the U.S. Department of Labor directly protects whistleblowers who report violations of the law and refuse to engage in any action made unlawful. The Corporate and Criminal Fraud Accountability Act protects employees of publicly traded companies from retaliation if they report violations of any law or regulation of the SEC, or any provision of federal law relating to fraud against shareholders. 97

Section 806 of SOX Section 806 of the Sarbanes-Oxley Act of 2002, Protection for Employees of Publicly Traded Companies Who Provide Evidence in Fraud Cases, confers legal protection upon employees of public companies that report suspected violations of a range of federal offenses—including those relating to fraud against shareholders. 98 This whistleblower

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provision protects employees who provide information on a fraud by prohibiting the discharge, demotion, discrimination, suspension, or threatening or harassing action against an employee who provides information in a federal or regulatory investigation or to Congress or to the employee’s supervisor. A person who alleges discharge or discrimination under this section can file a complaint with the Secretary of Labor. An employee who brings a successful action will be entitled to “reinstatement with the same seniority status that the employee would have had, but for the discrimination; the amount of back pay with interest; and compensation for any special damages sustained as a result of the discrimination, including litigation costs, expert witness fees, and reasonable attorney fees.”

The Department of Labor delegated to the Occupational Safety and Health Administration (OSHA) enforcement authority over the whistleblower provisions of SOX. OSHA’s regula- tions require that an employee first establish a prima facie case of retaliation. This is gener- ally interpreted as meaning that the employee must be engaged in a protected activity or conduct; that the employer knew “actually or constructively” that the conduct occurred; that the employee suffered an unfavorable personnel action; and that the circumstances “were sufficient to raise the inference that the protected activity was a contributing factor to the unfavorable action.”

R. Allen Stanford Ponzi Scheme and Whistleblower Action SOX and FSGO have institutionalized internal whistleblowing to encourage discovery of organizational misconduct. A good case study is that of R. Allen Stanford. On March 6, 2012, Stanford was convicted of a $7 billion Ponzi scheme in the style of Bernie Madoff and sentenced to 110 years in federal prison and to forfeit $5.9 billion of personal/business funds. Approximately 20,000 investors lost billions of dollars. Stanford cheated inves- tors by selling them certificates of deposit through the bank he controlled in Antigua (in the West Indies) and telling them that the money would be invested in stocks and bonds. Instead, he diverted $2 billion into risky real-estate ventures and his own busi- nesses. He bribed an Antiguan regulator and an outside auditor. James Davis, Stanford’s CFO, pled guilty to fraud and conspiring to obstruct a federal proceeding, and he testified against Stanford.

Lost in the news reports of the scandal is the role of whistleblower Leyla Wydler. Wydler, who had worked for Stanford, alerted the SEC back in 2003. She sent a letter to the commission about her former employer, the Stanford Financial Group. A year earlier, it had fired her for refusing to sell certificates of deposit that she rightly suspected were being misleadingly advertised to investors. The company, Wydler warned in her letter, “is the subject of a lingering corporate fraud scandal perpetrated as a massive Ponzi scheme that will destroy the life savings of many, damage the reputation of all associated parties, ridicule securities and banking authorities, and shame the U.S.” 99

Wydler had resisted Stanford’s pressure to get her clients to invest in his scheme. Eventually, she concluded that it was a Ponzi scheme, and she refused to sell the scheme to her clients. Stanford reacted by firing her. The SEC ignored her warnings and allowed Stanford to dupe thousands more of investors after the reporting. But she did not stop with the SEC. She also sent copies of the letter to the National Association of Securities Dealers (NASD)—now called Financial Industry Regulatory Authority (FINRA)—the trade group responsible for enforcing regulations throughout the industry, as well as various newspa- pers, including The Wall Street Journal.

Wydler was not able to sue Stanford in court because of a forced arbitration agree- ment. The securities arbitrator not only rejected her whistleblower retaliation claim but also ordered her to repay her $100,000 signing bonus from the company. (Under the 2010 Dodd-Frank Act, whistleblowers like Wydler are no longer bound by forced arbitration agreements.)

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Why did the regulators ignore Wydler? It seemed to be a pattern of behavior at the time. Recall that Harry Markopolos reported concerns about Bernie Madoff’s Ponzi scheme to the SEC, and his warnings were ignored as well. Perhaps the SEC did not have the resources to investigate all such allegations. Perhaps it just lacked the motivation to carry through with what would have been an exhaustive investigation. Or perhaps the SEC has failed in its obligations to protect the investing public.

Incentivizing Whistleblowing under Dodd-Frank The 2010 passage of Dodd-Frank proposed additional incentives for whistleblowers who provide information that aids in the recovery of over $1 million. The whistleblower could receive 10 to 30 percent of that amount. The belief is that monetary incentives will prompt observers of corporate misconduct to come forward, which could prevent future scandals like those leading up to the 2007–2008 financial crisis. One major concern with this new provision is that it may cause would-be whistleblowers to go external with the information rather than internal using the organization’s prescribed reporting mechanisms, as previously discussed. The reason is the potential for monetary rewards may encourage whistleblowers to go straight to the SEC with their reports rather than first reporting the misconduct to the company’s internal compliance officers. 100

Under Dodd-Frank, whistleblowers who report violations of the securities laws are supposed to be protected from being fired. These protections—which can include rein- statement, double back pay, and special damages—are designed to serve as an incentive for whistleblowers to come forward despite the risk that they will be retaliated against for exposing their employer’s wrongdoing.

There are many unanswered questions about Dodd-Frank, including whether specific whistleblowers are entitled to invoke the whistleblower protections under the law, even though they never reported the alleged wrongdoing to the government. A court decision in Asadi v. G. E. Energy 101 on June 28, 2012, indicates that whistleblowers who merely report internally are not necessarily protected; external reporting to the SEC may also be required to invoke Dodd-Frank protections. One concern we have here from an ethi- cal perspective is that it may be better for all involved—the whistleblower, the offending company, and the public—if the whistleblower works with the company to fix the matter without getting the government (and the press) involved. Another concern is that it may force the whistleblower to take a more adverse position against the company and endure greater scrutiny and exposure when they come forward. In fact, one of the biggest concerns that surrounded the passing of Dodd-Frank whistleblower provisions was that it would undermine companies’ internal compliance programs by encouraging whistleblowers to bypass them completely. Some even argued on behalf of a requirement that whistleblow- ers report internally first before going to the government. However, such a precondition was rejected, and the concerns about upending compliance programs have not really been borne out.

Accountants’ Obligations for Whistleblowing Accountants are increasingly being asked to blow the whistle on corporate wrongdoing to stem the tide of recent massive financial fraud such as at Enron and WorldCom, and Ponzi schemes like those of Madoff and Stanford. The question during congressional investigations of the financial services industry role in the 2007–2008 financial meltdown was: Where were the auditors? Dodd-Frank contains provisions to encourage accountants and auditors to report corporate wrongdoing to meet their public interest responsibilities.

The whistleblower provisions of Dodd-Frank exclude two categories of accountants from award eligibility because of their preexisting legal duty to report securities violations:

1. Individuals with internal compliance or audit responsibilities at an entity, including CPAs, who receive information about potential violations, cannot receive whistleblower

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awards because it is part of their job responsibilities to report suspicion of illegal acts to management. However, these individuals will not be excluded from receiving a whistleblower award where: a. Disclosure to the SEC is needed to prevent “substantial injury” to the financial inter-

est of an entity or its investors, b. The whistleblower reasonably believes the entity is impeding investigation of the

misconduct, or c. The whistleblower has first reported the violation internally and at least 120 days

have passed. 2. CPAs who receive information about potential violations of a client or its directors or

officers through an audit or other engagement required under the federal securities laws are not eligible to receive whistleblower awards. The SEC included this exclusion so as not to undermine the legal duty that auditors have under Section 10A of the Securities and Exchange Act of 1934 to report illegal acts by officers, directors, and other client personnel up the chain of command. If the issues are not addressed adequately by management, the auditor must then resign from the engagement and file a report with the SEC.

Notably, the whistleblower exclusions do not apply to CPAs who report information about potential violations regarding their own firms’ performance of audit services for a cli- ent. This is true even where the CPA’s information about his or her firm leads to a successful enforcement action against one of the firm’s clients.

Several members of the public accounting industry, including KPMG, Ernst & Young, PwC, and the Center for Audit Quality, have expressed concerns to the SEC that the accountant exclusion in the whistleblower provisions is too narrow. Those entities believe that permitting CPAs to obtain monetary rewards by blowing the whistle on their own firms’ performance of services for clients could create several significant problems with respect to maintaining the confidentiality of client information.

The issue of confidentiality is an important one for CPAs who have an ethical obligation under the AICPA Code of Professional Conduct not to divulge client confidential informa- tion unless under a valid court order or subpoena to do so, for ethics investigations of the CPA’s services, peer reviews, or if disclosure is approved by the client. The question of whether reporting to the SEC under Dodd-Frank under the conditions explained above would violate the confidentiality obligation of a CPA can be answered by referring to Rule 301 of the AICPA Code. In addition to the aforementioned exceptions, the rule specifies that the confidentiality obligation “does not prohibit a member’s compliance with applicable laws and government regulations,” 102 which presumably would include SEC regulations and Dodd-Frank. More will be said about the confidentiality obligation in Chapters 4 and 5.

The confidentiality obligation of internal accountants and auditors who are members of the IMA provide that confidential employer information should be kept confidential except when disclosure is authorized or legally required. The legal requirement aspect would once again seem to protect the whistleblower given Dodd-Frank requirements.

Has the Whistleblowing Program Been Successful? In an August 2012 interview with Directorship, a publication of the National Association of Corporate Directors (NACD), Sean McKessy, chief of the Office of the Whistleblower, said that his office is receiving about eight tips a day and is preparing for an increase in tip vol- ume. McKessy said the first payment may open the “tipster floodgates.” The whistleblower set to receive the SEC’s first payment has requested anonymity and will receive almost $50,000—30 percent of what the SEC has collected in the case, and the maximum that the SEC is allowed to pay out for providing evidence, which in this case is of securities fraud.

McKessy wondered about the long-term success of the program, given a study by the Ethics Resource Center stating that only 2 percent of employees went outside the company to report wrongdoing. He said that a significant majority of those who brought tips to the

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Office of the Whistleblower who were reporting on their current or former company claim that they first tried to report to someone internally—a boss, a compliance hotline, or the board of directors. “I think that speaks to the fact that—notwithstanding the claims we are destroying internal compliance—most people view their own company as the first line of defense.” While McKessy says that some may measure the success of the whistleblower program by the payments made, he points to another benchmark: “The program is success- ful if it shows people came forward who otherwise wouldn’t have.”

The SEC released its annual report on the Dodd-Frank Whistleblower Program for fiscal year 2012 on November 30, 2012. The commission reported that it received 3,001 tips in fiscal year 2012, with the lowest number (166) in November 2011 and the highest number (314) in May 2012. These numbers confirm the results of the “Whistleblower” study of the ERC that more employees have been reporting whistleblowing in current years compared to the past.

The value of the Whistleblower Program has been questioned in a survey by BDO International, the fifth-largest accountancy network in the world. According to the survey, 51 percent of corporate board members said the Whistleblower Program “has undermined internal anti-fraud and compliance programs.” But 83 percent said that there has been no increase or decrease in the number of internal whistleblower reports at their businesses since the SEC program began. According to Lee Graul, a BDO partner who specializes in corporate governance, “I guess if somebody is going to look outside and report, that steals some of the thunder and the responsibilities those people feel they have to identify and evaluate those situations internally.” 103 The BDO results seem to contradict the SEC’s observation of the value of the program. Perhaps, as with so many things in business, it depends on one’s perspective as to whether a controversial program is working. We believe that the jury is still out on this question.

The Ethics of Whistleblowing We have already discussed whistleblowing with respect to the confidentiality obligation of accountants and auditors under professional ethics codes. We also have expressed the concern that the whistleblowing provision of Dodd-Frank may lead an individual to report the matter to the SEC rather than work within internal channels to correct the wrongdoing. We believe employees who discover improprieties have an ethical obligation to do what- ever is necessary to work within the system to correct the situation. A related issue is the “incentivization” of whistleblowing under Dodd-Frank. Some have called it a “bounty hunter” program. Is it ethical to provide financial incentives to motivate employees to come forward and report financial wrongdoing? This is not an easy question to answer.

Employees have a loyalty obligation to their employers that include maintaining confidenti- ality and not doing anything to harm their employers. However, as discussed in Chapter 1, the loyalty obligation should never be used to mask one’s ethical obligation to be honest. Assuming the internal reporting process has played out and nothing has been done to correct for the wrongdoing, we believe from an ethical perspective external whistleblowing is the proper course of action especially if it is the only way for the public to know. An employee should not fall victim to the bystander effect and assume others will report it. Along with knowledge comes the responsibility to correct wrongdoings, which is in the best long-term interests of the organization. For CPAs, it honors the public trust to report an activity like fraud.

A valid question is whether the incentive provision itself is ethical. In other words, is Dodd-Frank replacing one unethical action (i.e., fraud) with another unethical practice (i.e., incentivizing the reporting of fraud with monetary reward)? Ideally, whistleblowing should be encouraged for the sole purpose of being the morally correct thing to do, not because of a reward that may come at the end of the process. The reward may be necessary to get someone to come forward, but it does not address the issue whether the government should pay for information about fraud or other illegal action.

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Concluding Thoughts

Fraud in business continues to persist in spite of efforts to improve the ethical climate of organi- zations and strengthen regulatory requirements and sanctions for wrongdoing. The post-Enron era ushered in a period of financial services fraud including firms involved in making risky mortgages and individuals like Bernie Madoff and Allen Stanford taking the traditional Ponzi scheme to a new (low) level. The greed of CEOs such as Dennis Kozlowski showed just how jaded one’s actions can be when given the power and control to run a major corporation. Internal corporate governance sys- tems have been strengthened and compliance programs enhanced. Yet, the National Business Ethics Survey indicates that pressure to compromise standards in the workplace is up. More employees believe that the ethical culture of their organization has weakened. An increasing number of employ- ees are reporting fraud and other improper behavior, and retaliation against whistleblowers has increased. Perhaps all this will change over time with the help of whistleblower provisions in laws such as SOX and Dodd-Frank, which seem to be encouraging more external reporting after exhaust- ing internal means of reporting. From an ethical perspective, we are concerned that employees may increasingly turn on their companies and violate the trust placed in them for personal reasons or just to receive a reward, and blow the whistle rather than to engage in that practice because it is the moral thing to do. So we end with a question that all students should ask: Notwithstanding regulatory obli- gations to blow the whistle, do the means of gathering and reporting information externally about an employer’s wrongdoing justify the ends of whistleblowing?

Discussion Questions

1. In her book The Seven Signs of Ethical Collapse, Jennings explains: “When an organization collapses ethically, it means that those in the organization have drifted into rationalizations and legalisms, and all for the purpose of getting the results they want and need at almost any cost.” Discuss what you think Jennings meant by this statement.

2. Five months before the new 2002 Lexus ES hit showroom floors, the company’s U.S. engineers sent a test report to Toyota City in Japan: The luxury sedan shifted gears so roughly that it was “not acceptable for production.” The warning was sent to Toyota executive vice president Katsuaki Watanabe on May 16, 2001. Days later, another Japanese executive sent an email to top managers saying that despite misgivings among U.S. officials, the 2002 Lexus was “marginally acceptable for production.” The new ES went on sale across the nation on October 1, 2001.

In years to come, thousands of Lexus buyers would discover firsthand that the vehicle’s trans- mission problems, which caused it to hesitate when motorists hit the gas, or lurch forward unin- tentionally, were far from fixed. The 2002–2006 ES models would become the target of lawsuits, federal safety investigations, and hundreds of consumer complaints, including claims of 49 injuries.

In an August 15, 2005, memo explaining the company’s position, a staff attorney wrote: “The objective will be to limit the number of vehicles to be serviced to those owners who com- plain and to limit the per-vehicle cost.”

In 2010, Toyota was fined a record $16.4 million for delays in notifying federal safety offi- cials about defects that could lead to sudden acceleration. The reaction of a Toyota spokesperson was: “Given the concerns raised by some customers about this drivability issue, we did not meet the very high customer satisfaction standards we set for ourselves. However, we fully stand behind the engineering and production quality of the vehicle, as well as our after-sale customer service and technical support.”

Evaluate Toyota’s actions from a corporate governance perspective. How would you charac- terize the ethical culture at Toyota, at least with respect to the Lexus incident? Can you draw any parallels between the Toyota experience and how Ford handled the matter with the Pinto?

3. The following questions deal with issues related to executive compensation: a. What is the business judgment rule and how does it relate to executive compensation? b. On August 9, 2005, Chancellor William B. Chandler III of the Delaware Chancery Court 104

ruled that the directors of the Walt Disney Company acted in good faith when Michael Ovitz was hired in 1995 to be the CEO of Disney and then allowed to walk away 15 months later with a severance package valued at $130 million after being fired by Michael Eisner, the chair of the Disney’s board of directors. Is it “fair” that Ovitz was allowed to walk away with such a lucrative severance package only 15 months after being fired? Include in your discus- sion what constitutes fairness in this instance from an ethical perspective.

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4. Explain the “say on pay rule” and whether you believe that it is likely to have an effect on large compensation packages of CEOs.

5. Distinguish between agency theory, stakeholder theory, and stewardship theory with respect to controlling the actions of managers.

6. Do you believe that a member of the audit engagement team servicing a client should also serve on the audit committee of the board of directors of the client entity? Why or why not?

7. COSO explains the importance of the control environment to internal controls by stating that it sets the tone of an organization, influencing the control consciousness of its people. It is the foundation for all aspects of internal control, providing discipline and structure. Explain what is meant by this statement.

8. According to the IIA Code of Ethics, internal auditors should make a balanced assessment of all the relevant circumstances and should not be unduly influenced by their own interests or by oth- ers in forming judgments. Which interests are being referred to in that statement, and how might they influence the ethical decisions of a member of the IIA?

9. In the accounting fraud at the cable company Adelphia, top management had established a “cash management” system that enabled the founder of Adelphia and former CEO and chair of the board of directors, John Rigas, to dip into the fund for personal expenses whenever he wanted. The final approval for such expenditures rested with Timothy Rigas, the son of John Rigas and Adelphia’s CEO during the final years that fraud had occurred. What’s wrong with the founder of a company, its former CEO and board chair, using corporate assets for personal reasons? Can you think of any circumstances where it would be permissible? That is, what would have to hap- pen for this to be acceptable?

10. The 2011 National Business Ethics Survey defines “active social networkers” as people who spend more than 30 percent of the workday participating on social networking sites. Such employees are much more likely to view their current jobs as temporary; 72 percent of active social networkers polled said they plan to change employers within the next five years, com- pared to 39 percent of nonactive social networkers.

That feeling of transience may lead to such workers thinking that it’s no big deal to swipe a few things from the office supply cabinet: 46 percent of active social networkers said that they thought it was acceptable to take a copy of work software home and use it on their personal computers, while just 7 percent of nonactive social networkers said the same.

Why do you think there is a difference in responses with respect to the use of company software at home on personal computers between active and nonactive social networkers? Do you believe that it is an ethics failing to take software home without asking for the company’s permission? What about simply checking your Facebook page once a day at work?

11. How do the concepts of cognitive dissonance, organizational dissonance, and ethical dissonance relate to whether an accountant might choose to blow the whistle on corporate wrongdoing?

12. According to the Business Roundtable, “Effective corporate governance requires a clear under- standing of the respective roles of the board and senior management and their relationships with others in the corporate structure. The relationships of the board and management with stockholders should be characterized with candor; their relationships with employees should be characterized by fairness; their relationships with communities in which they operate should be characterized by good citizenship; and their relationships with government should be character- ized by a commitment to compliance.” Discuss what is meant by each element of the statement with respect to creating an ethical organization environment.

13. Explain the components of Burchard’s Ethical Dissonance Model and how it describes the ethi- cal person-organization fit at various stages of the contractual relationship in each potential fit scenario. Assume a Low Organizational Ethics, High Individual Ethics (Low-High) fit. How might this relationship influence your motivation to blow the whistle on corporate wrongdoing?

14. Brief and Motowidlo define prosocial behavior within the organizational setting as “behav- ior which is (a) performed by a member of an organization, (b) directed toward an individual, group, or organization with whom she interacts while carrying out her organizational role, and (c) performed with the intention of promoting the welfare of the individual, group, or organiza- tion toward which it is directed.” 105

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The research on whistleblowing that has used this model has generally argued that stages 5 and 6 represent cognitive moral development consistent with prosocial behavior. Discuss why stages 5 and 6 of Kohlberg’s model are more likely to be associated with prosocial behavior than lower stages of moral development.

15. Compare the role of Sherron Watkins as a whistleblower in the Enron case to that of Leyla Wydler in the Allen Stanford Ponzi scheme in terms of the nature of the whistleblowing and the motivation to blow the whistle. Can you characterize each one’s actions from the perspective of organization-person fit?

16. In October 2010, it was reported that Cheryl Eckard, a quality-assurance manager at the phar- maceutical company GlaxoSmithKline (GSK) who had blown the whistle on the safety of prod- ucts made in its Puerto Rico plant, had been fired as a result of what the company called a “redundancy” related to the merger of Glaxo Wellcome and SmithKline Beecham a couple of years before. Of course, the suspicion was that Eckard was fired because she refused to go along in a cover-up of the quality assurance and compliance problems at the plant. She had made rec- ommendations to her superiors that were ignored, reportedly because the company was too busy preparing for an FDA inspection that they hoped would clear the way for approval to market two new products, including the diabetes drug Avandamet. Eckard had found that the manufactur- ing facility had a contaminated water system, an air system that allowed products to be cross- contaminated, and pills of different strengths mixed in the same bottles, among other problems.

Eckard filed a federal lawsuit against GSK under the U.S. False Claims Act. She won $96 million as part of a $750 million penalty against GSK. GSK agreed to pay millions in fines, penalties, and settlements to resolve claims that it knowingly made and sold adulterated drugs, including Paxil, a popular antidepressant, with the intent to defraud and mislead.

How do you view whistleblowers that approach the government under the False Claims Act and win large awards from the settlement? Are they just out for the money? Should they profit from the wrongdoing of their employer? Or are they performing an important public service?

17. It is a distinguishing mark of actions labeled whistleblowing that the agent intends to force attention to a serious moral problem. How does this statement relate to whistleblowers who come forward under provisions of the Dodd-Frank Financial Reform Act? Respond to the ques- tion by considering the motivations to blow the whistle as discussed in this chapter.

18. Do you believe that the Dodd-Frank Whistleblower Program, which incentivizes reporting fraud and other wrongdoings in return for a monetary reward, is ethical? Use the ethical reasoning methods discussed in Chapter 1 to answer this question.

19. Because of their access and knowledge, accountants are in an ideal position to provide their clients and the SEC with early and invaluable assistance in identifying the scope, participants, victims and ill-gotten gains associated with corporate wrongdoing. Historically, when CPAs discovered attempted or actual fraud, client confidentiality rules limited their ability to publicly report their observations. With the advent of Dodd-Frank, accountants no longer need to choose between doing the right thing and risking the loss of their professional licenses. Explain how and under what circumstances Dodd-Frank enables accountants to report their observations.

20. “Give me the ‘McFacts,’ ma’am, nothing but the McFacts!” So argued the defense attorney for McDonald’s Corporation as she questioned Stella Liebeck, an 81-year-old retired sales clerk, two years after her initial lawsuit against McDonald’s claiming that it served dangerously hot coffee. Liebeck had bought a 49-cent cup of coffee at the drive-in window of an Albuquerque McDonald’s, and while removing the lid to add cream and sugar, she spilled the coffee and suffered third-degree burns of the groin, inner thighs, and buttocks. Her suit claimed that the coffee was “defective.” During the trial, it was determined that testing of coffee at other local restaurants found that none came closer than 20° to the temperature at which McDonald’s coffee is poured (about 180°F). The jury decided in favor of Liebeck and awarded her compensatory damages of $200,000, which they reduced to $160,000 after determining that 20 percent of the fault belonged with Liebeck for spilling the coffee. The jury then found that McDonald’s had engaged in willful, reckless, malicious, or wanton conduct, the basis for punitive damages. It awarded $2.7 million in punitive damages. That amount was ultimately reduced by the presiding judge to $480,000. The parties then settled out of court for an unspecified amount reported to be less than the $480,000.

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For its part, McDonald’s had suggested that Liebeck may have contributed to her injuries by holding the cup between her legs and not removing her clothing immediately. The company also argued that Liebeck’s age may have made the injuries worse than they might have been in a younger individual, “since older skin is thinner and more vulnerable to injury.”

Who is to blame for the McSpill? Be sure to support your answer with a discussion of personal responsibility, corporate accountability, and ethical reasoning.

Endnotes 1. Craig E. Johnson, Meeting the Ethical Challenges of Leadership, 3d ed. (Thousand Oaks, CA: Sage Publications, Inc., 2009), p. 44.

2. Max H. Bazerman and Ann E. Trebrunsel, Blind Spots: Why We Fail to Do What’s Right and What to Do About It (Princeton, NJ: Princeton University Press, 2011).

3. Marianne M. Jennings, The Seven Signs of Ethical Collapse: How to Spot Moral Meltdowns in Companies Before It’s Too Late (New York: St. Martin’s Press, 2006).

4. Jennings. 5. Jennings. 6. Jennings, pp. 138–139. 7. Andrew Crockett, Frederic S. Mishkin, and Eugene N. White, Conflicts of Interest in the

Financial Services Industry: What Should We Do about Them? Centre for Economic Policy Research (January 2003) (Washington, DC: Center for Economic Policy Research, 2003).

8. Jennings, pp. 218–219. 9. Jennings. 10. Susan E. Fiske and Shelley E. Taylor, Social Cognition (New York: McGraw-Hill, 1991). 11. Thomas M. Jones, “Ethical Decsision Making by Individuals in Organizations: An Issue-

Contingent Model,” The Academy of Management Review 16, no. 2 (1991), pp. 366–395. 12. Mary Jo Burchard, “Ethical Dissonance and Response to Destructive Leadership: A Proposed

Model,” Emerging Leadership Journeys 4, no. 1, pp. 154–176. 13. Scott K. Jones and Kenneth M. Hiltebeitel, “Organizational Influence in a Model of the Moral

Decision Process of Accountants,” Journal of Business Ethics 14, no. 6 (1995), pp. 417–431. 14. Jones and Hiltebeitel. 15. Burchard. 16. Burchard, pp. 158–159. 17. Lawrence A. Pervin, “Performance and Satisfaction as a Function of Individual-Environment

Fit,” Psychological Bulletin 69, no. 1 (January 1968), pp. 56–68. 18. Burchard, pp. 162–163. 19. Hian Chye Koh and El’fred H. Y. Boo, “Organizational Ethics and Job Satisfaction and

Commitment, Management Decision 4, nos. 5 and 6 (2004), pp. 677–693. 20. Burchard, pp. 163–164. 21. Art Padilla, Robert Hogan, and Robert B. Kaiser, “The Toxic Triangle: Destructive Leaders,

Susceptible Followers, and Conducive Environments,” Leadership Quarterly 18(3), (2007), pp. 176–194.

22. Burchard, pp. 164–165. 23. V. Lee Hamilton and Herbert Kelman, Crimes of Obedience: Toward a Social Psychology of

Authority and Responsibility (New Haven, CT: Yale University Press, 1989). 24. Koh and Boo. 25. Randi L. Sims and Thomas L. Keon, The Influence of Ethical Fit on Employee Satisfaction,

Commitment, and Turnover, Journal of Business Ethics 13, no. 12 (1994), 939–948. 26. O. C. Ferrell, John Fraedich, and Linda Ferrell, Business Ethics: Ethical Decision Making and

Cases . 9th ed. (Mason: OH, South-Western, 2011). 27. Available at . 28. Available at

companies/ .

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29. Johnson, p. 89. 30. Jennings, p. 45. 31. Russ McGuire, “WorldCom’s Deadly Culture,” Available at . 32. Institute of Internal Auditors (IIA). Code of Ethics, http// . 33. John C. Maxwell, There’s No Such Thing as “Business” Ethics (New York: Warner Business

Books, 2003). 34. PBS Newshour interview with Paul O’Neill, July 9, 2002, Available at

bb/business/julydec02/oneill_7-9.html . 35. Johnson & Johnson Credo, 36. Tamara Kaplan, “The Tylenol Crisis: How Effective Public Relations Saved Johnson &

Johnson,” Pennsylvania State University, crisis.html .

37. Available at risperdal-settlement .

38. Ethics Resource Center (ERC), 2011 National Business Ethics Survey (NBES): Workplace Ethics in Transition, .

39. NBES. 40. NBES, p. 14. 41. Win Swenson, “The Organizational Guidelines ‘Carrot and Stick’ Philosophy, and Their

Focus on ‘Effective Compliance’” in Corporate Crime in America: Strengthening the “Good Citizenship,” Corporation (Washington, DC: U.S. Sentencing Commission, 1995), pp. 17–26.

42. Archie B. Carroll and Ann K. Buchholtz, Business & Society: Ethics and Stakeholder Management (Mason, OH: Cengage Learning, 2009).

43. Ferrell et al., p. 35. 44. Isabelle Maignan and O. C. Ferrell, “Corporate Social Responsibility: Toward a Marketing

Conceptualization,” Journal of the Academy of Marketing Science 32 (2004), pp. 3–19. 45. United States v. Carroll Towing, 159 F.2d 169 (2d Cir. 1947). 46. Douglas Birsch and John H. Fiedler, The Ford Pinto Case: A Study in Applied Ethics, Business,

and Technology (Albany: State University of New York, 1994). 47. Grimshaw v. Ford Motor Co., 1 19 Cal.App.3d 757, 174 Cal. Rptr. 348 (1981). 48. David De Cremer and Ann E. Tenbrunsel, Behavioral Business Ethics: Shaping an Emerging

Field (New York: Routledge, 2012). 49. Association of Certified Fraud Examiners, 2012 Global Fraud Study: Report to the Nations

on Occupational Fraud and Abuse, rttn/2012-report-to-nations.pdf .

50. ACFE, p. 6. 51. ACFE, p. 57. 52. Ernst & Young, Detecting Financial Statement Fraud: What Every Manager Needs to Know, $FILE/FIDS-FI_DetectingFinancialStatementFraud.pdf .

53. United States of America v. Quentin T. Wiles and Patrick J. Schleibaum, Nos. 94-1592, 95-1022. United States Court of Appeals, Tenth Circuit, December 10, 1996 102 F.3d 1043 , .

54. Ferrell et al., p. 42. 55. Andrei Shleifer and Robert Vishny, “A Survey of Corporate Governance,” Journal of Finance

(1997). 56. J. E. Parkinson, Corporate Power and Responsibility (Oxford, UK: Oxford University Press,

1994). 57. R. I. Tricker, Corporate Governance: Practices, Procedures and Powers in British Companies

and Their Boards of Directors (Aldershot, England: Gower Press, 1984). 58. Ferrell, p. 44.

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59. W. Steve Albrecht, Conan C. Albrecht, and Chad O. Albrecht, “Fraud and Corporate Executives: Agency, Stewardship, and Broken Trust,” Journal of Forensic Accounting 5 (2004), pp. 109–130.

60. Lex Donaldson and James H. Davis, “Stewardship Theory,” Australian Journal of Management 16, no. 1 (June 1991).

61. Michael Jensen and William H. Meckling, “Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure, Journal of Financial Economics (1976), pp. 305–360.

62. Chamu Sundaramurthy and Marianne Lewis, “Control and Collaboration: Paradoxes and Goverrnment,” Academy of Management Review 28, issue 3 (July 2003), pp. 397–416.

63. Donaldson and Davis. 64. James H. Davis, F. David Shoorman, and Lex Donaldson, “Toward a Stewardship Theory of

Management,” The Academy of Management Review 22, no. 1 (January 1997). 65. Economic Intelligence Unit (The Economist), “The Importance of Corporate Responsibility”

(2005), . 66. Economic Intelligence Unit (The Economist). 67. John A. Byrne with Louis Lavelle, Nanette Byrnes, Marcia Vickers, and Amy Borrus, “How to

Fix Corporate Governance,” Business Week, May 6, 2002, pp. 69–78. 68. Venkat Venkatasuvramanian, What Is Fair Pay for Executives? An Information Theoretic

Analysis of Wage Distributions, . 69. Available at worth-

all-that-dough/ . 70. DoddFrank Wall Street Reform and Consumer Protection Act (HR 4173),

laws/wallstreetreform-cpa.pdf . 71. Robert E. Scully, J. “Executive Compensation, the Business Judgment Rule, and the Dodd-

Frank Act: Back to the Future for Private Litigation?,” The Federal Lawyer, January 2011. 72. Zabihollah Rezaee, Corporate Governance and Ethics (New York: Wiley, 2009). 73. Floyd Norris, “For Boards, S.E.C. Keeps the Bar Low,” The New York Times, March 3, 2011, . 74. Sarbanes-Oxley Act of 2002 (HR 3763), . 75. KPMG International, “Ten to-do’s for Audit Committees in 2011,”

IssuesAndInsights/ArticlesPublications/Documents/ACI-ten-to-do%27s-2011_Canada.pdf . 76. Available at . 77. Rezaee, p. 130. 78. Report Available at

work.pdf . 79. Available at

model-s-risks . 80. National Commission on Fraudulent Financial Reporting (Treadway Commission Report),

Report of the National Commission on Fraudulent Financial Reporting, October 1987. 81. 82. SEC, Release No. 34-61067; File No. SR-NYSE-2009-89,

34-61067.pdf . 83. Alison Frankel, “Sarbanes-Oxley’s Lost Promise: Why CEOs Haven’t been Prosecuted,” July 27,

2012, ceos-havent-been-prosecuted/ .

84. Ethics and Compliance Officer Association (ECOA), . 85. PricewaterhouseCoopers, “State on Compliance: 2012 Study,

management/assets/2012-compliance-study.pdf . 86. Kevin Dowd, “Moral Hazard and the Financial Crisis, Cato Institute,

journal/cj29n1/cj29n1-12.pdf . 87. The SEC Web site points out that a “Ponzi” scheme was named after Charles Ponzi, a crook

who made his money by promising New England residents that he could provide 40 percent

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returns on their investment, compared to the 5 percent return they could receive from banks at the time. Ponzi believed he could take advantage of the difference between the U.S. and foreign currencies used in buying and selling international mail coupons. In reality, he developed a pyramid scheme that used a “rob-Peter-to-pay-Paul” approach to make his money.

88. Securities and Exchange Commission v. David G. Friehling, Friehling & Horowitz, CPA’s, P.C., March 18, 2009, .

89. SEC Web site, . 90. Securities and Exchange Commission (SEC), 17 CFR Parts 240 and 249 [Release No.

34-64545; File No. S7-33-10] Implementation of the Whistleblower Provisions of Section 21F of the Securities Exchange Act of 1934. .

91. Janet Near and Marcia Miceli, “Organizational dissidence: The case of whistle-blowing, Journal of Business Ethics 4, pp. 1–16.

92. Ferrell, p. 191. 93. Near and Miceli. 94. Ethics Resource Center (ERC), Inside the Mind of a Whistleblower: A Supplement Report of

the 2011 National Business Ethics Survey, . 95. Kristy Mathewson, “Whistleblowing and Bystander Apathy: Connecting Ethics with Social

Responsibility,” The Corporate Social Responsibility Newswire, posted August 7, 2012, www social-responsibility .

96. ERC, Inside the Mind of a Whistleblower. 97. . 98. Sarbanes-Oxley Act of 2002. 99. “Stanford’s Ponzi Scam: The System is Still Broken,”

03/07/stanfords-ponzi-scam-the-system-is-still-broken/print/ . 100. “Whistle-blower Debate Heats Up,” CFO, February 11, 2011,

145546017 . 101. Khaled Asadi v. G. E. Energy, LLC, Civil Action No. 12-345, in the U.S. District Court for the

Southern District of Texas, . 102. AICPA Code of Professional Conduct, Rule 301,

CodeofConduct/Pages/et_300.aspx#et_301 . 103. Ken Tysiac, “Hot tips: SEC fields 3,000 whistleblower complaints in 12 months,” Journal of

Accountancy online, November 15, 2012. 104. The Delaware Court of Chancery is widely recognized as the preeminent forum in the United

States for the determination of disputes involving the internal affairs of thousands of Delaware corporations and other business entities, especially matters of board of director responsibilities. The court has jurisdiction to hear all matters related to equity. Its decisions can be appealed to the Delaware Supreme Court.

105. Arthur P. Brief and Stephen J. Motowidlo, “Prosocial Organizational Behaviors,” The Academy of Management Review 11, no. 4, pp. 710–725.

106. . 107. U.S. District Court for the District of Massachusetts, Case 1:06-cv-10972-WGY Document

238 Filed 05/27/10, .

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Appendix 1

Ethical Decision-Making Model Analysis of Tylenol Poisoning 1. Frame the ethical issue. How should the company react

to the Tylenol crisis to protect the interests of those who rely on the product?

According to the company, its reaction was guided by the company’s credo. If you read the credo, you’ll notice how the company places the interests of the peo- ple who rely on the safety of the product ahead of its own self-interest. In fact, it links making a “fair profit” to its ethical action and social responsibility. The actions of Johnson & Johnson to the Tylenol crisis today are viewed as a model of business ethics.

2. Gather all the facts. Typically, these would be pre- sented in summary or bullet form. Because the facts have already been described, they will not be repeated here.

3. Identify the stakeholders and obligations. This is arguably the most important step for Johnson & Johnson. The credo clarifies the stakeholders. In addition to the company’s obligations to doctors, nurses, patients, and parents to provide a safe and reliable product, the company has an obligation to its employees to “walk the talk” of the credo. If it did not act in accordance with the company’s written statement of core values, then employees might wonder about the company’s commit- ment to its own credo. This would send a negative mes- sage concerning the tone at the top of the organization.

The company also has an important obligation to its investors. As noted earlier, even though the company’s stock price declined at first, it ultimately recovered all those losses. But the point is by acting ethically, the company retained the trust of its stockholders, many of whom are parents and can relate to the parents of chil- dren who might ingest a tainted product accidentally.

Finally, Johnson & Johnson has an obligation to the government because the FDA regulates pharmaceutical products and is concerned about its role in protecting public health. The issue of product tampering is one that has grown in importance since the Tylenol event, as more and more companies have been questioned about the safety of products, including automobile manufacturers, tire manufacturers, and makers of sili- cone gel breast implants.

4. Identify the relevant accounting ethics standards involved in the situation. These are limited by the facts of the case. However, the manner of disclosing the facts of the situation relates to being honest and transparent in financial reporting.

5. Identify the operational issues. The application of Johnson & Johnson’s credo in handling the Tylenol

incident is an operational issue. The company indicated that it turned to its credo immediately for guidance. This means that it was guided operationally by one of its internal reporting controls—the credo—that enabled it to respond in an ethical manner.

Additional facts of the Tylenol poisoning indi- cate that the company established a 1-800 hotline for consumers to call for any inquiries about the safety of Tylenol. Operationally, this was another positive step to assure the public of the company’s concern for its safety.

The company acted swiftly and responsibly to develop a safer packaging for Tylenol. It was a triple safety seal packaging—a glued box, a plastic seal over the neck of the bottle, and a foil seal over the mouth of the bottle. This is the industry standard today.

6. Identify the technical accounting and auditing issues. The main accounting issue was how to disclose informa- tion about the Tylenol poisonings and the ultimate legal liability of the company. Given that the Tylenol incident was the first of its kind, it would have been difficult for the accountants to determine the potential monetary lia- bility in any lawsuit brought against the company. Still, the event itself should have been disclosed in the foot- notes as a contingent liability because it was reasonably possible that there would have been a material liability for the company.

7. List all the possible alternatives of what you can or cannot do. In this case, the choices would be as follows:

a. Ignore the poisonings and let the government dictate what the company should do.

b. Do the minimum—recall the tainted product. c. Do all that the company can to assure the public by

acting in a responsible and ethical manner. Undoubtedly, other alternatives can be identified. Of

course, the company chose the last alternative, as already explained. Imagine the public outcry if the company had ignored or downplayed the severity of the situation as so many companies have since the Tylenol incident. Recall the way Ford reacted to safety concerns of its Pinto brand as discussed in this chapter by conducting a cost-benefit analysis of whether the company should fix the appar- ently unsafe placement of Pinto gas tanks behind the rear axle. Then there is the tobacco industry, which hid information from the public about studies it had con- ducted that showed nicotine was addictive. In that case, Jeffrey Wigand, the former vice president of research and development at Brown & Williamson, blew the whistle on the company’s actions to hide the information and even enhance the addictive component of cigarettes. Wigand went so far as to inform the television show 60 Minutes, which did an exposé on the tobacco industry. His story was ultimately told in the movie The Insider.

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8. Compare and weigh the alternatives. Here are the key questions: • Is it legal (in conformity with laws and rules)? Johnson &

Johnson is not obligated to recall product unless so ordered by the FDA. Its actions did not violate any laws.

• Is it consistent with professional standards? The main issue is full disclosure and honest, reliable financial reporting.

• Is it consistent with in-house rules (i.e., codes of conduct)? Yes, the “rules” in this instance reflect the company’s credo, and they were diligently followed.

• Is it right? This is the strength of the actions taken by Johnson & Johnson. The company respected the rights of the parties that used and relied on the safety of Tylenol in crafting a response to the crisis. Imagine if every company that faced a product tampering case did not act to assure the public of the safety of their product. All the public trust would be lost.

• What are the potential harms and benefits to the stake- holders? It is difficult to see how a stakeholder would have benefited from a response other than the one devel- oped by the company. The shareholders were harmed initially when the stock lost market value. However, in the long run, they were better off monetarily. From the perspective of employees working for Johnson & Johnson, they should have been proud to work for the company based on its handling of the Tylenol incident.

• Is it fair to the stakeholders? The company acted in accordance with its credo, which emphasizes fair treatment for its stakeholders, especially the “doc- tors, nurses and patients, mothers and fathers, and all those who use [company] products and services.”

• Is it consistent with virtue considerations? Virtually all of Josephson’s Six Pillars of Character are involved in the Tylenol situation. Honesty exists because the company has an obligation to fully dis- close all the information that the public has a right or need to know. Integrity requires that the com- pany have the courage to stand up for the values in its credo, regardless of the consequences. The com- pany demonstrated accountability and responsibility by acting to remove the tainted form of Tylenol from the shelves of all supermarkets. At first, Johnson & Johnson acted only to remove the product from Chicago-area markets, but it eventually did a national recall of the capsule form of the product. By assur- ing the public that it would not allow a tainted prod- uct to be sold, the company earned its trust. Finally, because the company acted in a socially responsible manner, its commitment to citizenship was clearly established.

9. Decide on a course of action. We know what Johnson & Johnson did and why. Imagine if it had ignored the situation. The number of deaths may have risen before the government stepped in and forced a recall. The com- pany’s reputation might have suffered irreparable harm. The lawsuits would have been flowing.

10. Reflect on your decision. Johnson & Johnson’s then- chair of the board of directors, James E. Burke, was quoted as saying with regard to questions about the survivability of the company after the poisonings were publicly reported: “It will take time, it will take money, and it will be very difficult; but we consider it a moral imperative, as well as good business, to restore Tylenol to its preeminent position.”

Appendix 2

Microsoft Finance Code of Professional Conduct Microsoft’s code of conduct for finance professionals pro- motes professional conduct in the practice of financial man- agement worldwide. Microsoft’s CEO, CFO, corporate controller, and other employees of the finance organization hold an important and elevated role in corporate governance in that they are uniquely empowered to ensure (and capable of ensuring) that all stakeholders’ interests are appropriately balanced, protected, and preserved. This Finance Code of Professional Conduct embodies principles that finance pro- fessionals are expected to adhere to and advocate. These principles of ethical business conduct encompass rules regarding both individual and peer responsibilities, as well as responsibilities to Microsoft employees, the public, and

other stakeholders. The CEO, CFO, and Finance organiza- tion employees are expected to abide by this Code, as well as all applicable Microsoft business conduct standards and policies or guidelines in Microsoft’s employee handbook relating to areas covered by the Code. Any violations of the Microsoft Finance Code of Professional Conduct may result in disciplinary action, up to and including termination of employment.

All employees covered by the Finance Code of Professional Conduct will

• Act with honesty and integrity, avoiding actual or appar- ent conflicts of interest in their personal and professional relationships.

• Provide stakeholders with information that is accurate, complete, objective, fair, relevant, timely, and under- standable, including information in our filings with and

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other submissions to the U.S. Securities and Exchange Commission and other public bodies.

• Comply with rules and regulations of federal, state, pro- vincial, and local governments, and of other appropriate private and public regulatory agencies.

• Act in good faith, responsibly, with due care, competence, and diligence, without misrepresenting material facts or allowing one’s independent judgment to be subordinated.

• Respect the confidentiality of information acquired in the course of one’s work except when authorized or other- wise legally obligated to disclose.

• Not use confidential information acquired in the course of one’s work for personal advantage.

• Share knowledge and maintain professional skills impor- tant and relevant to stakeholders’ needs.

• Proactively promote and be an example of ethical behav- ior as a responsible partner among peers, in the work environment, and the community.

• Exercise responsible use, control, and stewardship over all Microsoft assets and resources that are employed by or entrusted to us.

• Not coerce, manipulate, mislead, or unduly influence any authorized audit or interfere with any auditor engaged in the performance of an internal or independent audit of Microsoft’s system of internal controls, financial state- ments, or accounting books and records.

If you are aware of any suspected or known violations of this Code of Professional Conduct, the Standards of Business Conduct, or other Microsoft policies or guidelines, you have a duty to report such concerns promptly to one of the following:

• Your manager • Another responsible member of management • A Human Resources representative • A Legal and Corporate Affairs (LCA) contact

• The Director of Compliance • The 24-hour Business Conduct Line: Within the United States (toll-free number): (877)

320-MSFT (6738) International toll-free number: (1) (704) 540-0139

The procedures to be followed for such a report are outlined in the Standards of Business Conduct and the Whistleblowing Reporting Procedure and Guidelines in the Employee Handbook.

If you have a concern about a questionable accounting or auditing matter, you can send a confidential email message to the Microsoft Office of Legal Compliance. If you want to submit your concern anonymously, you may use one of the following methods:

• Submit a report through the Microsoft Integrity Web site • Call the Business Conduct Line • Send a letter to the Director of Compliance at the follow-

ing address: Microsoft Corporation Legal and Corporate Affairs One Microsoft Way Redmond, WA 98052 USA

• Send a confidential fax to the Director of Compliance at (1) (425) 705-2985.

Microsoft will handle all inquiries discreetly and make every effort to maintain, within the limits allowed by law, the confi- dentiality of anyone requesting guidance or reporting question- able behavior and/or a compliance concern. It is Microsoft’s intention that this Code of Professional Conduct be its written code of ethics under Section 406 of the Sarbanes-Oxley Act of 2002 complying with the standards set forth in Securities and Exchange Commission Regulation S-K Item 406.

Appendix 3

The False Claims Act (“FCA”) in 31 U.S.C. 3729 The False Claims Act (“FCA”), in 31 U.S.C. 3729, provides, in pertinent part, that:

a. Any person who (1) knowingly presents, or causes to be presented, to an officer or employee of the United States Government or a member of the Armed Forces of the United States a false or fraudulent claim for payment or approval; (2) knowingly makes, uses, or causes to be made or used, a false record or statement to get a false or fraudulent claim paid or approved by the Government;

(3) conspires to defraud the Government by getting a false or fraudulent claim paid or approved by the Government; . . . or (7) knowingly makes, uses, or causes to be made or used, a false record or statement to conceal, avoid, or decrease an obligation to pay or transmit money or prop- erty to the Government, is liable to the United States Government for a civil penalty of not less than $5,000 and not more than $10,000, plus 3 times the amount of dam- ages which the Government sustains because of the act of that person. . . .

b. For purposes of this section, the terms “knowing” and “knowingly” mean that a person, with respect to informa- tion (1) has actual knowledge of the information; (2) acts

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Chapter 3 Creating an Ethical Organization Environment and Effective Corporate Governance Systems 147

in deliberate ignorance of the truth or falsity of the infor- mation; or (3) acts in reckless disregard of the truth or falsity of the information, and no proof of specific intent to defraud is required.

While the False Claims Act imposes liability only when the claimant acts “knowingly,” it does not require that the person submitting the claim have actual knowledge that the claim is false. A person, who acts in reckless disregard or in deliberate ignorance of the truth or falsity of the information, also can be found liable under the Act.

In sum, the False Claims Act imposes liability on any per- son who submits a claim to the federal government that he or she knows (or should know) is false. An example may be a physician who submits a bill to Medicare for medical ser- vices she knows she has not provided. The False Claims Act also imposes liability on an individual who may knowingly submit a false record in order to obtain payment from the government. An example of this may include a government contractor who submits records that he knows (or should know) are false and that indicate compliance with certain contractual or regulatory requirements. The third area of lia- bility includes those instances in which someone may obtain money from the federal government to which he may not be entitled, and then uses false statements or records in order to retain the money. An example of this so-called “reverse false claim” may include a hospital that obtains interim payments from Medicare throughout the year, and then knowingly

files a false cost report at the end of the year in order to avoid making a refund to the Medicare program.

In addition to its substantive provisions, the FCA pro- vides that private parties may bring an action on behalf of the United States. These private parties, known as “ qui tam relators,” may share in a percentage of the proceeds from an FCA action or settlement.

The FCA provides, with some exceptions, that a qui tam relator, when the Government has intervened in the lawsuit, shall receive at least 15 percent but not more than 25 percent of the proceeds of the FCA action depending upon the extent to which the relator substantially contributed to the prosecu- tion of the action. When the Government does not intervene, the Act provides that the relator shall receive an amount that the court decides is reasonable and shall be not less than 25 percent and not more than 30 percent.

The FCA provides protection to qui tam relators who are discharged, demoted, suspended, threatened, harassed, or in any other manner discriminated against in the terms and conditions of their employment as a result of their further- ance of an action under the FCA. Remedies include rein- statement with comparable seniority as the qui tam relator would have had but for the discrimination, two times the amount of any back pay, interest on any back pay, and com- pensation for any special damages sustained as a result of the discrimination, including litigation costs and reasonable attorneys’ fees.

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Chapter 3 Cases

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Last year, as the first participant in the new six-month sab- batical program that Morgan Stanley has adopted, I enjoyed a rare opportunity to collect my thoughts as well as do some traveling. I spent the first three months in Nepal, walking 600 miles through 200 villages in the Himalayas and climb- ing some 120,000 vertical feet. My sole Western companion on the trip was an anthropologist who shed light on the cul- tural patterns of the villages that we passed through.

During the Nepal hike, something occurred that has had a powerful impact on my thinking about corporate ethics. Although some might argue that the experience has no rel- evance to business, it was a situation in which a basic ethi- cal dilemma suddenly intruded into the lives of a group of individuals. How the group responded holds a lesson for all organizations, no matter how defined.

The Sadhu

The Nepal experience was more rugged than I had antici- pated. Most commercial treks last two or three weeks and cover a quarter of the distance we traveled.

My friend Stephen, the anthropologist, and I were half- way through the 60-day Himalayan part of the trip when we reached the high point, an 18,000-foot pass over a crest that we’d have to traverse to reach the village of Muklinath, an ancient holy place for pilgrims.

Six years earlier, I had suffered pulmonary edema, an acute form of altitude sickness, at 16,500 feet in the vicin- ity of Everest base camp–so we were understandably con- cerned about what would happen at 18,000 feet. Moreover, the Himalayas were having their wettest spring in 20 years; hip-deep powder and ice had already driven us off one ridge. If we failed to cross the pass, I feared that the last half of our once-in-a-lifetime trip would be ruined.

The night before we would try the pass, we camped in a hut at 14,500 feet. In the photos taken at that camp, my face appears wan. The last village we’d passed through was a sturdy two-day walk below us, and I was tired.

During the late afternoon, four backpackers from New Zealand joined us, and we spent most of the night awake, anticipating the climb. Below, we could see the fires of two other parties, which turned out to be two Swiss couples and a Japanese hiking club.

To get over the steep part of the climb before the sun melted the steps cut in the ice, we departed at 3.30 a.m. The New Zealanders left first, followed by Stephen and myself, our porters and Sherpas, and then the Swiss. The Japanese lin- gered in their camp. The sky was clear, and we were confident that no spring storm would erupt that day to close the pass.

Case 3-1

The Parable of the Sadhu Bowen H. McCoy Reprinted with permission from “The Parable of the Sadhu,” by Bowen H. McCoy, Harvard Business Review. Copyright © Harvard Business Publishing.

At 15,500 feet, it looked to me as if Stephen was shuf- fling and staggering a bit, which are symptoms of altitude sickness. (The initial stage of altitude sickness brings a headache and nausea. As the condition worsens, a climber may encounter difficult breathing, disorientation, aphasia, and paralysis.) I felt strong—my adrenaline was flowing— but I was very concerned about my ultimate ability to get across. A couple of our porters were also suffering from the height, and Pasang, our Sherpa sirdar (leader), was worried.

Just after daybreak, while we rested at 15,500 feet, one of the New Zealanders, who had gone ahead, came stagger- ing down toward us with a body slung across his shoulders. He dumped the almost naked, barefoot body of an Indian holy man—a sadhu—–at my feet. He had found the pilgrim lying on the ice, shivering and suffering from hypothermia. I cradled the sadhu’s head and laid him out on the rocks. The New Zealander was angry. He wanted to get across the pass before the bright sun melted the snow. He said, “Look, I’ve done what I can. You have porters and Sherpa guides. You care for him. We’re going on!” He turned and went back up the mountain to join his friends.

I took a carotid pulse and found that the sadhu was still alive. We figured he had probably visited the holy shrines at Muklinath and was on his way home. It was fruitless to ques- tion why he had chosen this desperately high route instead of the safe, heavily traveled caravan route through the Kali Gandaki gorge. Or why he was shoeless and almost naked, or how long he had been lying in the pass. The answers weren’t going to solve our problem.

Stephen and the four Swiss began stripping off their outer clothing and opening their packs. The sadhu was soon clothed from head to foot. He was not able to walk, but he was very much alive. I looked down the mountain and spot- ted the Japanese climbers, marching up with a horse.

Without a great deal of thought, I told Stephen and Pasang that I was concerned about withstanding the heights to come and wanted to get over the pass. I took off after several of our porters who had gone ahead.

On the steep part of the ascent where, if the ice steps had given way, I would have slid down about 3,000 feet, I felt ver- tigo. I stopped for a breather, allowing the Swiss to catch up with me. I inquired about the sadhu and Stephen. They said that the sadhu was fine and that Stephen was just behind them. I set off again for the summit.

Stephen arrived at the summit an hour after I did. Still exhil- arated by victory, I ran down the slope to congratulate him. He was suffering from altitude sickness—walking 15 steps, then stopping, walking 15 steps, then stopping. Pasang

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Chapter 3 Creating an Ethical Organization Environment and Effective Corporate Governance Systems 151

accompanied him all the way up. When I reached them, Stephen glared at me and said: “How do you feel about con- tributing to the death of a fellow man?”

I did not completely comprehend what he meant. “Is the sadhu dead?” I inquired.

“No,” replied Stephen, “but he surely will be!” After I had gone, followed not long after by the Swiss,

Stephen had remained with the sadhu. When the Japanese had arrived, Stephen had asked to use their horse to transport the sadhu down to the hut. They had refused. He had then asked Pasang to have a group of our porters carry the sadhu. Pasang had resisted the idea, saying that the porters would have to exert all their energy to get themselves over the pass. He believed they could not carry a man down 1,000 feet to the hut, reclimb the slope, and get across safely before the snow melted. Pasang had pressed Stephen not to delay any longer.

The Sherpas had carried the sadhu down to a rock in the sun at about 15,000 feet and pointed out the hut another 500 feet below. The Japanese had given him food and drink. When they had last seen him, he was listlessly throwing rocks at the Japanese party’s dog, which had frightened him.

We do not know if the sadhu lived or died. For many of the following days and evenings, Stephen

and I discussed and debated our behavior toward the sadhu. Stephen is a committed Quaker with deep moral vision. He said, “I feel that what happened with the sadhu is a good example of the breakdown between the individual ethic and the corporate ethic. No one person was willing to assume ultimate responsibility for the sadhu. Each was willing to do his bit just so long as it was not too inconvenient. When it got to be a bother, everyone just passed the buck to someone else and took off. Jesus was relevant to a more individual- istic stage of society, but how do we interpret his teaching today in a world filled with large, impersonal organizations and groups?”

I defended the larger group, saying, “Look, we all cared. We all gave aid and comfort. Everyone did his bit. The New Zealander carried him down below the snow line. I took his pulse and suggested we treat him for hypothermia. You and the Swiss gave him clothing and got him warmed up. The Japanese gave him food and water. The Sherpas carried him down to the sun and pointed out the easy trail toward the hut. He was well enough to throw rocks at a dog. What more could we do?”

“You have just described the typical affluent Westerner’s response to a problem. Throwing money—in this case, food and sweaters—at it, but not solving the fundamentals!” Stephen retorted.

“What would satisfy you?” I said. “Here we are, a group of New Zealanders, Swiss, Americans, and Japanese who have never met before and who are at the apex of one of the most powerful experiences of our lives. Some years the pass is so bad no one gets over it. What right does an almost naked pilgrim who chooses the wrong trail have to disrupt our lives? Even the Sherpas had no interest in risking the trip to help him beyond a certain point.”

Stephen calmly rebutted, “I wonder what the Sherpas would have done if the sadhu had been a well-dressed Nepali, or what the Japanese would have done if the sadhu had been a well-dressed Asian, or what you would have done, Buzz, if the sadhu had been a well-dressed Western woman?”

“Where, in your opinion,” I asked, “is the limit of our responsibility in a situation like this? We had our own well- being to worry about. Our Sherpa guides were unwilling to jeopardize us or the porters for the sadhu. No one else on the mountain was willing to commit himself beyond certain self- imposed limits.”

Stephen said, “As individual Christians or people with a Western ethical tradition, we can fulfill our obligations in such a situation only if one, the sadhu dies in our care; two, the sadhu demonstrates to us that he can undertake the two- day walk down to the village; or three, we carry the sadhu for two days down to the village and persuade someone there to care for him.”

“Leaving the sadhu in the sun with food and clothing— where he demonstrated hand-eye coordination by throwing a rock at a dog—comes close to fulfilling items one and two,” I answered. “And it wouldn’t have made sense to take him to the village where the people appeared to be far less caring than the Sherpas, so the third condition is impractical. Are you really saying that, no matter what the implications, we should, at the drop of a hat, have changed our entire plan?”

The Individual versus the Group Ethic

Despite my arguments, I felt and continue to feel guilt about the sadhu. I had literally walked through a classic moral dilemma without fully thinking through the consequences. My excuses for my actions include a high adrenaline flow, a superordinate goal, and a once-in-a-lifetime opportunity— common factors in corporate situations, especially stressful ones.

Real moral dilemmas are ambiguous, and many of us hike right through them, unaware that they exist. When, usually after the fact, someone makes an issue of one, we tend to resent his or her bringing it up. Often, when the full import of what we have done (or not done) hits us, we dig into a defen- sive position from which it is very difficult to emerge. In rare circumstances, we may contemplate what we have done from inside a prison.

Had we mountaineers been free of stress caused by the effort and the high altitude, we might have treated the sadhu differently. Yet isn’t stress the real test of personal and cor- porate values? The instant decisions that executives make under pressure reveal the most about personal and corporate character.

Among the many questions that occur to me when I pon- der my experience with the sadhu are: What are the practical limits of moral imagination and vision? Is there a collective or institutional ethic that differs from the ethics of the indi- vidual? At what level of effort or commitment can one dis- charge one’s ethical responsibilities?

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152 Chapter 3 Creating an Ethical Organization Environment and Effective Corporate Governance Systems

Not every ethical dilemma has a right solution. Reasonable people often disagree; otherwise there would be no dilemma. In a business context, however, it is essential that managers agree on a process for dealing with dilemmas.

Our experience with the sadhu offers an interesting parallel to business situations. An immediate response was mandatory. Failure to act was a decision in itself. Up on the mountain, we could not resign and submit our résumés to a headhunter. In contrast to philosophy, business involves action and imple- mentation—getting things done. Managers must come up with answers based on what they see and what they allow to influence their decision-making processes. On the mountain, none of us but Stephen realized the true dimensions of the situation we were facing.

One of our problems was that as a group, we had no pro- cess for developing a consensus. We had no sense of purpose or plan. The difficulties of dealing with the sadhu were so complex that no one person could handle them. Because the group did not have a set of preconditions that could guide its action to an acceptable resolution, we reacted instinctively as individuals. The cross-cultural nature of the group added a further layer of complexity. We had no leader with whom we could all identify and in whose purpose we believed. Only Stephen was willing to take charge, but he could not gain adequate support from the group to care for the sadhu.

Some organizations do have values that transcend the per- sonal values of their managers. Such values, which go beyond profitability, are usually revealed when the organization is under stress. People throughout the organization generally accept its values, which, because they are not presented as a rigid list of commandments, may be somewhat ambiguous. The stories people tell, rather than printed materials, transmit the organization’s conceptions of what is proper behavior.

For 20 years, I have been exposed at senior levels to a variety of corporations and organizations. It is amazing how quickly an outsider can sense the tone and style of an orga- nization and, with that, the degree of tolerated openness and freedom to challenge management.

Organizations that do not have a heritage of mutually accepted, shared values tend to become unhinged during stress, with each individual bailing out for himself or herself. In the great takeover battles we have witnessed during past years, companies that had strong cultures drew the wagons around them and fought it out, while other companies saw executives—supported by golden parachutes—bail out of the struggles.

Because corporations and their members are interdepen- dent, for the corporation to be strong, the members need to share a preconceived notion of correct behavior, a “business ethic,” and think of it as a positive force, not a constraint.

As an investment banker, I am continually warned by well-meaning lawyers, clients, and associates to be wary of conflicts of interest. Yet if I were to run away from every dif- ficult situation, I wouldn’t be an effective investment banker. I have to feel my way through conflicts. An effective man- ager can’t run from risk either; he or she has to confront

risk. To feel “safe” in doing that, managers need the guide- lines of an agreed-upon process and set of values within the organization.

After my three months in Nepal, I spent three months as an executive-in-residence at both the Stanford Business School and the University of California at Berkeley’s Center for Ethics and Social Policy of the Graduate Theological Union. Those six months away from my job gave me time to assimilate 20 years of business experience. My thoughts turned often to the meaning of the leadership role in any large organization. Students at the seminary thought of themselves as antibusiness. But when I questioned them, they agreed that they distrusted all large organizations, including the church. They perceived all large organizations as impersonal and opposed to individual values and needs. Yet we all know of organizations in which people’s values and beliefs are respected and their expressions encouraged. What makes the difference? Can we identify the difference and, as a result, manage more effectively?

The word ethics turns off many and confuses more. Yet the notions of shared values and an agreed-upon process for dealing with adversity and change—what many people mean when they talk about corporate culture—seem to be at the heart of the ethical issue. People who are in touch with their own core beliefs and the beliefs of others and who are sus- tained by them can be more comfortable living on the cutting edge. At times, taking a tough line or a decisive stand in a muddle of ambiguity is the only ethical thing to do. If a man- ager is indecisive about a problem and spends time trying to figure out the “good” thing to do, the enterprise may be lost.

Business ethics, then, has to do with the authenticity and integrity of the enterprise. To be ethical is to follow the business as well as the cultural goals of the corporation, its owners, its employees, and its customers. Those who cannot serve the corporate vision are not authentic businesspeople and, therefore, are not ethical in the business sense.

At this stage of my own business experience, I have a strong interest in organizational behavior. Sociologists are keenly studying what they call corporate stories, legends, and heroes as a way organizations have of transmitting value sys- tems. Corporations such as Arco have even hired consultants to perform an audit of their corporate culture. In a company, a leader is a person who understands, interprets, and manages the corporate value system. Effective managers, therefore, are action-oriented people who resolve conflict, are tolerant of ambiguity, stress, and change, and have a strong sense of purpose for themselves and their organizations.

If all this is true, I wonder about the role of the profes- sional manager who moves from company to company. How can he or she quickly absorb the values and culture of differ- ent organizations? Or is there, indeed, an art of management that is totally transportable? Assuming that such fungible managers do exist, is it proper for them to manipulate the values of others?

What would have happened had Stephen and I carried the sadhu for two days back to the village and become involved

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Chapter 3 Creating an Ethical Organization Environment and Effective Corporate Governance Systems 153

with the villagers in his care? In four trips to Nepal, my most interesting experience occurred in 1975, when I lived in a Sherpa home in the Khumbu for five days while recover- ing from altitude sickness. The high point of Stephen’s trip was an invitation to participate in a family funeral ceremony in Manang. Neither experience had to do with climbing the high passes of the Himalayas. Why were we so reluctant to try the lower path, the ambiguous trail? Perhaps because we did not have a leader who could reveal the greater purpose of the trip to us.

Why didn’t Stephen, with his moral vision, opt to take the sadhu under his personal care? The answer is partly because Stephen was hard-stressed physically himself and partly because, without some support system that encompassed our involuntary and episodic community on the mountain, it was beyond his individual capacity to do so.

I see the current interest in corporate culture and corpo- rate value systems as a positive response to pessimism such as Stephen’s about the decline of the role of the individual in large organizations. Individuals who operate from a thought- ful set of personal values provide the foundation for a corpo- rate culture. A corporate tradition that encourages freedom of inquiry, supports personal values, and reinforces a focused sense of direction can fulfill the need to combine individu- ality with the prosperity and success of the group. Without such corporate support, the individual is lost.

That is the lesson of the sadhu. In a complex corporate situation, the individual requires and deserves the support of the group. When people cannot find such support in their organizations, they don’t know how to act. If such support is forthcoming, a person has a stake in the success of the group and can add much to the process of establishing and main- taining a corporate culture. Management’s challenge is to be sensitive to individual needs, to shape them, and to direct and focus them for the benefit of the group as a whole.

For each of us, the sadhu lives. Should we stop what we are doing and comfort him; or should we keep trudging up toward the high pass? Should I pause to help the derelict

I pass on the street each night as I walk by the Yale Club en route to Grand Central Station? Am I his brother? What is the nature of our responsibility if we consider ourselves to be ethical persons? Perhaps it is to change the values of the group so that it can, with all its resources, take the other road.

Questions 1. According to the Ethical Dissonance Model, the ethical

person-organization fit helps to define the ethical culture of an organization and one’s role in it. The ethics of an individual influences the values one brings to the work- place and decision making, while the ethics (through culture) of the organization influences that behavior. Throughout The Parable of the Sadhu, Bowen McCoy refers to the breakdown between the individual and cor- porate ethic. Explain what he meant by that and how, if we view the hikers on the trek up the mountain in Nepal as an organization, the ethical person-organization fit applied to the decisions made on the climb.

2. Evaluate the actions of McCoy and Stephen from the per- spective of Kohlberg’s model of moral development. At what stage did each reason throughout the trek? Do you think there was a bystander effect in how McCoy and the others acted?

3. What role did ethical fading have on the decision making of Bowen and other members of the group? How is utili- tarian thinking involved in ethical fading?

4. McCoy concludes that the lesson of the sadhu is that “in a complex corporate situation, the individual requires and deserves the support of the group. When people cannot find such support in their organizations, they don’t know how to act.” What support in organizations do you think McCoy is referring to? If such support is not found, what should individuals do when they have an ethical dilemma such as that in the sadhu case?

5. What is the moral of the story of the sadhu from your perspective?

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154 Chapter 3 Creating an Ethical Organization Environment and Effective Corporate Governance Systems

Amgen, a Thousand Oaks, California–based company, has been dealing with lawsuits and whistleblower claims for years over its marketing tactics. The following describes the law- suits, language from the legal filings against Amgen, and a statement made by the company on October 24, 2012, about its settlements in its earnings announcement for the third quar- ter of 2012.

Whistleblower Shawn O’Brien In 2009, the company was embroiled in lawsuits filed by 15  states alleging a Medicaid kickback scheme. 106 Two additional whistleblowing lawsuits were filed against the company in Ventura County. The whistleblowing com- plaints, which don’t appear related to the fraud alleged by the group of states, were brought by former employees who said they had uncovered wrongdoing at the biotech giant and were terminated after they raised red flags to superiors. One employee alleged that the company violated federal law by underreporting complaints and problems with the company’s drugs after they hit the market.

Former Amgen employee Shawn O’Brien sued Amgen for wrongful termination on October 9, 2009, alleging that he was laid off in October 2007 in retaliation for raising concerns about how the company reported complaints and problems with drugs already on the market. O’Brien worked as a senior project manager for Amgen’s “Ongoing Change Program,” according to the lawsuit filed in Ventura County Superior Court. His job was to improve Amgen’s “com- pliance processes with high inherent risk to public safety, major criminal and civil liability, or both,” according to the lawsuit.

The lawsuit alleged that in April 2007, Amgen’s board of directors flagged the company’s process for dealing with postmarket complaints about drugs as a potential problem. Federal law requires drug companies to track and report to the FDA any problems with their drugs after they hit the market. In June 2007, O’Brien was put on the case. He soon uncovered facts that Amgen was not adequately and consistently identifying phone calls or mail related to post- market product complaints. That year, O’Brien warned the company about the seriousness of the issues but, he claims, the company would not take any action or offer any sup- port. In August 2007, O’Brien took his complaint to a senior executive/corporate officer (unnamed) and warned that Amgen’s process for dealing with postmarket problems wasn’t adequate.

In early September 2007, O’Brien’s managers instructed him to stop all work and not discuss the issues any further with anyone. Approximately four weeks later, he was informed that he was being terminated as part of Amgen’s October 12, 2007, reduction in the workforce.

Whistleblower Kassie Westmoreland On October 22, 2012, Amgen announced it had set aside $780 million to settle various federal and state investigations and whistleblower lawsuits accusing it of illegal sales and marketing tactics. Amgen said it had reached an agreement in principle to settle criminal and civil investigations that had been under way for several years by the U.S. Attorney’s offices in Brooklyn and Seattle. On December 18, 2012, the company pleaded guilty to a federal misdemeanor of mis- branding its anemia drug Aranesp and has agreed to pay $762 million in fines and penalties. The information below describes the proceedings leading up to the legal action.

The federal investigations, according to Amgen, involved the marketing, pricing, and dosing of its anemia drugs, Aranesp and Epogen, and its dissemination of information about clinical trials on the safety and efficacy of those drugs. Numerous current and former executives had received civil and grand jury subpoenas.

One whistleblower lawsuit 107 that was unsealed accused the company of overfilling vials of Aranesp, essentially pro- viding doctors with free amounts of the drug to give patients and then charge to Medicare, Medicaid, or private insurers. The lawsuit, filed by Kassie Westmoreland, a former Amgen sales representative and Aranesp product manager fired from Amgen, said that Amgen tried to persuade doctors to use Aranesp rather than Procrit, a rival drug sold by Johnson & Johnson, by pointing to the extra profits the doctors could make by using the overfill and billing for it. The federal gov- ernment declined to join the lawsuit, but more than a dozen states did, including New York and California. Westmoreland is entitled to part of any settlement under whistleblower statutes. The court has not released the amount of the whis- tleblower award.

Legal Filings The filing in the Kassie Moreland case included the follow- ing statement by the court in response to how Amgen dealt with warnings of the FDA about the safety of its products:

In addition to causing damage to programs such as Medicare, Defendants’ actions have also put patient safety and health at risk. The population of patients for whom Aranesp is indicated is especially vulnerable. Though Amgen was aware of issues earlier, beginning on or about March 9, 2007, the FDA issued a series of black box warnings for Aranesp when used in kidney and cancer patients, the most serious warning available on a drug’s label. The black box warned of increased risk of death, of serious cardiovascular or thromboembolic events, and more rapid tumor progressions. The new warnings cautioned physicians to administer the lowest dose possible in order to bring red blood cell counts

Case 3-2

Amgen Whistleblowing Case

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Chapter 3 Creating an Ethical Organization Environment and Effective Corporate Governance Systems 155

to the lowest level necessary to avoid blood transfusions. The FDA imposed a “Risk Evaluation and Mitigation Strategy” on Amgen for Aranesp in February 2010. This action resulted from concerns that, rather than helping patients, Aranesp can increase the risk of tumor growth and shorten survival in patients with cancer, and increase the risk of heart attack, heart failure, stroke, and blood clots in other patients.

One of Amgen’s responses to the black box warnings appears to have been to treat them as humorous. A script for a July 2007 meeting of Amgen’s Nephrology Business Unit from the files of Amgen Vice President of Sales Leslie Mirani included a joke about “black box warnings,” follow- ing up on the FDA’s February 2007 warning about potential harm from Aranesp.

Questions 1. The following is from Amgen’s values statement:

Our Values form a deeply held belief system that guides our behavior, helps us make the right decisions and builds the framework for our daily interactions with each other. We value people, integrity, and results. This combi- nation is essential in accomplishing our primary purpose of using science to dramatically improve people’s lives. ( ).

What is the role of a “values statement” in creating an ethical organization environment? Comment on the lawsuits described above and whistleblowing with respect to Amgen’s values statement. What message do you get

about what drives Amgen’s operations when compared to a company like Alcoa and its values statement discussed in this chapter?

2. Evaluate the actions of Amgen and the two whistle- blowers from an ethical perspective including motivation for action and ethical reasoning.

3. The following statement appears in Amgen’s code of ethics with respect to “making ethical decisions” ( 2%20Members/Companies/Code-Amgen/Amgen-EN- Code.pdf ):

No code of conduct can cover every situation. When you face ethical issues which are difficult to resolve, ask yourself these questions to help you: Is it legal and ethi- cal?; Is it consistent with Amgen’s Code of Conduct and company policies?; Is it consistent with the Amgen Val- ues?; Would I be comfortable explaining it to my fam- ily and friends, and if it appeared on television or in a newspaper?” The Code goes on to say if unsure about what to do, seek additional guidance about the ethics and legality of a matter before proceeding and “Do the Right Thing.”

What are the similarities between steps 8 and 10 of the Comprehensive Ethical Decision-Making Model dis- cussed in chapter 2 and these statements in the Amgen Code? How does organizational dissonance relate to the actions taken by management of Amgen in light of these statements?

1 .

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156 Chapter 3 Creating an Ethical Organization Environment and Effective Corporate Governance Systems

United Thermostatic Controls is a publicly owned company that engages in the manufacturing and marketing of residen- tial and commercial thermostats. The thermostats are used to regulate temperature in furnaces and refrigerators. United sells its product primarily to retailers in the domestic market,

with the company headquartered in San Jose, California. Its operations are decentralized according to geographic region. As a publicly owned company, United’s common stock is listed and traded on the NYSE. The organization chart for United is presented in Figure 1 .

Case 3-3

United Thermostatic Controls

Figure 1 United Thermostatic Controls Organization Chart

Audit Committee

CEO and President*

*Member of the board of directors.

VP of Operations

Corporate Counsel

Director of Human Resources

Controller Treasurer Internal Auditing

Tony Cupertino, Director

U.S.A. Sales Division

Western Sales Division

Southern Sales Division

Frank Campbell, Director

Eastern Sales Division

Board of Directors

Executive VP of Sales & Marketing

Sam Lorenzo

Chief Financial Officer*

Walter Hayward


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Chapter 3 Creating an Ethical Organization Environment and Effective Corporate Governance Systems 157

Frank Campbell is the director of the Southern sales divi- sion. Worsening regional economic conditions and a reduced rate of demand for United’s products have created pressures to achieve sales revenue targets set by United management none- theless. Also, significant pressures exist within the organization for sales divisions to maximize their revenues and earnings for 2013 in anticipation of a public offering of stock early in 2014. Budgeted and actual sales revenue amounts, by division, for the first three quarters in 2013 are presented in Exhibit 1.

Campbell knows that actual sales lagged even further behind budgeted sales during the first two months of the fourth quarter. He also knows that each of the other three sales divisions exceeded their budgeted sales amounts dur- ing the first three quarters in 2013. He is very concerned that the Southern division has been unable to meet or exceed budgeted sales amounts. He is particularly worried about the effect this might have on his and the division managers’ bonuses and share of corporate profits.

In an attempt to improve the sales revenue of the Southern division for the fourth quarter and for the year ended December 31, 2013, Campbell reviewed purchase orders received during the latter half of November and early December to determine whether shipments could be made to customers prior to December 31. Campbell knows that sometimes orders that are received before the end of the year can be filled by December 31, thereby enabling the division to record the sales revenue during the current fiscal year. It could simply be a matter of accelerating production and ship- ping to increase sales revenue for the year.

Reported sales revenue of the Southern division for the fourth quarter of 2013 was $792,000. This represented an 18.6 percent increase over the actual sales revenue for the third quarter of the year. As a result of this increase, reported sales revenue for the fourth quarter exceeded the budgeted amount by $80,000, or 11.2 percent. Actual sales revenue for the year exceeded the budgeted amount for the Southern division by $14,000, or 0.5 percent. Budgeted and actual sales revenue amounts, by division, for the year ended December 31, 2013, are presented in Exhibit 2.

During the course of their test of controls, the internal audit staff questioned the appropriateness of recording rev- enue of $150,000 on two shipments made by the Southern division in the fourth quarter of the year. These shipments are described as follows:

1. United shipped thermostats to Allen Corporation on December 31, 2013, and billed Allen $85,000, even though Allen had specified a delivery date of no earlier than February 1, 2014, to take control of the product. Allen intended to use the thermostats in the heating system of a new building that would not be ready for occupancy until March 1, 2014.

2. United shipped thermostats to Bilco Corporation on December 30, 2013, in partial (one-half) fulfillment of an order. United recorded $65,000 revenue on that date. Bilco had previously specified that partial shipments would not be accepted. Delivery of the full shipment had been scheduled for February 1, 2014.

Exhibit 1 United Thermostatic Controls

Budgeted and Actual Sales Revenue First Three Quarters in 2013

U.S.A. Sales Division Western Sales Division

Quarter Ended Budget Actual % Var. Budget Actual % Var.

March 31 $ 632,000 $ 638,000 .009% $ 886,000 $ 898,000 .014% June 30 640,000 642,000 .003 908,000 918,000 .011 September 30 648,000 656,000 .012 930,000 936,000 .006

Through September 30 $1,920,000 $1,936,000 .008% $2,724,000 $2,752,000 .010%

Eastern Sales Division Southern Sales Division

Quarter Ended Budget Actual % Var. Budget Actual % Var.

March 31 $ 743,000 $ 750,000 .009% $ 688,000 $ 680,000 (.012)% June 30 752,000 760,000 .011 696,000 674,000 (.032) September 30 761,000 769,000 .011 704,000 668,000 (.051)

Through September 30 $2,256,000 $2,279,000 .010% $2,088,000 $2,022,000 (.032)%

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158 Chapter 3 Creating an Ethical Organization Environment and Effective Corporate Governance Systems

During their investigation, the internal auditors learned that Campbell had pressured United’s accounting department to record these two shipments early to enable the Southern division to achieve its goals with respect to the company’s revenue targets. The auditors were concerned about the appro- priateness of recording the $150,000 revenue in 2013 in the absence of an expressed or implied agreement with the cus- tomers to accept and pay for the prematurely shipped mer- chandise. The auditors noted that, had the revenue from these two shipments not been recorded, the Southern division’s actual sales for the fourth quarter would have been below the budgeted amount by $70,000, or 9.8 percent. Actual sales revenue for the year ended December 31, 2013, would have been below the budgeted amount by $136,000, or 4.9 percent. The revenue effect of the two shipments in question created a 5.4 percent shift in the variance between actual and budgeted sales for the year. The auditors felt that this effect was signifi- cant with respect to the division’s revenue and earnings for the fourth quarter and for the year ended December 31, 2013. The auditors decided to take their concerns to Tony Cupertino, director of the internal auditing department. Cupertino is a licensed CPA and holds the CIA designation.

Cupertino discussed the situation with Campbell. Campbell informed Cupertino that he had received assurances

from Sam Lorenzo, executive vice president of sales and mar- keting, that top management would support the recording of the $150,000 revenue because of its strong desire to meet or exceed budgeted revenue and earnings amounts. Moreover, top management is very sensitive to the need to meet finan- cial analysts’ consensus earnings estimates. According to Campbell, the company is concerned that earnings must be high enough to meet analysts’ expectations because any other effect might cause the stock price to go down. In fact, Lorenzo has already told Campbell that he did not see anything wrong with recording the revenue in 2013 because the merchandise had been shipped to the customers before the end of the year and the terms of shipment were FOB shipping point.

At this point, Cupertino is uncertain whether he should take his concerns to Walter Hayward, the CFO, who is also a mem- ber of the board of directors, or take them directly to the audit committee. Cupertino knows that the majority of the members of the board, including those on the audit committee, have ties to the company and members of top management. Cupertino is not even certain that he should pursue the matter any further because of the financial performance pressures that exist within the organization. However, he is very concerned about his responsibilities and obligations to coordinate the work of the internal auditing department with that of the external auditors.

Exhibit 2 United Thermostatic Controls

Budgeted and Actual Sales Revenue for the Year Ended December 31, 2013

U.S.A. Sales Division Western Sales Division

Quarter Ended Budget Actual % Var. Budget Actual % Var.

March 31 $ 632,000 $ 638,000 .009% $ 886,000 $ 898,000 .014% June 30 640,000 642,000 .003 908,000 918,000 .011 September 30 648,000 656,000 .012 930,000 936,000 .006 December 31 656,000 662,000 .009 952,000 958,000 .006

2013 Totals $2,576,000 $2,598,000 .009% $3,676,000 $3,710,000 .009 %

Eastern Sales Division Southern Sales Division

Quarter Ended Budget Actual % Var. Budget Actual % Var.

March 31 $ 743,000 $ 750,000 .009% $ 688,000 $ 680,000 (.012)% June 30 752,000 760,000 .011 696,000 674,000 (.032) September 30 761,000 769,000 .011 704,000 668,000 (.051) December 31 770,000 778,000 .010 712,000 792,000 .112

2013 Totals $3,026,000 $3,057,000 .010% $2,800,000 $2,814,000 .005%

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Chapter 3 Creating an Ethical Organization Environment and Effective Corporate Governance Systems 159

Questions 1. Identify the stakeholders in this case. Identify their inter-

ests and United’s obligations to satisfy those interests from an ethical perspective.

2. Describe the ethical responsibilities of Tony Cupertino as a CPA and CIA. How do these responsibilities effect whom Cupertino should approach in United based on the organization chart?

3. Assume that Tony Cupertino decides to delay contact- ing Walter Hayward. Instead, he contacts the CFO of Bilco Corporation and offers a 20 percent discount on

the total $130,000 cost of merchandise if Bilco agrees to approve the partial shipment on December 30, 2013. Cupertino adds that the $26,000 would be deducted from the remaining $65,000 to be shipped during January 2014. Evaluate Cupertino’s actions with respect to the following: a. Is the offer ethical or unethical? Why? b. Has Cupertino violated any of his reporting responsi-

bilities in directly contacting the CFO of Bilco?

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160 Chapter 3 Creating an Ethical Organization Environment and Effective Corporate Governance Systems

Legal Settlement

On December 8, 2006, California’s attorney general announced a settlement with Hewlett-Packard (HP) over its corporate spy- ing scandal. The civil settlement involved a lawsuit that the state filed against the computer giant in Santa Clara County Superior Court. Under the agreement, HP paid $13.5 million to create a “privacy and piracy” fund to help state and local law enforcement fight privacy and intellectual property viola- tions. The company also paid $650,000 in civil penalties and $350,000 to cover expenses of the investigation.

The scandal broke in September 2006 when HP acknowl- edged in an SEC filing that investigators probing internal HP leaks to the media had gained access to board members’ per- sonal phone records by impersonating the board members, a practice known as “pretexting.” HP’s investigators also con- ducted physical and electronic surveillance of board mem- bers and reporters, according to HP documents.

Pretexting violates a California criminal law banning the use of “false and fraudulent pretenses” to obtain confidential information from a phone company, stated Attorney General Bill Lockyer. California civil law also considers criminal acts unlawful business practices, which was the basis of the state’s civil action.

Mark V. Hurd, HP’s chair and chief executive, hailed the deal. “We are pleased to settle this matter with the attorney gen- eral and are committed to ensuring that HP regains its standing as a global leader in corporate ethics and responsibility,” he said.

The HP Investigation An article in January 2006 by CNET reporter Dawn Kawamoto discussed confidential information available only to HP’s board. The CNET article reignited the leak investi- gation. Recognizing the potential legal problems that board- level leaks could pose for HP, chairwoman Patricia Dunn immediately initiated a new investigation of the leak and expressed her urgency to HP’s general counsel, Ann Baskins. The second and far more intrusive investigation extended from January through March and included the following:

• Reviewing the company email accounts, company phone records, and computer hard drives of every member of HP’s “Executive Council”

• Hiring a private investigation firm, which in turn subcon- tracted the job of obtaining the private telephone records of select board members and nine journalists, including Kawamoto

• Surreptitiously following Kawamoto and suspected board members in public (and apparently searching through their trash)

• Setting up a “sting” in which investigators sent Kawamoto an email containing fake tips about HP and an attachment whose tracking software would trace the email’s path after it reached Kawamoto’s computer

Insider Trading HP investors sued some of the computer maker’s directors, claiming they sold $38 million in company stock shortly before publicly acknowledging an internal probe into board- room leaks. The directors, including CEO Mark Hurd, exer- cised options and sold shares during a 2 ½-week period beginning August 21, 2006. HP began its internal investiga- tion after boardroom discussions about ex-CEO Carly Fiorina were quoted in news stories.

The flap over the probe cost chairwoman Dunn and two HP executives their jobs and sparked investigations by U.S. regulators. The company said on November 16 that the SEC stepped up its examination of the company’s tactics and the Federal Communications Commission (FCC) had requested documents related to the leak probe.

California prosecutors had charged Dunn, HP’s former CEO, with conspiracy and fraud for directing the boardroom spying. They also charged Kevin Hunsaker, an in-house law- yer and former director of ethics, as well as three private investigators who participated in the probe.

Board members, worried about negative publicity over the leak probe, took steps to protect the company’s stock by approv- ing a $6 billion share buyback program less than a month before the spying became public. That brought the amount of shares that HP was authorized to buy back to $11.7 billion, according to the complaint. The investors alleged that the share buybacks were prompted by defendants’ illegal misconduct.

Ethics Compliance Officer Having a chief ethics officer didn’t help HP. Chairwoman Dunn lost her job after hiring private investigators to find leakers on HP’s board. The spying scandal that ensued led to Dunn’s indictment and an investigation by the House Energy and Commerce Committee. Even Hurd, who had replaced Dunn as chair, has been implicated in the scandal. And it all happened under the watch of Kevin Hunsaker, HP’s senior counsel and chief ethics officer. He resigned in September 2006.

Corporate Governance and Ethics Issues The original lawsuit claimed “breach of fiduciary responsi- bilities” by HP executives. It alleged that the executives’ spy- like tactics to uncover boardroom leaks harmed the company,

Case 3-4

Hewlett-Packard 1

1 The case is The 1199 SEIU Greater New York Pension Fund, et al. v. Patricia C. Dunn, et al., CA No. 06-071186 , Santa Clara County Superior Court (San Jose).

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Chapter 3 Creating an Ethical Organization Environment and Effective Corporate Governance Systems 161

and that they engaged in insider trading just before news of the spying incident became public. Specifically, the suit claims that they sold off $41.3 million worth of stock two weeks before the scandal broke. The lawsuit also alleged that the executives approved stock buybacks in the months pre- ceding the scandal in an effort “to keep the company’s stock price propped up while insiders were selling.”

HP also agreed to strengthen in-house monitoring to ensure that future investigations launched by HP or its con- tractors would comply with legal and ethical standards and protect privacy rights. HP further agreed to hire an indepen- dent director, expand the duties of its chief ethics officer and chief privacy officer, beef up staff ethics training, and create a compliance council to set policies for ethics programs.

In the lawsuit, Attorney General Bill Lockyer was quoted as saying:

With its governance reforms, this settlement should help guide companies across the country as they seek to protect confidential business information without violating corporate ethics or privacy rights. The new fund will help ensure that when businesses cross the legal line they will be held accountable. Fortunately, Hewlett-Packard is not Enron. I commend the firm for cooperating instead of stonewalling, for taking instead of shirking responsibility, and for working with my office to expeditiously craft a creative resolution.

The settlement’s corporate governance reforms aimed to strengthen in-house monitoring and oversight to ensure compliance with legal and ethical standards, and protec- tion of privacy rights, during any investigations launched by HP or outside firms hired by HP. “This settlement creates a template for other companies seeking to protect confidential business information without violating corporate ethics or privacy rights,” stated Lockyer.

Major Governance Reforms The major governance reforms included the following:

• A new independent director will serve as the board’s watchdog on compliance with ethical and legal require- ments. The director will have specific responsibilities in carrying out that oversight function and report violations to the board, other responsible HP officials, and the at- torney general.

• HP’s chief ethics and compliance officer (CECO) will have expanded oversight and reporting duties. The CECO will review HP’s investigation practices and make recom- mendations to the board on how to improve the practices by July 31, 2007. The CECO, who previously reported only to the general counsel, now also will report to the board’s audit committee. In addition, the CECO will have authority to retain independent legal advisors.

• HP will expand the duties and responsibilities of its chief privacy officer to include review of the firm’s investiga- tion protocols to ensure that they protect privacy and com- ply with ethical requirements.

• HP will establish a new Compliance Council, headed by the CECO and also comprised of the chief privacy officer, deputy general counsel for compliance, head of internal audit, and ethics and compliance liaisons. The council will develop and maintain policies and procedures gov- erning HP’s ethics and compliance program, and provide periodic reports to the CEO, audit committee, and board.

• HP will beef up the ethics and conflict-of-interest components of its training program. The training redesign will be directed and monitored by the CECO, Compliance Council, independent director, and chief privacy officer. HP also will create a separate code of conduct, for use by outside investigators that addresses privacy and business ethics issues.

The HP scandal ended on December 14, 2012, when Bryan Wagner, a player in the explosion of corporate drama that rocked HP, was sentenced to three months in jail. He had pleaded guilty in 2007 to charges of aggravated identity theft and faced a minimum sentence of two years in prison. Wagner was the only player in the pretexting scandal to see the inside of a prison cell. Others who were criminally sen- tenced received probation.

Questions 1. The original lawsuit filed in the HP case claimed that the

executives breached their fiduciary responsibilities. What are the fiduciary responsibilities of executives and mem- bers of the board of directors to shareholders? How were these obligations violated in the HP case?

2. Describe how ethical fading influenced the actions taken in the pretexting scandal, including those identified in the HP investigation. Are there similarities between the actions of management in the HP case and those in the Challenger Shuttle Disaster?

3. Recently, in 2011, Hewlett-Packard Vice President and Chief Ethics and Compliance Officer Jon Hoak talked about renewing HP’s commitment to a culture of integrity at a meeting with members of the Business and Organizational Ethics Partnership at the Markkula Center for Applied Ethics at Santa Clara University. In his presentation that addressed the pretexting scandal, Hoak said “The people involved were only concerned about whether pretexting was legal. Nobody asked, ‘Even if it’s legal, is it the right thing to do?’ What is the relationship between legality and what is the right thing to do in making business decisions?

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162 Chapter 3 Creating an Ethical Organization Environment and Effective Corporate Governance Systems

On October 4, 2012, the Internal Revenue Service (IRS) paid a $2 million reward to a whistleblower that exposed an alleged tax avoidance scheme by Illinois Tool Works Inc. (ITW) that cost the U.S. Treasury hundreds of millions of dollars. The scheme involved ITW enlisting a Swiss bank to fabricate unauthorized tax deductions by duplicating its own tax deductions in order for ITW, as a client and unrelated tax- payer, to claim the same deductions as an offset to ITW’s otherwise taxable income. As a result of tax audits, ITW wrote down its deferred tax asset by $383 million.

Whether motivated by a sense of justice or the pursuit of a seven-figure reward, the Wall Street insider known only as “Mr. ABC” has demonstrated the huge return on investment available to IRS whistleblowers that provide information under a program that pays out between 15 percent to 30 percent of any recovery, without any monetary cap on the amount of the reward.

It was the third time that Mr. ABC had received an IRS whistleblowing award, including $1.1 million in 2004, when he provided information about abusive tax shelters that helped Enron avoid taxes on more than $600 million of tax- able income, and $1.24 million in another case.

In testimony before the 2004 U.S. Senate Finance Committee, Mr. ABC proceeded to explain his motivation to blow the whistle by criticizing the government’s ability to identify and investigate sophisticated tax shelters. “When I looked through all the financial engineering and big words, I believed it was just a fake deduction scheme,” he testified.

The IRS refused to comment, noting confidentiality issues.

Questions 1. Should we regard Mr. ABC as a new “caped crusader” or

an opportunist? Explain the reasons for your response. 2. Is it ethical for a Wall Street insider to analyze financial

data of an unrelated company in order to identify corpo- rate wrongdoing, report it to the appropriate authorities, and then receive a whistleblowing reward?

3. Consider Mr. ABC’s motivation for blowing the whistle in the ITW case and the fact that it was the third time he had engaged in whistleblowing to the IRS. Using Kohlberg’s model of moral development, at what stage of ethical rea- soning would you say Mr. ABC was at? Why?

Case 3-5

IRS Whistleblower and Informing on Tax Cheats

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Chapter 3 Creating an Ethical Organization Environment and Effective Corporate Governance Systems 163

Bennie Gordon is a CPA and a member of the AICPA. Gordon works as an accounting manager at the division level at Jet Energy Company, a publicly owned company headquartered in South Carolina. Jet Energy is a regulated utility company by the state and provides electricity to 7 million customers in southern states. Jet Energy is allowed a rate of return on oper- ating income at a maximum rate of 12.5 percent on electricity it sells. If the company is earning more than that, regulators can cut the rate that it charges to customers.

Gordon reports to Sarah Higgins, the controller of the division. Higgins holds the Certificate in Management Accounting (CMA) and is a member of the IMA. Higgins reports to Sam Thornton, the chief financial officer, who is a CPA. In turn, Thornton reports to Vanessa Jones, the CEO of the company. Joan Franks is the chief compliance officer. The company has an audit committee of three members, all of whom sit on the board of directors.

Gordon has identified irregular accounting entries dealing with the reclassification of some accounting items to make its returns lower so state regulators would not cut rates. One example is that Jet Energy often gets rebates from insurers of its nuclear plants based on safety records. Although the cost of the premiums is expensed to the electricity business,

the rebates—approximately $26 million to $30.5 million each—were not booked back to the same accounts. On a number of occasions, they were booked below operat- ing income in a nonoperating account. The moves kept Jet Energy from exceeding its allowable returns and kept the states from reducing electricity rates.

After two years of being silent, Gordon decided it was time to address the issue.

Questions 1. What steps should Bennie Gordon take to ensure that the

accounting matter is adequately addressed by the com- pany? Why do you suggest those steps be taken? What are the ethical obligations of Bennie Gordon, Sarah Higgins, and Sam Thornton?

2. Assume that Gordon made a strong case that the account- ing did not comply with GAAP, but his superiors said that the decisions already made were final. They never offered an explanation. What would you do next if you were Gordon? Would you blow the whistle and, if so, how would you do it? Explain your answer in terms of ethical reasoning.


Case 3-6

Bennie and the Jets

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164 Chapter 3 Creating an Ethical Organization Environment and Effective Corporate Governance Systems

ExxonMobil Corporation (Exxon) is the world’s largest corporation in terms of revenue and one of the largest in market capitalization. It had sales of $486 billion in 2011, giving it the number one position on the Fortune 500 list in that category. In recent years, Exxon has expanded its opera- tions into hydraulic fracking. By pumping water, sand, and chemicals into a well at high pressure, cracks develop in the stone where gas is trapped, and the process allows it to flow out. There were more than 493,000 active natural-gas wells across 31 states in the United States in 2009, almost double the number in 1990. Around 90 percent have used fracking to get more gas flowing, according to the drilling industry. By 2015, the United States will produce more oil from uncon- ventional methods like fracking than conventional means, according to a 2012 report from the economic forecasting firm IHS Global Insight.

Nationwide, residents living near fracked gas wells have filed over 1,000 complaints regarding tainted water, severe illnesses, livestock deaths, and fish kills. Fracking is contro- versial because the chemicals, mixed with water, may find their way into aquifers that supply drinking water. Oil com- panies say that fracking is safe and poses no threat to drink- ing water. Right now, few groups are calling for an outright ban on fracking. However, shareholders want companies to issue full disclosure about individual fracking operations and the chemicals used during the process. Some companies counter that they already abide by environmental laws and regulations and that further disclosure is not necessary.

On June 24, 2010, Exxon completed a $41 billion merger with XTO Energy, in large part to buy the company’s hydraulic- fracking expertise and gain access to its 45 trillion cubic feet of gas. The terms of the merger called for Exxon to issue 0.7098 common shares for each common share of XTO. The merger augments Exxon’s total production of energy resources by increasing natural gas production to 50 percent of the total, and its reserves will go up 50 percent as well.

Breach of Fiduciary Duties The merger was not without its critics, in part because of the way the deal was structured and the role of XTO’s manage- ment and board of directors. On December 17, 2009, the Shareholders Foundation, Inc., 1 filed a lawsuit in Tarrant County (Texas) District Court on behalf of current inves- tors in XTO Energy who purchased their XTO shares before

December 14, 2009, over alleged breach of fiduciary duty by the board of directors of XTO Energy.

The plaintiff alleged breaches of fiduciary duty by the board of directors of XTO Energy arising out of the compa- ny’s attempt to sell XTO Energy to ExxonMobil. In addition, the plaintiff claims that the XTO management and directors agreed to sell the company through “an unfair process,” and that XTO Energy is worth more because of likely future global warming regulations that could curtail carbon emissions.

Previous investigations by law firms examined the follow- ing: (1) whether the XTO Energy board of directors breached their fiduciary duties to XTO shareholders by agreeing to sell XTO at an unfair price, thereby harming the company and its shareholders; (2) whether the directors of XTO may have breached their fiduciary duties by not acting in XTO share- holders’ best interests; and (3) whether the company may not have adequately shopped itself around before entering into this transaction and, pursuant to this proposed transaction, ExxonMobil may be underpaying for XTO, thereby unlaw- fully harming XTO shareholders. After the announcement, Exxon’s shares fell 4.3 percent, to $69.69, while XTO shares jumped more than 15 percent, to $47.86 on the NYSE.

Payments Made to Officers and Members of the Board of Directors of XTO An important part of the merger agreement was payments made to officers and members of the board of directors at XTO. Given the distaste for large payout packages to corporate insiders during the period of the financial crisis in 2007–2008, there was some concern whether Congress would approve the merger. The issue was the arrangements detailed in Exhibit 1. At the end of its investigation, Congress approved the merger, although it raised concerns about disclosures to shareholders.

SEC Financial Disclosures Rule In 2011, shareholders of Exxon voted not to require com- pany officials to disclose more information about fracking, although 30 percent of the shareholders voted to increase dis- closures, indicating some concern whether investors receive sufficient information for their decision-making needs.

The SEC requires that publicly traded companies release and provide for the free exchange of all material facts that are relevant to their ongoing business operations. From an ethical perspective, the general need in business transactions is for both parties to tell the whole truth about any material issue pertaining to the transaction.

The SEC requires full disclosure from public companies that wish to be publicly traded on the major U.S. exchanges. By enforcing this rule, the SEC attempts to instill confidence in investors that the financial marketplace is efficient and

Case 3-7

Exxon-XTO Merger

1 The Shareholders Foundation, Inc., is an investor advocacy group that does research related to shareholder issues and informs investors of securities class actions, settlements, judg- ments, and other legal related news to the stock/financial mar- ket. The group offers help, support, and assistance for every shareholder, and investors find answers to their questions and equitable solutions to their problems.

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Chapter 3 Creating an Ethical Organization Environment and Effective Corporate Governance Systems 165

Exhibit 1 Form 8-K Filing with the SEC on Officer/Board Member Payments

Consulting Agreements & Amendments to Share Grant Agreements In connection with the Merger and pursuant to negotiations with ExxonMobil, Messrs. Simpson, Hutton, Vennerberg, Baldwin, and Petrus (each an “Officer” and collectively, the “Officers”) have agreed to waive their employment and change in control protections under their existing arrangements with the Company and enter into consulting agreements with the Company and ExxonMobil which were executed on December 13, 2009, and will become effective at the time of the Merger. Pursuant to their existing employment agreements (for Messrs. Simpson, Hutton, and Vennerberg) or the Third Amended and Restated Management Group Employee Severance Protection Plan (for Messrs. Baldwin and Petrus), upon the occurrence of a change in control transaction, which would include the Merger, each of the Officers was entitled to receive a lump sum cash payment, within 45 days after the change in control, generally equal to three times (2.5 times for Messrs. Baldwin and Petrus) the sum of his (1) annual base salary, (2) annual cash bonus, and (3) for Mr. Simpson only, annual grant of the Company’s common stock. Each Officer, other than Mr. Simpson, was also entitled to receive a gross-up payment for any excise taxes imposed under Section 280G of the Internal Revenue Code (“280G Excise Taxes”). In connection with entering into the Consulting Agreements, each Officer generally agreed to (i) waive his right to receive a portion of the Change in Control Payments; (ii) subject all or a portion of the remainder of his Change in Control Payments, as retention payments, to the continued performance of consulting services and continued compliance with agreed restrictive covenants (relating to confidentiality, noncompetition, and nonsolicitation) and (iii) relinquish his right to any Gross-Up Payment due.

The waiver of the existing arrangements and effectiveness of the new Consulting Agreements among the Officers, the Company, and ExxonMobil will be contingent on the closing of the Merger. Under the Consulting Agreements, the Officers will retire as employees of the Company upon completion of the Merger and continue to serve the Company thereafter as consultants on a full time basis. The initial term of the Consulting Agreements will end, unless earlier terminated, on the first anniversary of the Merger. The Consulting Agreements are each renewable for an additional one-year period upon the mutual agreement of the Officer and ExxonMobil, in consultation with the Company.

The Company will provide each Officer with an annual consulting fee equal to one-half of the Officer’s current base salary. Each Officer will also be entitled to receive an annual cash bonus equal to one-half of the Officer’s current base salary, generally subject to the Officer’s continued service to the payment date (for reference, the Officers’ current base salaries are: Simpson—$3,600,000; Hutton—$1,400,000; Vennerberg—$900,000; Baldwin—$500,000; Petrus—$475,000). Also under the Consulting Agreements, ExxonMobil has agreed to provide each Officer with a one-time grant of restricted ExxonMobil common stock or stock units having a grant date fair market value equal to 100% of the Officer’s current base salary. One- half of the Restricted Equity will vest on the first anniversary of the Merger and one-half will vest on either the second anniversary of the Merger, or, if the Initial Term is extended, on the third anniversary of the Merger, in either case subject to service requirements and the Officer’s continued compliance with the applicable restrictive covenants through the applicable vesting date.

In lieu of the payment Mr. Simpson otherwise would have received in connection with the Merger under his existing employment agreement, Mr. Simpson will receive a lump sum cash payment within five days after the Merger in an amount equal to $10,800,000 (which equals three times his current base salary). In addition, Mr. Simpson will be entitled to receive a retention payment, payable in equal installments at six and twelve months after the Merger, generally subject to Mr. Simpson’s continued performance of consulting services through the payment date. Mr. Simpson’s retention payment, which relates to his annual grant of the Company’s common stock, will equal up to $24,750,000.

In lieu of payments each of the Officers, other than Mr. Simpson, would have received in connection with the Merger under either an existing employment agreement or the terms of the Third Amended and Restated Management Group Employee Severance Protection Plan, each of the Officers (other than Mr. Simpson and Mr. Petrus) will be entitled to receive a retention payment, payable in equal installments at six and twelve months after the Merger, generally subject to the Officer’s continued performance of consulting services to the payment date. The payment for the Officers, which relates to the amount of the Change in Control Payments, will equal an amount up to the following: Mr. Hutton, $10,913,662; Mr. Vennerberg, $6,172,817; and Mr. Baldwin, $2,591,527. Mr. Petrus will not receive a retention payment.

Under pre-existing Amended and Restated Agreements with the Company, each of the Officers was entitled to certain additional lump sum cash payments in the event of a change in control transaction, which would include the Merger. On December 13, 2009, the Grant Agreements were amended to provide that the lump sum cash payments due thereunder in connection with the Merger will be made in the form of shares of the Company’s common stock immediately prior to completion of the Merger. The number of shares is


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166 Chapter 3 Creating an Ethical Organization Environment and Effective Corporate Governance Systems

transparent so that individual investors can take part in it for material profit. The rule is often referred to as providing “full and fair disclosure.”

Waiver of Rights Under Outside Directors Severance Plan The Outside Directors Severance Plan provides that, upon a change in control, each nonemployee director will receive a lump sum cash payment equal to three times the sum of the annual cash retainer and value of the company’s common stock most recently granted to the nonemployee director. In February 2009, each nonemployee director received a grant of 4,166 fully vested shares of the company’s common stock. The nonemployee directors received an annual cash retainer of $180,000 in respect of services performed in 2009.

On December 13, 2009, all nonemployee members of the company’s board of directors voluntarily waived their rights to receive the payments that otherwise would have become payable to them upon the completion of the merger under XTO Energy. Absent such a waiver, based on the closing price of the company’s common stock on December 1, 2009 ($42.93), each nonemployee director was entitled to receive a lump sum cash payment of approximately $1,000,000 upon completion of the merger.

Questions 1. The lawsuit filed by the Shareholders Foundation alleged

that the board of directors of XTO breached its fiduciary duties. What are the fiduciary duties of the board? Identify the duties allegedly violated in the XTO case. Do you think the board acted in accordance with a shareholder or stewardship perspective?

2. Much has been said during the recent financial crisis about top executive salaries being way too large, espe- cially in those companies receiving a government bailout. The Obama administration sought to rein them in through threats of taxation or other forms of moral suasion. Do you

believe that the government has an ethical right to inter- vene in a company’s executive compensation program? Support your answer with reference to ethical reasoning. Review Exhibit 1. Do you believe that the agreement in the Form 8-K about payments to officers and board mem- bers raises any ethical issues? What is the role of the busi- ness judgment rule in such decisions?

3. One aspect of being an ethical corporation is to oper- ate in a socially responsible way. The Corporate Social Responsibility Initiative at Harvard University 2 defines corporate social responsibility strategically: “Corporate social responsibility encompasses not only what compa- nies do with their profits, but also how they make them. It goes beyond philanthropy and compliance and addresses how companies manage their economic, social, and envi- ronmental impacts, as well as their relationships in all key spheres of influence: the workplace, the marketplace, the supply chain, the community, and the public policy realm.” The ethics of fracking is an issue raised in a num- ber of articles and in the blog of one of the authors of this book. According to Mintz, 3 “From an ethical perspec- tive, we might look at the harms and benefits of frack- ing. In other words, do the potential dangers of fracking, including contamination of water supplies, outweigh the potential benefits of producing badly needed oil and gas resources at a time when our national security may be in jeopardy because of our continued reliance on unreliable sources of energy? Is U.S. energy independence more important than the potential for harm to those affected by fracking procedures? Do jobs and economic growth trump health and safety concerns?”

4. Evaluate the ethics of fracking from a moral reasoning perspective using the methods discussed in Chapter 1. Going forward, do you believe that fracking should con- tinue without regulation? Why or why not?

Exhibit 1 (Continued) as follows: Mr. Simpson, 833,333 Shares; Mr. Hutton, 687,500 Shares; Mr. Vennerberg, 583,333 Shares; Mr. Baldwin, 166,667 Shares; and Mr. Petrus 156,250 Shares.

Each Officer has agreed pursuant to the terms of the Consulting Agreements and the Grant Agreement amendments that, instead of receiving a Gross-Up Payment for any 280G Excise Taxes that might apply to the amounts the Officer is entitled to receive in connection with the Merger, the combined amount of the Shares and the retention payment will be subject to an added reduction, if necessary, so that the total value of this combined amount, when added to the value of other equity awards granted to the Officer which are vesting in connection with the Merger and, for Mr. Simpson, his lump sum payment, does not exceed 90% of the amount that could be provided to the Officer without the imposition of 280G Excise Taxes.

Upon termination of an Officer’s services as a consultant either by the Company without “Cause” or by the Officer with “Good Reason” (each as defined in the Consulting Agreements) or upon an Officer’s death or disability, the Officer will be entitled to receive (1) a lump sum cash payment equal to the unpaid portion of the Consulting Fee, and the Completion Bonus for the current term, and the unpaid portion of the retention payment and (2) in the case of all Officers other than Mr. Simpson, accelerated vesting of any unvested equity awards which were granted prior to the Merger.

2 . 3

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Chapter 3 Creating an Ethical Organization Environment and Effective Corporate Governance Systems 167

An important issue within the scope of corporate governance is whether a company should disclose the health problems of its CEO and how much information should be disclosed. The sensitivity of this issue is exemplified at Apple Inc., where CEO Steve Jobs faced numerous questions regarding his health and the impact that his sudden departure would have on the company.

In October 2003, Jobs was diagnosed with pancreatic can- cer. No public announcement was made, although the board of directors was notified of his condition. The specific form of cancer was rare but considered treatable, with the major- ity of patients who undergo surgery experiencing a survival rate of more than 10 years. On July 31, 2004, Jobs entered Stanford Hospital for treatment.

The following day, Jobs sent an email to Apple employ- ees stating, “This weekend I underwent a successful surgery to remove a cancerous tumor from my pancreas. . . . I will be recuperating during the month of August, and expect to return to work in September. While I’m out, I’ve asked Tim Cook [executive vice president of sales and operations] to be responsible for Apple’s day-to-day operations, so we shouldn’t miss a beat.” A copy of the message was distrib- uted to the Associated Press. It was the first public disclo- sure of his condition. Given Jobs’s strategic and visionary role at Apple, it is perhaps not surprising that when trading resumed the next day, Apple stock fell 2.4 percent almost immediately.

The issue of Jobs’s health resurfaced in June 2008, when he appeared noticeably thin at a public appearance.

A company spokeswoman responded to inquiries by stat- ing that Jobs had “a common bug . . . He’s been on antibiotics and getting better day by day and didn’t want to miss [the event]. That’s all there is to it.” When analysts asked for more information during an earnings conference call, Apple CFO Peter Oppenheimer declined to elaborate: “Steve loves Apple. He serves as the CEO at the pleasure of Apple’s board and has no plans to leave Apple. Steve’s health is a private matter.”

In January 2009, Apple released another letter from Jobs in which he explained that his recent weight loss was due to a “hormone imbalance.” According to the letter, “The remedy for this nutritional problem is relatively simple and straight- forward, and I’ve already begun treatment . . . I will continue as Apple’s CEO during my recovery.” Concurrently, the board of directors issued a statement that “[Jobs] deserves our complete and unwavering support during his recupera- tion. He most certainly has that from Apple and its Board.”

However, the company announced 10 days later that Jobs would take another leave of absence. According to Jobs, “dur- ing the past week I have learned that my health-related issues

are more complex than I originally thought. In order to take myself out of the limelight and focus on my health . . . I have decided to take a medical leave of absence until the end of June.” No elaboration was offered. Cook, then chief operat- ing officer (COO), would resume leadership of the company. In the two-week period surrounding these announcements, Apple stock fell 17 percent.

Jobs returned to work as scheduled six months later. Two weeks prior to his return, however, news leaked that Jobs had received a liver transplant at a Tennessee hospital the previous April. A company spokeswoman declined to comment other than to say, “Steve continues to look forward to returning at the end of June, and there’s nothing further to say.” Doctors unaffiliated with the case explained that tumors associated with the pancreatic cancer that Jobs was originally diagnosed with often metastasize in another organ, commonly the liver. The hospital where Jobs received the transplant stated that his prognosis was “excellent.”

In January 2011, Jobs took a third leave of absence. In an email to employees, he explained that he would “continue as CEO and be involved in major strategic decisions” but that Cook would be responsible for “day-to-day operations.” Jobs said he would be back with the company as soon as he could. “In the meantime, my family and I would deeply appreciate respect for our privacy.” When asked for addi- tional comment, an Apple spokeswoman replied, “We’ve said all we’re going to say.” Jobs died on October 5 of that year, due to complications from pancreatic cancer that led to respiratory arrest.

Questions 1. Were the shareholders of Apple entitled to receive infor-

mation about the health of Jobs? What about the general public? Of what value is such information? How might the company benefit from the disclosure of such informa- tion, and how might it suffer? How might the sharehold- ers benefit, and how might they suffer?

2. From a corporate governance perspective, what issues are important in determining whether there should be dis- closure of the health problems of a CEO? Is it an ethical matter?

3. Should information about the health of other senior man- agers, such as the five most highly compensated senior managers or the vice chair of the board of directors, be disclosed? Should other information be disclosed about the CEO of a public company, such as being involved in a contentious divorce that distracts from day-to-day man- agement of the company?

Case 3-8

Disclosure of Steve Jobs’s Health as Apple CEO: A Public or Private Matter?

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168 Chapter 3 Creating an Ethical Organization Environment and Effective Corporate Governance Systems

We are citizens of the world. The tragedy of our times is that we do not know this.

Woodrow T. Wilson (1856–1924), 28th president of the United States

At five past midnight on December 3, 1984, 40 tons of the chemical methyl isocynate (MIC), a toxic gas, started to leak out of a pesticide tank at the Union Carbide plant in Bhopal, India. The leak was first detected by workers about 11:30 p.m. on December 2, 1984, when their eyes began to tear and burn. According to AcuSafe, 1 “in 1991 the official Indian gov- ernment panel charged with tabulating deaths and injuries counted more than 3,800 dead and approximately 11,000 with disabilities.” However, estimates now range as high as 8,000 killed in the first three days and over 120,000 injured. 2 There were 4,000 deaths officially recorded by the government, although 13,000 death claims were filed with the government, according to a United Nations report, and hundreds of thou- sands more claim injury as a result of the disaster. 3 On June 7, 2010, an Indian court convicted eight former senior employ- ees of Union Carbide’s Indian subsidiary to two years in jail each for causing “death by negligence” over their part in the Bhopal gas tragedy in which an estimated 15,000 people died more than 25 years ago. While the actual numbers may be debatable, there can be no doubt that the Bhopal incident raises a variety of interesting ethical questions, including:

• Did the company knowingly sacrifice safety at the Bhopal plant?

• Did the Indian government properly oversee the function- ing of the plant consistent with its regulatory authority?

• Did the company react quickly enough to avoid sustained health problems to those injured by the leak of toxic fumes?

• In the aftermath of the disaster, were the disclosures made by Union Carbide sufficiently transparent to enable a con- cerned public to understand the causes of the leak and the steps that the company was taking to address all the issues?

• Did the company and the Indian government reach a fair resolution of the thousands of claims filed by Indian citizens?

1 AcuSafe is an Internet resource for safety and risk management information that is a publication of AcuTech, a global leader in process safety and security risk management located in Houston, Texas; see incidentbhopal1984.htm . 2 According to CorpWatch, . 3 United Nations, United Nations University Report (UNU Report) on Toxic Gas Leak, uu211eOc.htm .

• Is “business risk” a valid basis on which to make business decisions?

You make up your own mind as you read about the tragedy that is Bhopal.

In the Beginning On May 4, 1980, the first factory exported from the West to make pesticides using MIC began production in Bhopal, India. The company planned to export the chemicals from the United States to make the pesticide Sevin. The new CEO of Union Carbide came over from the United States especially for the occasion. 4

As you might expect, the company seemed very con- cerned about safety issues. “Carbide’s manifesto set down certain truths, the first being that ‘all accidents are avoidable provided the measures necessary to avoid them are defined and implemented.’” The company’s slogan was “Good safety and good accident prevention practices are good business.”

Safety Measures The Union Carbide plant in Bhopal was equipped with an alarm system with a siren that was supposed to be set off when- ever the “duty supervisor in the control room” sensed even the slightest indication that a possible fire might be developing “or the smallest emission of toxic gas.” The “alarm system was intended to warn the crews working on the factory site.” Even though thousands of people lived in the nearby bustees (shan- tytowns), “none of the loudspeakers pointed outward” in their direction. Still, they could hear the sirens coming from the plant. The siren went off so frequently that it seemed as though the population became used to it and weren’t completely aware that one death and several accidental poisonings had occurred before the night of December 2, and there was a “mysterious fire in the alpha-naphtol unit.”

In May 1982, three engineers from Union Carbide came to Bhopal to evaluate the plant and confirm that everything was operating according to company standards. However, the investigators identified more than 60 violations of opera- tional and safety regulations. An Indian reporter managed to obtain a copy of the report that noted “shoddy workman- ship,” warped equipment, corroded circuitry, “the absence of automatic sprinklers in the MIC and phosgene production zones,” a lack of pressure gauges, and numerous other vio- lations. The severest criticism was in the area of personnel. There was “an alarming turnover of inadequately trained staff, unsatisfactory instruction methods, and a lack of rigor in maintenance reports.”

4 Dominique LaPierre and Javier Moro, Five Past Midnight in Bhopal (New York: Warner Books, 2002).

Case 3-9

Bhopal, India: A Tragedy of Massive Proportions

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Chapter 3 Creating an Ethical Organization Environment and Effective Corporate Governance Systems 169

The reporter wrote three articles proclaiming the unsafe plant. The third article was titled “If You Refuse to Understand, You Will Be Reduced to Dust.” Nothing seemed to matter in the end because the population was assured by Union Carbide and government representatives that no one need be concerned because the phosgene produced at the plant was not a toxic gas.

The Accident The accident occurred when a large volume of water entered the MIC storage tanks and triggered a violent chain reaction. Normally, water and MIC were kept separate, but on the night of December 2, “metal barriers known as slip blinds were not inserted and the cleaning water passed directly into the MIC tanks.” It is possible that additional water entered the tanks later on in the attempts to control the reaction. Shortly after the introduction of water, “temperatures and pressures in the tanks increased to the point of explosion.”

The report of consultants that reviewed the facts sur- rounding the accident indicates that workers made a variety of attempts to save the plant, including: 5

• They tried to turn on the plant refrigeration system to cool down the environment and slow the reaction, but the sys- tem had been drained of coolant weeks before and never refilled as a cost-saving measure.

• They tried to route expanding gases to a neighboring tank, but the tank’s pressure gauge was broken, indicating that the tank was full when it was really empty.

• They tried other measures that didn’t work due to inad- equate or broken equipment.

• They tried to spray water on the gases and have them settle to the ground, but it was too late as the chemical reaction was nearly completed.

The Workers and Their Reaction It was reported that the maintenance workers did not flush out the pipes after the factory’s production of MIC stopped on December 2. This was important because the pipes carried the liquid MIC produced by the plant’s reactors to the tanks. The highly corrosive MIC leaves chemical deposits on the lining of the tanks that can eventually get into the storage tanks and contaminate the MIC. Was it laziness, as suggested by one worker?

Another worker pointed out that the production supervi- sor of the plant left strict instructions to flush the pipes, but it was late at night and neither worker really wanted to do it. Still, they followed the instructions for the washing opera- tion, but the supervisor had omitted the crucial step to place solid metal discs at the end of each pipe to ensure hermeti- cally sealed tanks.

5 Ron Graham, “FAQ on Failures: Union Carbide Bhopal,” Barrett Engineering Consulting, failures/UCBhopal.html .

The cleansing operation began when one worker con- nected a hosepipe to a drain cock on the pipework and turned on the tap. After a short time, it was clear to the worker that the injected water was not coming out of two of the four drain cocks. The worker called the supervisor, who walked over to the plant and instructed the worker to clean the filters in the two clogged drain cocks and turn the water back on. They did that, but the water did not flow out of one drain. After inform- ing the supervisor, who said to just keep the water flowing, the worker left for the night. It would now be up to the night shift to turn off the tap.

The attitude of the workers as they started the night shift was not good as Union Carbide had started to cut back on pro- duction and lay off workers. They wondered if they might be next. The culture of safety that Union Carbide tried to build up was largely gone, as the workers typically handled toxic sub- stances without protective gear. The temperature readings in the tanks were made less frequently, and it was rare when anyone checked the welding on the pipework in the middle of the night.

Even though the pressure gauge on one of the tanks increased beyond the “permitted maximum working pres- sure,” the supervisor ignored warnings coming from the con- trol room because he was under the impression that Union Carbide had built the tanks with special steel and walls thick enough to resist even greater pressures. Still, the duty head of the control room and another worker went to look directly at the pressure gauge attached to the three tanks. They con- firmed the excessive pressure in one tank.

The duty head climbed to the top of that tank, examined the metal casing carefully, and sensed the stirring action. The pressure inside was increasing quickly, leading to a popping sound “like champagne corks.” Some of the gas then escaped, and a brownish cloud appeared. The workers returned to where the pipes had been cleaned and turned off the water tap. They smelled the powerful gas emissions, and they heard the fizzing, which sounded as if someone was blowing into an empty bottle. One worker had a cool enough head to sound the general alarm, but it was too late for most of the workers and many of those living in the shantytowns below the plant.

The Political Response Union Carbide sent a team to investigate the catastrophe, but the Indian government had seized all records and denied the investigators access to the plant and the eyewitnesses. The government of the state of Madhya Pradesh (where the plant was located) tried to place the blame squarely on the shoul- ders of Union Carbide. It sued the company for damages on behalf of the victims. The ruling Congress Party was facing national parliamentary elections three weeks after the acci- dent, and it “stood to lose heavily if its partners in the state government were seen to be implicated, or did not deal firmly with Union Carbide.” 6

6 United Nations, United Nations University Report (UNU Report) on Toxic Gas Leak.

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170 Chapter 3 Creating an Ethical Organization Environment and Effective Corporate Governance Systems

The government thwarted early efforts by Union Carbide to provide relief to the victims to block its attempt to gain the goodwill of the public. The strategy worked: the Congress Party won both the state legislative assembly and the national parliament seats from Madhya Pradesh by large margins.

Economic Effects The economic impact of a disaster like the one that happened in Bhopal is staggering. The $25 million Union Carbide plant in Bhopal was shut down immediately after the accident, and 650 permanent jobs were lost. The loss of human life means a loss of future earning power and economic production. The thousands of accident victims had to be treated and in many cases rehabilitated. The closure of the plant had peripheral effects on local businesses and the population of Bhopal. It is estimated that “two mass evacuations disrupted commercial activities for several weeks, with resulting business losses of $8 to $65 million.”

In the year after the accident, the government paid com- pensation of about $800 per fatality to relatives of the dead persons. About $100 apiece was awarded to 20,000 victims. Beginning in March 1991, new relief payments were made to all victims who lived in affected areas, and a total of $260 million was disbursed. Overall, Union Carbide agreed to pay $470 million to the residents of Bhopal. By the end of October 2003, according to the Bhopal Gas Tragedy Relief and Rehabilitation Department, compensation had been awarded to 554,895 people for injuries received and 15,310 survivors of those killed. The average amount that families of the dead received was $2,200.

Union Carbide’s Response Shortly after the gas release, Union Carbide launched what it called “an aggressive effort to identify the cause.” According to the company, the results of an independent investigation conducted by the engineering consulting firm Arthur D. Little were that “the gas leak could only have been caused by deliberate sabotage. Someone purposely put water in the gas storage tank, causing a massive chemical reaction. Process safety systems had been put in place that would have kept the water from entering the tank by accident.” 7

A 1993 report prepared by Jackson B. Browning, the retired vice president of Health, Safety, and Environmental Programs at Union Carbide Corporation, stated that he didn’t find out about the accident until 2:30 a.m. on December 3. He claims to have been told that “no plant employees had been injured, but there were fatalities—possibly eight or twelve—in the nearby community.”

A meeting was called at the company’s headquarters in Danbury, Connecticut, for 6 a.m. The chair of the board of directors of Union Carbide, Warren M. Anderson, had

7 After the leak, Union Carbide started a Web site, www.bhopal .com , to provide its side of the story and details about the tragedy. In 1998, the Indian state government of Madhya Pradesh took over the site.

received the news while returning from a business trip to Washington, DC. He had a “bad cold and a fever,” so Anderson stayed at home and designated Browning as his “media stand-in” until Anderson could return to the office. 8

At the first press conference called for 1:00 p.m. on December 3, the company acknowledged that a disaster had occurred at its plant in Bhopal. The company reported that it was sending “medical and technical experts to aid the people of Bhopal, to help dispose of the remaining [MIC] at the plant and to investigate the cause of the tragedy.” Notably, Union Carbide halted production at its only other MIC plant in West Virginia, and it stated its intention “to convert exist- ing supplies into less volatile compounds.”

Anderson traveled to India and offered aid of $1 million and the Indian subsidiary of Union Carbide pledged the Indian equivalent of $840,000. Within a few months, the com- pany offered an additional $5 million in aid that was rejected by the Indian government. The money was then turned over to the Indian Red Cross and used for relief efforts.

The company continued to offer relief aid with “no strings attached.” However, the Indian government rejected the overtures, and it didn’t help the company to go through third parties. Union Carbide believed that the volatile politi- cal situation in India—Prime Minister Indira Gandhi had just been assassinated in October—hindered its relief efforts, especially after the election of Rajiv Gandhi shortly after the assassination on a government reform platform. It appeared to the company that Union Carbide was to be made an exam- ple of as an exploiter of Indian natural resources, and it sus- pected that the Indian government may have wanted to “gain access to Union Carbide’s financial resources.”

Union Carbide had a contingency plan for emergencies, but it didn’t cover the “unthinkable.” The company felt com- pelled to show its “commitment to employee and commu- nity safety and specifically, to reaffirm the safety measures in place at their operation.” Anderson went to West Virginia to meet with the employees in early February 1985. At that meeting, as “a measure of the personal concern and compas- sion of Union Carbide employees,” the workers established a “Carbide Employees Bhopal Relief Fund and collected more than $100,000 to aid the tragedy’s victims.” 9

Analysis of Union Carbide’s Bhopal Problems Documents uncovered in litigation 10 and obtained by the Environmental Working Group of the Chemical Industry Archives, an organization that investigates chemical com- pany claims of product safety, indicate that Union Carbide “cut corners and employed untested technologies when building the Bhopal Plant.” The company went ahead with

8 Jackson B. Browning, The Browning Report, Union Carbide Corporation, 1993, . 9 The Browning Report , p. 8. 10 Bano et al. v. Union Carbide Corp & Warren Anderson, 99cv11329 SDNY , filed on 11/15/99.

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Chapter 3 Creating an Ethical Organization Environment and Effective Corporate Governance Systems 171

the unproven design even though it posed a “danger of pol- luting subsurface water supplies in the Bhopal area.” The fol- lowing is an excerpt from a document numbered UCC 04206 and included in the Environmental Working Group Report on Bhopal, India. 11 It also reveals the indifferent attitude of the Indian government toward environmental safety.

“The systems described have received provisional endorse- ment by the Public Health Engineering Office of the State of Madhya Pradesh in Bhopal. At present, there are no state or central government laws and/or regulations for environmental protection, though enactment is expected in the near future. It is not expected that this will require any design modifications. ”

Technology Risks “ The comparative risk of poor performance and of conse- quent need for further investment to correct it is consider- ably higher in the [Union Carbide–India] operation than it would be had proven technology been followed throughout . . . the MIC-to-Sevin process, as developed by Union Carbide, has had only a limited trial run. Furthermore, while similar waste streams have been handled elsewhere, this par- ticular combination of materials to be disposed of is new and, accordingly, affords further chance for difficulty. In short, it can be expected that there will be interruptions in operations and delays in reaching capacity or product quality that might have been avoided by adoption of proven technology.

[Union Carbide–India] finds the business risk in the pro- posed mode of operation acceptable, however, in view of the desired long-term objectives of minimum capital and foreign exchange expenditures. SO long as [Union Carbide-India] is diligent in pursuing solutions, it is their feeling that any short- falls can be mitigated by imports. Union Carbide concurs.”

As previously mentioned, there were one death and several accidental poisonings at the Bhopal plant before December 3, 1984. The International Environmental Law Research Center prepared a Bhopal Date Line showing that the death occurred on December 25, 1981, when a worker was exposed to phos- gene gas. On January 9, 1982, 25 workers were hospitalized as a result of another leak. On October 5, 1982, another leak from the plant led to the hospitalization of hundreds of residents. 12

It is worth noting that the workers had protested unsafe conditions after the January 9, 1982, leak, but their warning went unheeded. In March 1982, a leak from one of the solar evaporation ponds took place, and the Indian plant expressed its concern to Union Carbide headquarters. In May 1982, the company sent its U.S. experts to the Bhopal plant to conduct the audit previously mentioned.

Union Carbide’s reaction to newspaper allegations that Union Carbide–India was running an unsafe operation was for

11 Environmental Working Group, Chemical Industry Archives , .asp . 12 S. Muralidhar, “The Bhopal Date Line,” International Environmental Law Research Centre, n0409.htm .

the plant’s works manager to write a denial of the charges as baseless. The company’s next step was, to say the least, bewil- dering. It rewrote the safety manuals to permit switching off of the refrigeration unit and a shutdown of the vent gas scrubber when the plant was not in operation. The staffing at the MIC unit was reduced from 12 workers to 6. On November 29, 1984, three days before the disaster, Union Carbide completed a feasibility report and the company had decided to dismantle the plant and ship it to Indonesia or Brazil.

India’s Position The Indian government has acknowledged that 521,262 per- sons, well over half the population of Bhopal at the time of the toxic leak, were “exposed” to the lethal gas. 13 In the imme- diate aftermath of the accident, most attention was devoted to medical recovery. The victims of the MIC leak suffered damage to lung tissue and respiratory functions. The lack of medical documentation affected relief efforts. The absence of baseline data made it difficult to identify specific medical consequences of MIC exposure and to develop appropriate medical treatment. Another problem was that malnourish- ment of the poor Indians affected by the tragedy added to the difficulty because they already suffered from many of the postexposure symptoms such as coughing, breathlessness, nausea, vomiting, chest pains, and poor sight. 14

In a paper on the Bhopal tragedy written by Pratima Ungarala, a student at Hindu University, he analyzed the Browning Report and characterized the company’s response as one of public rela- tions. He noted that the report identified the media and other interested parties such as customers, shareholders, suppliers, and other employees as the most important to pacify. Ungarala criticized this response for its lack of concern for the people of Bhopal and the Indian people in general. Instead, the corpora- tion saw the urgency to assure the people of the United States that such an incident would not happen here. 15

Browning’s main strategy to restore Union Carbide’s image was to distance the company from the site of the disas- ter. He points out early in the document that Union Carbide had owned only 50.9 percent of the affiliate, Union Carbide India Ltd. He notes that all the employees in the company were Indians and that the last American employee had left two years before the leak.

The report contended that the company “did not have any hold over its Indian affiliate.” This seems to be a conten- tious issue because while “many of the day-to-day details, such as staffing and maintenance, were left to Indian offi- cials, the major decisions, such as the annual budget, had to be cleared with the American headquarters.” In addition, according to both Indian and U.S. laws, a parent company

14 Paul Shrivastava, “Long-Term Recovery from the Bhopal Crisis,” The Long Road to Recovery: Community Responses to Industrial Disaster ( New York: United Nations University, 1996). 15 Pratima Ungarala, Bhopal Gas Tragedy: An Analysis, Final Paper HU521/Dale Sullivan 5/19/98, hu_ dept/tc@mtu/papers/bhopal.htm .

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172 Chapter 3 Creating an Ethical Organization Environment and Effective Corporate Governance Systems

(United Carbide in this case) holds full responsibility for any plants that it operates through subsidiaries and in which it has a majority stake. Ungarala concluded that Union Carbide was trying to avoid paying the $3 billion that India demanded as compensation and was looking to find a “scapegoat” to take the blame. 16

After the government of Madhya Pradesh took over the information Web site from Union Carbide, it began to keep track of applications for compensation. Between 1985 and 1997, over 1 million claims were filed for personal injury. In more than half of those cases, the claimant was awarded a monetary settlement. The total amount disbursed as of March 31, 2003, was about $345 million. 17 An additional $25 million was released through July 2004, at which time the Indian Supreme Court ordered the government to pay the victims and families of the dead the remaining $330 million in the compensation fund.

Lawsuits The inevitable lawsuits began in December 1984 and March 1985, when the government of India filed against Union Carbide–India and the United States, respectively. Union Carbide asked for the case filed in the Federal District Court of New York to be moved to India because that was where the accident had occurred and most of the evidence existed. The case went to the Bhopal District Court—the lowest-level court that could hear such a case. During the next four years, the case made “its way through the maze of legal bureaucracy” from the state high court up to the Supreme Court of India.

The legal disputes were over the amount of compensation and the exoneration of Union Carbide from future liabilities. The disputes were complicated by a lack of reliable infor- mation about the causes of the event and its consequences. The government of India had adopted the “Bhopal Gas Leak Disaster Ordinance—a law that appointed the government as sole representative of the victims.” It was challenged by victim activists, who pointed out that the victims were not consulted about legal matters or settlement possibilities. The result was, in effect, to dissolve “the victims’ identity as a constituency separate and differing from the government.” 18

In 1989, India had another parliamentary election, and it seemed a politically opportune time to settle the case and win support from the voters. It had been five years since the acci- dent and the victims were fed up with waiting. By that time, “hundreds of victims had died and thousands had moved out of the gas-affected neighborhoods.” Even though the Indian government had taken Union Carbide to court asking for $3 billion, the company reached a settlement with the gov-

ernment in January 1989 for $470 million; the agreement gave Union Carbide immunity from future prosecution.

In October 1991, India’s Supreme Court upheld the com- pensation settlement but cancelled Union Carbide’s immu- nity from criminal prosecution. The money had been held in a court-administered account until 1992 while claims were sorted out. By early 1993, there were 630,000 claims filed, of which 350,000 had been substantiated on the basis of medical records. The numbers are larger than previously mentioned because the extent of health problems grew con- tinuously after the accident and hundreds of victims contin- ued to die. Despite challenges by victims and activists to the settlement with Union Carbide, at the beginning of 1993, the government of India began to distribute the $470 million, which had increased to $700 million as a result of interest earned on the funds. 19

What Happened to Union Carbide?

Not surprisingly, the lawsuits and bad publicity affected Union Carbide’s stock price. Before the disaster, the compa- ny’s stock traded between $50 and $58 a share. In the months immediately following the accident, it traded at $32 to $40. In the latter half of 1985, the GAF Corporation of New York made a hostile bid to take over Union Carbide. The ensuing battle and speculative stock trading ran up the stock price to $96, and it forced the company into financial restructuring.

The company’s response was to fight back. It sold off its consumer products division and received more than $3.3 billion for the assets. It took on additional debt and used the funds from the sale and borrowing to repurchase 38.8 million of its shares to protect the company from fur- ther threats of a takeover.

The debt burden had accounted for 80 percent of the com- pany’s capitalization by 1986. At the end of 1991, the debt levels were still high—50 percent of capitalization. The com- pany sold its Linde Gas Division for $2.4 billion, “leaving the company at less than half its pre-Bhopal size.”

The Bhopal disaster “slowly but steadily sapped the financial strength of Union Carbide and adversely affected” employee morale and productivity. The company’s inability to prove its sabotage claim affected its reputation. In 1994, Union Carbide sold its Indian subsidiary, which had operated the Bhopal plant, to an Indian battery manufacturer. It used $90 million from the sale to fund a charitable trust that would build a hospital to treat victims in Bhopal.

Two significant events occurred in 2001. First, the Bhopal Memorial Hospital and Research Centre opened its doors. Second, the Dow Chemical Company purchased Union Carbide for $10.3 billion in stock and debt, and Union Carbide became a subsidiary of Dow Chemical.

Subsequent to the initial settlement with Union Carbide, the Indian government took steps to right the wrong and its aftereffects caused by the failure of management and the

16 Ungarala. 17 Madhya Pradesh Government, Bhopal Gas Tragedy Relief and Rehabilitation Department, facts.htm . 18 Michael R. Reich, Toxic Politics: Responding to Chemical Disasters (Ithaca, NY: Cornell University Press, 1991). 19 United Nations Report.

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Chapter 3 Creating an Ethical Organization Environment and Effective Corporate Governance Systems 173

systems at Union Carbide in Bhopal. On August 8, 2007, the Indian government announced that it would meet many of the demands of the survivors by taking legal action on the civil and criminal liabilities of Union Carbide and its new owner, Dow Chemical. The government established an “Empowered Commission” on Bhopal to address the health and welfare needs of the survivors, as well as environmental, social, eco- nomic, and medical rehabilitation.

On June 26, 2012, Dow Chemical Co. won dismissal of a lawsuit alleging polluted soil and water produced by its Union Carbide’s chemical plant in Bhopal, India , injured area residents, one of at least two pending cases involving the facility known for the 1984 disaster that killed thousands.

U.S. District Judge John Keenan in Manhattan ruled that Union Carbide and its former chairman, Warren Anderson, weren’t liable for environmental remediation or pollution- related claims made by residents near the plant, which had been owned and operated by a former Union Carbide unit in India.

Questions 1. Evaluate the actions of the workers and management of

Union Carbide in this case from the perspectives of System 1 and System 2 thinking that was discussed in Chapter 2.

2. The document uncovered by the Environmental Working Group Report refers to the acceptable “business risk” in the Bhopal operation due to questions about the technology. Is it ethical for a company to use business risk as a measure of whether to go ahead with an operation that may have safety problems? How would you characterize such a thought pro- cess from the perspective of ethical reasoning?

3. Evaluate management decision making in the Bhopal case from a corporate governance perspective. Compare the decision-making process used by Union Carbide to deal with its disaster with that of Ford Motor Co. in the Pinto case and Johnson & Johnson in the Tylenol incident as described in this chapter. How do you assess stakeholder responsibilities in each of these cases?

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174 Chapter 3 Creating an Ethical Organization Environment and Effective Corporate Governance Systems

How could a CEO and chairperson of the board of direc- tors of a major company resign in disgrace over a personal relationship with a contractor that led to a sexual harassment charge and involved a conflict of interests, a violation of the code of ethics? It happened to Mark Hurd on August 6, 2010. Hurd was the former CEO for Hewlett-Packard (HP) for five years and also served as the chair of the board of directors for four years. On departure from HP, Hurd said he had not lived up to his own standards regarding trust, respect, and integrity.

In 2006, Hurd led the company out of disgrace when it was found guilty of spying on its own members of the board of directors in a “pretexting case” where the company gained access to board members’ personal phone records by imper- sonating the board members. The goal of obtaining informa- tion under false pretenses, was to plug leaks from the board by using private detectives to spy on directors, employees, and journalists who covered the company. The scandal resulted in the removal of then-chair Patricia Dunn and vaulted Hurd into the board chair position after assuming the CEO role in 2005. The facts of the pretexting situation are discussed in Case 3-4.

The board of directors of HP began an investigation of Hurd in response to a sexual harassment complaint by Jodie Fisher, a former contractor, who retained lawyer Gloria Allred to represent her. While HP did not find that the facts sup- ported the complaint, they did reveal behavior that the board would not tolerate. Subsequent to Hurd’s resignation, a sev- erance package was negotiated granting Hurd $12.2 million, COBRA benefits, and stock options, for a total package of somewhere between $40 and $50 million.

In a letter to employees of HP on August 6, interim CEO Cathie Lesjak outlined where Hurd violated the “Standards of Business Conduct” and the reasons for his departure. Lesjak wrote that Hurd “failed to maintain accurate expense reports, and misused company assets.” She indicated that each was a violation of the standards and “together they demonstrated a profound lack of judgment that significantly undermined Mark’s credibility and his ability to effectively lead HP.” The letter reminded employees that everyone is expected to adhere strictly to the standards in all business dealings and relationships and senior executives should set the highest standards for professional and personal conduct.

The woman who brought forward the sexual harassment complaint was a “marketing consultant” who was hired by HP for certain projects, but she was never an employee of HP. During the investigation, inaccurately documented expenses were found that were claimed to have been paid to the con- sultant for her services. Falsifying the use of company funds violated the HP Standards of Business Conduct.

On December 30, 2011, a letter from Allred about Fisher’s responsibilities was leaked to the Associated Press during the

trial in a Delaware court. The letter showed that in an effort to impress Fisher, who was hired as an event hostess (not a true marketing consultant), Hurd showed her his checking account balance holding over $1 million. The Delaware court had ruled that the disclosure of the letter did not violate Delaware laws. In rejecting efforts by Hurd’s lawyers to keep it con- fidential, the court concluded that the letter did not contain trade secrets, nonpublic financial information, or third-party confidential information. The ruling said information that is only “mildly embarrassing” is not protected from public disclosure. Some sentences concerning Hurd’s family were ordered redacted from the letter, however. 1

Allred alleged in the letter that, while Fisher was ostensi- bly hired as an HP event hostess in late 2007, she was really brought on to accompany Hurd to HP events held out of town. In a serious corporate allegation, during a trip to Madrid in March 2008, Hurd allegedly called Fisher’s room and told her about a then-undisclosed deal in the works, in which HP was going to acquire the tech consulting firm EDS. Fisher had heard of the company, having lived before in Dallas. Hurd told her to keep what she knew about the deal secret.

As for the sexual harassment claim, Allred alleged in the letter that Hurd harassed Fisher at meetings and dinners over a several year period during which time Fisher experienced a number of unwelcome sexual advances from Hurd including kissing and grabbing. Fisher said that this continual sexual harassment made her uncertain about her employment status.

Questions 1. What is the role of trust in business? How does trust relate

to stakeholder interests? How does trust engender ethi- cal leadership? Evaluate Mark Hurd’s actions in this case from a trust perspective.

2. Define conflict of interests in a business sense. How does Hurd’s actions and relationship with Jodie Fisher in the case create a conflict of interest? Did the conflict of inter- est and trust issue contribute the possibility that sexual harassment may have existed? Why or why not?

3. Leo Apotheker, the former CEO of HP who succeeded Mark Hurd, resigned in September 2011, after just 11 months on the job—but he left with a $13.2 million severance pack- age. Hurd left with a package between $40 million and $50 million. What is the role of a severance package in hir- ing a CEO? Do you think the size of the severance package given to Hurd was ethical? Does the Hurd case affect your views about the “say on pay” rule?

Case 3-10

Accountability of Ex-HP CEO in Conflict of Interest Charges

1 The letter is Available at 76795283/Allred-Letter-Redacted-New .

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4 AICPA Code of Professional Conduct

First, it was the Big Eight CPA firms. Then, Arthur Young and Ernst & Whinney combined to form Ernst & Young (EY). This was followed by the merger of Deloitte Haskins & Sells and Touche Ross & Co. (Deloitte & Touche), and then Price Waterhouse and Coopers & Lybrand (Pricewa ter- houseCoopers). The Big Five, which also included KPMG, existed until the early 2000s, when Arthur Andersen (Andersen) was forced out of business as a result of the fallout from a criminal investigation of the firm by the U.S. Department of Justice that was triggered by the Enron fraud. Now, it’s the Big Four certified public accounting (CPA) firms—the four largest firms in the world that audit major international companies.

In her book Final Accounting, which chronicles the rise and fall of Arthur Andersen, Barbara Ley Toffler describes Andersen’s employees as “Androids.” Toffler points to a cul- ture at Andersen that led to a compromise of its ethical values by establishing a tone at the top for employees to live the mantra of “keep the client happy.” 1

The shortcomings of the Enron audit are generally cred- ited with leading to the demise of Andersen. However, before that, the firm had reportedly settled more than a dozen cases over a 25-year period pertaining to claims that auditors concealed or failed to reveal material mis- statements within financial reports. Multimillion-dollar set- tlements preceded the Enron scandal, which at that time was the largest bankruptcy case in the history of the United States. 2 Accounting frauds at Andersen clients, including Sunbeam, Waste Management, Enron, and WorldCom, typified Andersen’s failure to act in the public interest.

On December 2, 2001, Enron filed for Chapter 11 bank- ruptcy, and two weeks later, it fired Andersen as its auditor.

On January 15, 2002, the main partner, David Duncan— who was responsible for the Enron audit—was fired by Andersen for his role in overseeing the mass destruction of Enron documents prior to the investigation of the firm by the Securities and Exchange Commission (SEC). On January 28, 2002, the U.S. Department of Justice filed a criminal obstruction-of-justice charge against Andersen for its shred- ding of documents in the Enron case. Andersen pleaded not guilty to a charge of obstructing justice and explained that the destruction of Enron documentation and e-mails was just part of routine company procedures of destroy- ing confidential client documentation. On April 9, 2002, in an agreement with the Department of Justice, Duncan pleaded guilty to illegally shredding Enron documents. Just a day before, Andersen announced a massive layoff of 7,000 of its workforce. On June 15, 2002, after five weeks of hearing evidence and 10 days of deliberation, the jury found Andersen guilty of obstructing the course of justice.

In a surprise reversal, the U.S. Supreme Court reviewed the original jury instructions given by Judge Melinda Harmon, which defined the standards and hurdles that the jury had to clear to reach a guilty verdict. The court ruled that the instructions “failed to convey the requisite consciousness of wrongdoing,” as Chief Justice William Rehnquist wrote in the unanimous opinion. “Indeed, it is striking how little culpabil- ity the instructions required.” 3 Unfortunately for Andersen, it was too late; the firm had already closed its doors for good.

In this chapter we discuss a variety of terms that apply to varying services of CPAs and CPA firms. The ethical requirements in the AICPA Code are discussed as well. An assurance service is an independent professional service to improve the quality of information for decision makers.

Ethics Reflection


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An attestation service is a form of assurance service in which the CPA firm issues a report about the reliability of an assertion that is the responsibility of another party. Audit services are a form of attestation service in which the audi- tor expresses a written conclusion about the degree of cor- respondence between information and established criteria.

The most common form of audit service is an audit of historical financial statements, in which the auditor expresses a conclusion as to whether the financial state- ments are presented in conformity with generally accepted accounting principles. An example of an attestation ser- vice is a report on the effectiveness of an entity’s internal control over financial reporting. There are many possible forms of assurance services, including services related to

business performance measurement, health care perfor- mance, and information system reliability. For simplifica- tion purposes we use the term audit or attest services to refer to the examination of a client’s financial statements and rendering of an independent opinion. The term non- audit or nonattest services is then used when no opinion is rendered.

As you read this chapter, think about the following: (1) What are the ethical obligations of CPAs under the AICPA Code? (2) What is the role of independence in an audit, and how can CPAs manage the threats that exist to audit independence? (3) What are the professional and ethical obligations of CPAs in performing nonattest services including tax services?

Ethics Reflection (Concluded)

By certifying the public reports that collectively depict a corporation’s financial status, the independent auditor assumes a public responsibility transcending any employment responsibility with the client. The independent public accountant performing this special function owes ultimate allegiance to the corporation’s creditors and stockholders, as well as to the investing public. This “public watchdog” function demands that the accountant maintain total independence from the client at all times and requires complete fidelity to the public trust. 4 Chief Justice Warren Burger, writing the unanimous opinion of the Supreme Court in United States v. Arthur Young & Co.

This important ruling of the U.S. Supreme Court reminds us that the independent audit provides the foundation for the existence of the accounting profession in the United States. Even though independent audits were common before the passage of the landmark legisla- tion of the Securities Act of 1933 and the Securities Exchange Act of 1934, there is no doubt that CPAs derive their franchise as a profession from these two pieces of legislation, which require independent audits of publicly owned companies.

The Burger Court opinion emphasizes the trust that the public places in the independent auditor. The accounting profession is the only profession where one’s public obligation supersedes that to a client. The medical profession recognizes the primacy of the physi- cian’s responsibility to a patient. The legal profession emphasizes the lawyer’s responsi- bility to the client. The Public Interest Principle in the Code of Professional Conduct of the American Institute of CPAs (AICPA Code) states, “In discharging their professional responsibilities, members (of the AICPA) may encounter conflicting pressures from each of these groups [clients, employers . . . ]. In resolving those conflicts, members should act with integrity, guided by the precept that when members fulfill their responsibility to the public, clients’ and employers’ interests are best served.” 5

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Chapter 4 AICPA Code of Professional Conduct 177

The Public Interest in Accounting: An International Perspective

We introduced the concept of “the public interest” in accounting in Chapter 1, pointing out that it primarily refers to the interests of investors and creditors. The interests of the client, an employer, and one’s self-interest should not be placed ahead of the public interest.

Enron, WorldCom, Royal Dutch Shell, Parmalat, Satyam, and Cadbury Nigeria all were involved in major financial statement frauds during the dark days of the first decade of the 2000s. It was a disease that infected virtually every continent in the world and brought into question whether the public trust in accountants to produce accurate and reliable financial reports had been compromised. From special-purpose entities to improper capitalization of costs to disclosing unproven reserves to recording fictitious bank accounts to recording ficti- tious invoices for stock-buybacks, the dizzying array of transactions that created the frauds knew no bounds. A lack of internal controls, ineffective internal audits, and inattentive boards of directors all share blame for these frauds. In each case, a culture was established that made it easier for top management to perpetrate the fraud, and the accountants who were on the front lines of the fraud failed to act in the public interest and report and/or stop it.

Following the disclosure of numerous accounting scandals, the accounting profession and professional bodies turned their attention to examining how to rebuild the public trust and confidence in financial reporting. Stuebs and Wilkinson point out that restoring the accounting profession’s public interest focus is a crucial first step in recapturing the public trust and securing the profession’s future. 6 Copeland believes to regain the trust and respect that the profession enjoyed prior to the scandals of the early 2000s, the profession must rebuild its reputation on its historical foundation of ethics and integrity. 7

The International Federation of Accountants (IFAC), a global organization that represents the accountancy profession, issued a research report, Rebuilding Public Confidence in Financial Reporting: An International Perspective, examining ways of restoring the credibility of financial reporting and corporate disclosure from an inter- national perspective. The report reflects the views of accounting professionals from six countries: Australia, Canada, France, Japan, the United Kingdom, and the United States. It identifies several key weaknesses in corporate governance from a number of corporate failures worldwide. The findings of the study include a recommendation for more effective corporate ethics codes, as well as the provision of training and support for individuals within organizations to better prepare them to deal with ethical dilemmas. 8

IFAC addresses the public interest dimension in its Policy Position Paper #4, entitled A Public Interest Framework for the Accountancy Profession. The framework is designed to enable IFAC and other professional bodies to better evaluate whether the public interest is being served through actions of the profession and its institutions. IFAC considers the “public interest” to represent the common benefits derived by stakeholders of the account- ing profession through sound financial reporting. It links these benefits to responsibilities of professional accountants, including the application of high standards of ethical behavior and professional judgment. 9

The International Ethics Standards Board for Accountants (IESBA) is an independent standard-setting body that serves the public interest by setting high-quality ethical stan- dards for professional accountants and by facilitating the convergence of international and national ethical standards, including auditor independence requirements, through its Handbook of the Code of Ethics for Professional Accountants (IFAC Code) (IESBA 2012). The IESBA, along with the International Accounting Education Standards Board (IAESB), establish guidelines for 167 members and associates in 127 countries worldwide, represent- ing approximately 2.5 million accountants in public practice, industry and commerce, the public sector, and education. No other accountancy body in the world, and few other professional organizations, have the broad-based international support that characterizes

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178 Chapter 4 AICPA Code of Professional Conduct

IFAC. The IAESB and IESBA standards are authoritative pronouncements that have the same force as standards promulgated by other boards operating under the auspices of IFAC, such as the International Auditing and Assurance Standards Board (IAASB).

The ethical decision-making process explained in Chapter 2 includes consideration of the IFAC Code in step #8 of the comprehensive model and in step 1 of the condensed model. We also address international education standards using IES 4 in step #3, along with virtue considerations. Moreover, the decision-making process incorporates elements of the IFAC framework and includes ethical reasoning and the application of core values, ethics, and attitudes that are, for the most part, similar to those in the United States. As a member body of IFAC, the AICPA agrees to have ethics standards that are at least as stringent as the IESBA standards. Since 2001, the AICPA Professional Ethics Executive Committee has undertaken certain convergence projects to align the AICPA Code with the IFAC Code. Efforts are ongoing and currently include the initiation of a task force to evaluate the IFAC provisions for members in business and industry and another to review the application of independence rules to affiliates of an attest client. 10

The fundamental principles of professional ethics for professional accountants identi- fied by the IESBA include integrity, objectivity, professional competence and due care, confidentiality, and professional behavior, including compliance with laws and regulations. These principles are similar to those in the AICPA Code, state board of accountancy rules in the United States, and the codes of conduct in the United Kingdom and Australia, as well as most of the developed world. 11

Support exists among professional bodies for education in professional values, ethics, and attitudes. A survey of IFAC member bodies reported in the IAESB’s information paper notes that member bodies agree that ethics education is necessary to do all of the following: 12

• Develop a sense of ethical responsibility in accountants. • Improve the moral standards and attitudes of accountants. • Develop the problem-solving skills that have ethical implications. • Develop a sense of professional responsibility or obligation.

The report considers the term ethics as an overarching term for values, ethics, and atti- tudes. Professional values, ethics, and attitudes include the ethical principles of conduct that are found in professional codes of ethics. Collectively, the values, ethics, and attitudes include technical competence; core values of integrity, objectivity, independence, and con- fidentiality; professionalism of respect, reliability, responsibility, timelines, due care, and courteousness; commitment to continuous improvement and lifelong learning; and social responsibility.

Our discussion of ethics, core values, behaviors, and attitudes recognizes the importance of establishing consistent professional ethics standards in countries throughout the world. We have a global economic system that relies on accurate financial reporting and efficient audits to assure the public of the reliability of financial statements. We build on this discussion in Chapter 8 and include the role of ethics in establishing International Financial Reporting Standards (IFRS). Finally, note that state boards of accountancy (i.e., California and Texas) have recognized the need to incorporate behaviors and attitudes with ethics and ethical rea- soning in developing ethics courses that prepare accounting students to take the CPA Exam.

Investigations of the Profession: Where Were the Auditors?

The auditing profession in the United States has come under periodic scrutiny from Congress during the past 40 years. The questions that are consistently asked are: Where were the auditors? Why didn’t auditing firms detect and report the many frauds that

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Chapter 4 AICPA Code of Professional Conduct 179

occurred during this time period? Was it a matter of bending to the wishes of the client that hires (and can fire) the firm, and pays its fee? Were these failures due to inadequate and sometimes sloppy audits by firms that may have been trying to cut corners because they lowballed their audit fees to lure clients, with the hope of gaining lucrative tax advice and consulting fees down the road? In the case of Andersen’s treatment of Enron, it seems all of the factors were present, as well as the cozy relationship that the auditor had with Enron that influenced the firm’s ability to be independent in making decisions regarding the audits.

The rules of conduct in the AICPA Code are best understood in light of the investi- gations of the accounting profession that followed high-profile frauds during the past 40 years. Congressional concern was that auditors were not living up to their ethical and professional responsibilities (as stated in the Burger Court opinion). The major themes of these investigations were (1) whether nonauditing services impair auditor independence, (2) the need for management to report on internal controls, (3) the importance of develop- ing techniques to prevent and detect fraud, and (4) the need to strengthen the role of the audit committee and communications between the auditor and audit committee.

Metcalf Committee and Cohen Commission: 1977–1978 As CPA firms have become global entities, the profession’s concern about ethics and regulation has grown. In 1977, a major study examined the relationship between auditors and clients and the provision of nonauditing services for those clients. The Metcalf (Moss) Report was the first real investigation of the accounting profession since the 1930s. An investigation was conducted between 1975 and 1977 by Senator Lee Metcalf (D-MT) and, on the House side, Representative John Moss (D-CA). 13 The Metcalf Report issued four recommendations, two of which are described here. The report did not lead to any new legislation at the time, although in the aftermath of the frauds at Enron and WorldCom, changes were made to enhance audits and financial reporting.

The first recommendation of the Metcalf Committee was to establish a self-regulatory organization of firms that audit publicly owned companies. It led to the AICPA’s formation of a two-tier voluntary peer review program in 1977: one for firms with public-company clients and one for smaller firms with only private companies. In 2004, the Public Company Accounting Oversight Board (PCAOB) assumed the AICPA’s responsibilities relating to firms that audit public clients ending the period of self-regulation by the profession, at least for public companies. * PCAOB instituted a mandatory quality inspection program for CPA firms that audit public companies. The AICPA continued its two-tier program to assist firms in meeting state licensing and AICPA membership requirements. We discuss the PCAOB audit inspection program in Chapter 5. 14

The second recommendation of the Metcalf Committee was to limit types of manage- ment services to those relating directly to accounting. The accounting profession was upset at the implication that the provision of management consulting services somehow tainted the audit. It was left to the Cohen Commission to conduct an in-depth study of the issue. In the meantime, the SEC followed up the concern with a requirement that public companies

* In Free Enterprise Fund v. Public Company Accounting Oversight Board , No. 08-861, 2010 WL 2555191 (June 28, 2010), the United States Supreme Court held that the provisions of Sarbanes-Oxley (SOX) that restrict the removal of the members of the five member Public Company Accounting Oversight Board (PCAOB) violate the Constitution’s separation of legislative and executive powers. The Court held, however, that the unconstitutional removal provision was severable from the remainder of SOX. Pursuant to SOX, the Board has extensive authority to promulgate auditing standards and conduct investigative and disciplinary proceedings. Violations of Board rules are treated as violations of the Securities Exchange Act of 1934. Although subject to SEC oversight, members of the Board can only be removed by formal SEC Order “for good cause shown” based on certain specified misconduct, which is subject to judicial review.

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disclose in their annual reports the aggregate fees that they paid to their accountants for nonauditing services.

The profession’s own Cohen Commission Report on auditors’ responsibilities exam- ined a variety of issues that are still debated today, including the auditor’s responsibility for detecting fraud and the expectation gap that exists between the profession’s goals for the audit and what the public expects an audit to accomplish. 15 Beyond that, the com- mission recommended that management report on its internal controls to the users of the financial statements and that the auditor should evaluate management’s report. This recommendation was ultimately enacted into legislation as part of the Sarbanes-Oxley (SOX) Act of 2002.

The events that eventually led to change were two rounds of major scandals—one in the 1980s that included the failures of savings and loan institutions, and the second in the late 1990s and early 2000s, led by Enron and WorldCom. After Enron and WorldCom, the profession agreed to go along with change in the form of the provisions passed by SOX and the creation of PCAOB.

The Cohen Commission headed by Manny Cohen, a former SEC commissioner, was important for two reasons. First, its final report included an instance that demonstrates the potential conflict when providing nonauditing services for an audit client. It was discovered that the audit of Westec Corporation had been compromised because of a consulting proj- ect. Second, it decried the lowballing of audit fees that raised the possibility of a decline in audit quality. 16 The latter concern, along with opinion shopping, have contributed over the years to a shift in the environment of professionalism that has existed in the accounting profession to one emphasizing the commercialization of accounting services.

The practice of lowballing consists of deliberately underbidding for an audit engage- ment to obtain the audit client and with the hope of securing more lucrative management advisory or other consulting services from that client in the future. To a large extent, the practice became less prevalent after the passage of SOX, which restricts providing certain nonauditing services for audit clients. Opinion shopping occurs when a client seeks out the views of various accountants until finding one that will go along with the client’s desired— if not necessarily most ethical—accounting treatment. This practice can lead to pressure being applied on the auditor to remain silent or risk losing the account, an intimidation threat to independence.

House Subcommittee on Oversight and Investigations: 1986 Representative Ron Wyden (D-OR) had introduced a bill in May 1986 to hold the accounting profession responsible for the detection of fraud in light of the failure at ESM Government Securities and bank failures in the early 1980s at Continental Illinois National Bank and Trust and Penn Square Bank. 17 Even though Continental Illinois had received a $4.5 billion federal bailout, the company ultimately was liquidated by the Federal Deposit Insurance Corporation (FDIC) just four months after receiving an unqualified opinion on its audit by Peat Marwick (now KPMG). This was the first time we heard the refrain in Congress, “Where were the auditors?”

Wyden eventually changed his proposed legislation because of criticisms by the AICPA and SEC, the latter under then-chair John Shad, who believed the system was “working well” to protect the public from major financial fraud. The new legislation called once again for internal control reports and emphasized the need for auditors to detect material illegalities or irregularities.

Representative John Dingell (D-MI) was chair of both the House Committee on Energy and Commerce and its Subcommittee on Oversight and Investigations. In January and February 1988, the subcommittee held two hearings concerning the failure of ZZZZ Best Company, a corporation that had “created” 80 percent or more of its total revenue in the

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form of fictitious revenue from the restoration of carpets, drapes, and other items in office buildings after fires and floods. Chair Dingell characterized the fraud as follows: 18

The fact that auditors and attorneys repeatedly visited make-believe job sites and came away satisfied does not speak well for the present regulatory system. The fact that the auditing firm discovering the fraud resigned the engagement without telling enforcement authorities is even more disturbing. . . . Cases such as ZZZZ Best demonstrate vividly that we cannot afford to tolerate a system that fails to meet the public’s legitimate expectations in this regard.

Savings and Loan Industry Failures: Late 1980s–Early 1990s By the late 1980s, the savings and loan (S&L) industry failures became the focus of the congres- sional hearings as a $300 million failure at Beverly Hills Savings & Loan and a $250 million failure at Sunrise Savings, a Florida S&L, engulfed Deloitte & Touche. Arthur Young, the firm that was to merge with Ernst & Whinney to form Ernst & Young, had run into deep trouble in its S&L audits. In particular, it certified the financial statements of the Western Savings Association in 1984 and 1985, which were overstated by $400 million. If Arthur Young had not merged with Ernst & Whinney, the firm may have been forced out of business. Eventually the firm paid the federal government $400 million to settle claims that the company’s auditors failed to warn of disastrous financial problems that caused some of the nation’s biggest thrift failures.

Perhaps the most publicized failure is that of Lincoln Savings & Loan. Thousands of California retirees lost their life savings after buying uninsured subordinated debentures issued by Lincoln’s parent company, American Continental, and sold through Lincoln branches. Arthur Young, the auditors of American Continental, issued unqualified opinions on the entity’s financial statements for fiscal years 1986 and 1987. The audit opinions were part of the annual reports of American Continental that were furnished to prospective buyers of the worthless debentures.

The cost to the public to clean up 1,043 failed thrift institutions with total assets of over $500 billion during the 1986–1995 period was reported to be $152.9 billion, including $123.8 billion of U.S. taxpayer losses. The balance was absorbed by the thrift industry itself. It was the greatest collapse of U.S. financial institutions since the Great Depression. 19 Little did we know that 20 years later, banks and financial institutions would be embroiled in a scandal that involved risky investments, including derivatives and worthless mortgage- backed securities, and some institutions would need federal bailout funds to stay in busi- ness, while others were taken over by the government or other institutions.

The accounting issues in failed S&Ls centered on three issues: (1) the failure to provide adequate allowances for loan losses, (2) the failure to disclose dubious deals between the S&Ls and some of their major customers, and (3) the existence of inadequate internal controls to prevent these occurrences. The profession was already considering ways to address the large number of business failures in the 1980s when the S&L debacle occurred. The profession’s response to deal with this new pressure was to form the Treadway Commission, and its work was given a new sense of urgency.

Treadway Commission Report: 1985; COSO: 1992; and Enterprise Risk Management: 2004

The National Commission on Fraudulent Financial Reporting, referred to as the Treadway Committee after its chair James C. Treadway, was formed in 1985 to study and report on the factors that can lead to fraudulent financial reporting. The Committee of Sponsoring Organizations of the Treadway Commission (COSO) is a joint initiative of five private sector organizations, established in the United States, that provides leadership on organiza- tional governance, business ethics, internal control, enterprise risk management, fraud, and

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financial reporting. COSO has established a common internal control model against which companies and organizations may assess their control systems.

COSO has emphasized the need to change the corporate culture and establish the sys- tems necessary to prevent fraudulent financial reporting. It starts with the “tone at the top”; that is, top management should set an ethical tone that filters throughout the organization and influences everything and everyone.

While Metcalf and Moss, Dingell, and Wyden focused mainly on the role of the external auditor (including independence), COSO extended the review to include the role and responsibilities of internal accountants and auditors and the board of directors in preventing and detecting fraud. An important part of the COSO framework is to stress the importance of a strong control environment so that the internal auditors can have direct and unrestricted access to the audit committee of the board of directors (refer back to Exhibit 3.10 in Chapter 3). 20 If top management, such as the chief executive officer (CEO) and chief financial officer (CFO), attempts to manipulate earnings or use company assets for inappropriate reasons, then the internal auditors supported by strong internal controls should detect and report the wrongdoing to the audit committee. The audit committee’s responsibility is to do whatever is necessary to reverse top manage- ment’s action.

In an interview with The CPA Journal on April 20, 2005, former COSO chairman Larry Rittenberg identified the contributions of the Treadway Report and follow-up work in creating a sounder ethical culture in organizations. According to Rittenberg, “One of its most consequential recommendations was for the development of a conceptual framework for implementing and evaluating internal controls. Prior to the 1992 issuance of COSO’s Internal Control–Integrated Framework, internal control guidance consisted primarily of ad hoc checklists. The COSO framework developed all aspects of the organization: financial reporting, operational activities, and compliance issues. As a result, it has been widely accepted over time. In terms of overall impact on businesses, the 1992 internal control project is COSO’s most significant contribution to date.” 21

In the years following the COSO report, the audit profession experienced a height- ened concern and focus on risk management, and it became increasingly clear that a need existed for a robust framework to identify, assess, and manage risk effectively. In 2001, COSO initiated a project to develop a framework that would be readily usable by managements to evaluate and improve their organizations’ enterprise risk management. PricewaterhouseCoopers was the firm engaged for this task.

The period of the framework’s development was marked by a series of high-profile business scandals and failures, including Enron and WorldCom, where investors, company personnel, and other stakeholders suffered major losses. This led to calls for enhanced corporate governance and risk management, with new laws, regulations, and listing stan- dards. The need for an enterprise risk management framework that provided key principles and concepts, a common language, and clear direction and guidance, became even more compelling. The result was the issuance of a study titled Enterprise Risk Management– Integrated Framework. COSO believes that the recommendations of the study fill this need and expects that it will become widely accepted by companies and other organizations over time and gain the support of all stakeholders and interested parties. 22

Rittenberg explained the role of “enterprise risk management (ERM)” as broader than internal controls. He stated that controls exist only to mitigate risks that are part of organiza- tional behavior. So every internal control framework has to start with a systematic approach to identifying risk. Management and boards have to determine their risk “appetites” and their risk tolerances and discuss these at the highest levels of an organization.

In the ERM framework, controls are designed to manage the risks within the organiza- tion’s tolerances. There are a variety of ways to manage risk: one way is to control the risk, perhaps through diversification; another way is to insure against the risk. The ERM framework is an enhanced, proactive approach to managing organizational risk. More will

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be said about internal controls and risk management in Chapter 5, when we discuss audit standards and fraud detection and prevention.

A Final Word About the Internal Control Environment: Armadillo Foods, Inc. Let’s assume that you are a CPA and the controller of Armadillo Foods, Inc., a large southwestern processor of armadillo-based food products. One day, the CFO comes to you and says the earnings results for the quarter ending June 30, 2013, are 20 percent below the financial analysts’ estimates. Because Armadillo is a public company, you know that the stock price is likely to decline—perhaps significantly—after public disclosure of the earnings reduction for the second straight quarter in 2013. You also know that bonuses to top management depend on increasing reported earnings. The CFO tells you that the CEO insists the company must “make the numbers” this quarter, and you need to find a way to make that happen. What would you do? Why?

This is a hypothetical situation but one that occurred all too often during the accounting scandals of the 1990s and 2000s. The pressure applied by the CFO and CEO on the con- troller tests that person’s commitment to act with objectivity and integrity. The controller is probably quite aware of her ethical obligations to act in accordance with the public interest. She also knows that integrity requires that she not subordinate her judgment and give in to the pressure to go along with materially misstated financial statements. Recall that AICPA Code Interpretation 102-4, which was discussed in Chapter 1, outlines the steps to be taken by internal accountants to avoid subordinating judgment. The controller has an ethical dilemma that challenges her ability and willingness to take ethical action. Interpretation 102-4 requires that she bring her concerns to higher-ups in the organization, including the audit committee, and prepare an informative memorandum that summarizes the various positions, including those of top management. The memo should help provide a defense of due care and the compliance with ethical standards in case it becomes a regulatory or legal matter.

If all parties refuse to support the controller, then the question is whether to inform the external auditors who, after all, rely on the objectivity and integrity of the controller in performing external auditing services. The relationship of trust that exists between the controller and the external auditors may be compromised if the controller is silent. Beyond informing the external auditors, the controller has no responsibility to bring accounting matters of concern to outsiders—not only that, to do so violates confiden- tiality under the AICPA Code. However, under the Dodd-Frank Financial Reform Act that was discussed in Chapter 3, individuals with internal compliance or audit respon- sibilities at an entity, including CPAs, are expected to disclose improper accounting practices to the SEC to prevent “substantial injury” to the financial interest of an entity or its investors.

The Role of the Accounting Profession in the Financial Crisis of 2007–2008

The financial crisis that started in 2007 and accelerated in 2008, ushered in a period of reflection about how the United States could have been pushed into a recession brought on by excessive risk taking and a mortgage meltdown. Some have blamed moral hazard as a major contributing factor. Moral hazard occurs where one party is responsible for the interests of another, but has an incentive to put her own interests first. Research by Atif Mian and Amir Sufi of the University of Chicago’s business school provides hard evidence that securitization of mortgages fostered moral hazard among mortgage originators, which led them to issue loans to uncreditworthy borrowers. They were motivated to do so by moral hazard effects, in that the securitized assets were sold off to unsuspecting investors and so the risk of default transferred to these parties, not the originating banks.23

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184 Chapter 4 AICPA Code of Professional Conduct

Despite the profession’s efforts to control for risk and improve corporate culture, the United States experienced its worst recession that began in 2007 in part due to risky financial activities and improper accounting practices. It started when the investment banking firm of Lehman Brothers failed because it was unable to retain the confidence of its lenders and counterparts and because it did not have sufficient liquidity to meet its current obligations. Lehman engaged in a series of business decisions and transactions using a device known as “Repo 105” that had left it with heavy concentrations of illiquid assets with deteriorating values such as residential and commercial real estate.

Confidence eroded when Lehman reportedly had two consecutive quarters of huge reported losses, $2.8 billion in the second quarter of 2008 and $3.9 billion in the third quarter of that year.

The business decisions that had brought Lehman to its crisis of confidence may have been in error but were deemed by the bankruptcy examiner to be largely within the business judgment rule. But the decision not to disclose the effects of those judgments created a valid claim against the senior officers who oversaw and certified misleading financial statements. Legal claims of failing to meet professional responsibilities were charged against Lehman’s CEO, Richard Fuld, and its CFOs, Christopher O’Meara, Erin M. Callan, and Ian Lowitt. A valid claim also existed against its external auditor, Ernst & Young, for its failure to question and challenge improper or inadequate disclosures in those financial statements, among other things.

Lehman had used an accounting device (known within Lehman as “Repo 105”) to manage its balance sheet by temporarily removing approximately $50 billion of assets from the balance sheet at the end of the first and second quarters of 2008.

In an ordinary “repo,” Lehman raised cash by selling assets with a simultaneous obligation to repurchase them the next day or several days later; such transactions were accounted for as financings, and the assets remained on Lehman’s balance sheet. In a Repo 105 transaction, Lehman did exactly the same thing, but because the assets were 105 percent or more of the cash received, accounting rules permitted the transactions to be treated as sales rather than financings, so that the assets could be removed from the balance sheet. With Repo 105 transactions, Lehman’s reported net leverage was 12.1 at the end of the second quarter of 2008, but if Lehman had used ordinary repos, net leverage would have been reported at 13.9.

Lehman did not disclose its use—or the significant magnitude of its use—of Repo 105 to the federal government, to the rating agencies, to its investors, or to its own board of directors. Ernst & Young was aware of its use but did not question it or the nondisclosure of the Repo 105 accounting transactions. It took Lehman until September 2008, several months into the financial meltdown, to publicly disclose the liquidity issues. On September 10, 2008, the company announced that it was projecting a $3.9 billion loss for the third quarter of 2008. By the close of trading on September 12, its stock price had declined to $3.65 a share, a 94 percent drop from the $62.19 price on January 2, 2008.

Over the weekend of September 12–14, 2008, a series of meetings were held by U.S. Treasury Secretary Henry Paulson, president of the Federal Reserve Bank of New York Timothy Geithner, SEC chairman Christopher Cox, and the chief executives of leading financial institutions. The government made a decision that many believe ushered in the financial crisis. It refused to fund a solution to the Lehman problem, stating that it did not have the legal authority to make a direct capital investment in Lehman, and Lehman’s assets were insufficient to support a loan large enough to avoid its collapse.

As an alternative to government intervention, Lehman approached Barclays, a British bank, and it appeared a deal had been reached on September 14 that would save Lehman from collapse, but later that day, the deal fell apart when it was learned that the Financial Services Authority, the United Kingdom’s bank regulator, refused to waive U.K.-shareholder-approval requirements. Clearly, that would take too long. Meanwhile, Lehman could no longer fund its operations. The bank collapsed on September 15, when it filed for bankruptcy protection. The filing remains the largest bankruptcy filing in U.S. history, with Lehman holding over $600 billion in assets.

EXHIBIT 4.1 Lehman’s Financial Transactions and Accounting Disclosures

For two and a half years, the U.S. Senate focused on the role of financial institutions in the financial crisis of 2007–2008 that started with the failure of Lehman Brothers. A bank- ruptcy examiners report 24 issued on April 12, 2011, shed light on the role of auditing firms in the financial meltdown. The report was written by Jenner & Block chairman Anton Valukas. The details of Lehman’s financial activities that vaulted the company into bank- ruptcy are too complicated to discuss in detail, but we provide a summary in Exhibit 4.1 .

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At the Senate Banking Committee hearings on the Lehman failure and subsequent financial crisis, Jenner & Block chairman Anton Valukas spoke about the general principle that auditors play a critical role in the proper functioning of public companies and financial markets. He said:

Boards of directors and audit committees are entitled to rely on external auditors to serve as watchdogs—to be important gatekeepers who provide an independent check on management. And the investing public is entitled to believe that a “clean” report from an independent auditor stands for something. The public has every right to conclude that auditors who hold themselves out as independent will stand up to management and not succumb to pressure to avoid rocking the boat. I found that [valid] claims exist against Lehman’s external auditor in connection with Lehman’s issuance of materially misleading financial reports. 25

Also at the hearing before the Senate Banking Committee, SEC chief accountant James Kroeker was called on to answer questions that the SEC had information about problems at Lehman (specifically, concerns about liquidity pools) and failed to take adequate action.

The Valukas report suggested that the now-defunct Trading and Markets unit at the SEC knew about problems and did not inform officials at other divisions of the commission. Kroeker said that the SEC took the report seriously and responded: “It is a very serious observation, but it has been addressed.” 26 It was not explained exactly how the problem was addressed, beyond the fact that the SEC went through a reorganization of divisions in late 2008.

In addition to Valukas and Kroeker, the chairman of PCAOB, James Doty, was called on to testify. Doty admitted that auditors should have been more vigilant—not just at Lehman, but across the board. “There were a number of areas where auditors should have delved more deeply,” Doty said. He pointed to serious ongoing problems with valuations and end-of-period transactions. 27

The findings of the committee will likely have a serious impact on the oversight of the auditing industry as a whole. The SEC requires mandatory rotation of key auditing personnel within a firm every five years in keeping with that requirement in SOX. Now, the government is examining various aspects of the way auditing firms are regulated and their level of accountability to companies and investors who rely on their assess- ments. One controversial proposal is to institute a mandatory auditor rotation policy whereby every few years (i.e., 5 or 10 years), there would be a required change in the auditing firm.

On October 19, 2012, the PCAOB held a public meeting in Houston to hear feed- back on its proposals for mandatory auditing firm rotation and auditor independence. The PCAOB heard from a variety of speakers, including a representative from the European Commission, who described the proposal for mandatory firm rotation in the European Union (EU). Nathalie Berger, head of the European Commission’s audit and credit-rating agencies unit, told the PCAOB that it is seeing support in the European Parliament for mandatory firm rotation. “There are obvious reasons and good grounds on which the introduction of mandatory auditing firm rotation can be based,” she said. “It would strengthen the independence of auditors by mitigating the familiarity threat.” 28

The other side of the issue was presented by W. David Rook, partner-in-charge of firm assurance and advisory services at Weaver & Tidwell in Houston. Weaver & Tidwell does root cause analysis after a CPA firm receives an negative inspection report from the PCAOB to see what went wrong. While Rook agreed that independence, objectivity, and professional skepticism are critical to the viability of auditing, he said that the firm opposed mandatory rotation.

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“While we support the board’s ongoing efforts to improve independence, objectivity, and audit quality, we do not believe that mandatory auditing firm rotation is a concept that will work and, if enacted, could raise significant risks and result in unintended con- sequences,” he said. “We have always believed that the danger of a failed audit is greater when the auditor does not fully understand the client’s business than from the auditor being too familiar with the client’s business.” 29

On April 25, 2013, the Legal Affairs Committee of the European Parliament, the legisla- tive arm of the EU, voted to require public companies to change audit firms after up to 14 years. The proposed law was scheduled to be voted on in later 2013. On July 8, 2013, the U.S. House of Representatives approved a bill that prohibits the Public Company Accounting Oversight Board from forcing public companies to automatically change or rotate their independent auditing firm. 30

Reflecting on the years of investigations after business and audit failures and important changes in the landscape of audit regulation, we believe that there will continue to be instances of audit independence violations because of the growing personal and business relationships between auditing firms, the client, and client management. A culture of ethics and professionalism that existed for so many years has been replaced by an emphasis on marketing of professional services. Growth and revenue enhancement now rules the day rather than providing services in the public interest.

AICPA Code of Professional Conduct and State Board Requirements

The AICPA Code is generally recognized as a model for the accounting profession. Each of the 50 states as well as Washington, DC, and U.S. territories—Puerto Rico, the Virgin Islands, Guam, and the Commonwealth of the Northern Mariana Islands—have indepen- dent professional societies for CPAs. The state CPA societies also have codes of conduct for their membership that often mirror the AICPA Code. Even though only members of these voluntary organizations are bound by the codes, the provisions are generally similar to those of state boards of accountancy, so we use the AICPA Code as the model of ethical standards to be followed by CPAs.

We urge students to become familiar with their state board regulations and rules of conduct because differences may exist with the AICPA Code; licensed CPAs in a given state are expected to follow that state’s requirements in such cases. From time to time in this text, we refer to the rules of conduct in California and Texas. The reason is that, as discussed in Chapter 1, these two states require ethics education as part of the university coursework of accounting students. Moreover, well over 100,000 CPAs are licensed in these two states alone.

A good example of a difference between AICPA and state board rules is the ethical obligation of a licensed CPA to return client books and records. The rules in most states include a requirement that a licensee cannot refuse to return client books and records solely because there are unpaid fees. While the AICPA permits withholding client books and records with respect to specific work product under these circumstances, most state boards consider it to be a violation of the rules of conduct. An example is Section 68 of the California regulations, which provides as follows: 31

A licensee, after demand by or on behalf of a client, for books, records or other data, whether in written or machine sensible form, that are the client’s records shall not retain such records. Unpaid fees do not constitute justification for retention of client records. Although, in general, the accountant’s working papers are the property of the licensee, if such working papers include records which would ordinarily constitute part of the client’s

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books and records and are not otherwise available to the client, then the information on those working papers must be treated the same as if it were part of the client’s books and records.

A similar requirement exists in Texas under Rule Section 501.76 32

A person [licensee] shall return original client records to a client or former client within a reasonable time (promptly, not to exceed 10 business days) after the client or former client has made a request for those records. Client records are those records provided to the person by the client or former client in order for the person to provide professional accounting services to the client or former client. Client records also include those documents obtained by the person on behalf of the client or former client in order for the person to provide professional accounting services to the client or former client. Client records include only the original client documents and do not include the electronic and hard copies that the firm produces. The person shall provide these records to the client or former client, regardless of the status of the client’s or former client’s account and cannot charge a fee to provide such records. Such records shall be returned to the client or former client in the same format, to the extent possible, that they were provided to the person by the client or former client. The person may make copies of such records and retain those copies.

One of the most frequently violated rules of conduct is records retention. The failure to return client books and records in all likelihood would lead to a disciplinary action against the licensee by the state board of accountancy. Always remember that your state board issues your license to practice public accounting in the state as a CPA, and the state board can impose disciplinary action for violating the rules. Disciplinary action might include requiring specific continuing professional education hours. ** Disciplinary action also might include the suspension or revocation of the license to practice.

National Association of State Boards of Accountancy We briefly introduced the National Association of State Boards of Accountancy (NASBA) in Chapter 1. Founded in 1908, NASBA has served as an association dedicated to enhancing the effectiveness of the country’s 55 state boards of accountancy for more than 100 years. NASBA and its Member Boards are responsible for the nearly 700,000 accounting profes- sionals licensed in the 55 U.S. jurisdictions. NASBA creates a forum for accounting regula- tors and practitioners to address issues relevant to the accounting profession. One way it accomplishes its goal is through the Uniform Accountancy Act (UAA). Recall that in 2009, NASBA revised its Rule 5.2 on education and set an either/or approach that recommends either the integration of ethics course material throughout the undergraduate and/or graduate curriculum or a three-hour stand-alone course in ethics.

Students should be aware that their ability to move from state to state and practice public accounting as a licensed CPA without meeting additional requirements may be constrained by whether state board rules in your state of licensure are equal to or require more than another state you might move into. Under Section 23 of the UAA, a CPA with a license in good standing from a jurisdiction with CPA licensing requirements essentially

** Most states require as a condition of license renewal 40 hours of continuing education each year; 80 hours every two years; or 120 hours every three years. The majority of states also require that licensed CPAs complete a course in ethics and professional responsibility as part of the continuing education requirement.

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equivalent to those outlined in the UAA is deemed to be “substantially equivalent,” or a licensee who individually meets the requirements of:

• Obtaining 150 semester credit-hours (225 quarter-hours) with a baccalaureate degree • Minimum 1 year of CPA experience • Passing the Uniform CPA Examination

Uniform adoption of the UAA’s substantial equivalency provision creates a system similar to the nation’s driver’s license program by providing CPAs with mobility while retaining and strengthening state boards’ ability to protect the public interest. The system enables consumers to receive timely services from the CPA best suited to the job, regard- less of location, and without the hindrances of unnecessary filings, forms, and increased costs that do not protect the public interest.

As of May 2013, a total of 49 states and the District of Columbia have passed mobility laws and are now in the implementation and navigation phases. Only the Commonwealth of the Northern Mariana Islands, the Virgin Islands, Hawaii, Puerto Rico, and Guam have not passed mobility laws.

Professional Services of CPAs Rules of professional conduct, whether issued by the AICPA or a state board of accoun- tancy, apply to CPAs in public accounting, private industry, government, and education. The rules apply to a variety of professional services, including accounting, auditing and other assurance services, taxation, financial advisory services, and consulting services.

The practice of public accounting33 is defined under the AICPA Code as the performance for a client, by a member or member’s firm, while holding out as CPA(s) of the professional services of accounting, tax, personal financial planning, litigation support services, and those professional services for which standards are established by bodies designated by the AICPA ruling Council. Such standards include:

• Financial Accounting Standards, established by the Financial Accounting Standards Board (FASB)

• Statements on Auditing Standards, established by the AICPA for non-public companies • Auditing standards of the PCAOB for public company audits • Statements on Standards for Accounting and Review Services • Statements on Standards for Consulting Services • Statements of Governmental Accounting Standards • International Financial Reporting Standards (IFRS) and International Accounting

Standards set by the International Accounting Standards Board (IASB) • Statements on Standards for Attestation Engagements • Statements on Standards for Valuation Services

The cornerstone ethical obligation of a CPA to society is to render an opinion on the financial statements of an entity. An opinion is rendered after auditing or examining the financial statements of that entity. All publicly owned companies that sell stock on an established exchange such as the New York Stock Exchange (NYSE) and National Association of Securities Dealers (NASDAQ) are required by the SEC to have their financial statements audited annually and their interim financial information reviewed. A review provides only limited assurance that there are no material modifications that should be made to the financial statements in order for them to be in conformity with generally accepted accounting principles (GAAP), whereas an audit provides “reasonable assurance” that the financial statements are free of material misstatements. We explore auditing standards in Chapter 5.

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A CPA also might compile financial statements based on data provided by the client. Because a compilation entails putting together the statements from accounting data, both internal and external accountants can perform this service. Unlike the audit and review service, which cannot be performed by an external CPA unless that person is independent of the client, a compilation can be performed when independence is lacking, so long as there is disclosure of that fact to the client and any third-party users. The reason for not requiring independence with a compilation is that the CPA does not render an opinion along with the compiled statements.

SOX prohibits the performance of certain services for audit clients because it may cre- ate the appearance in the mind of a reasonable third party that independence is lacking. For example, bookkeeping services cannot be provided for audit clients. Auditors should not record transactions or prepare the financial statements for an entity under audit. To do so would create a conflict of interests that impairs independence because the auditor would be placed in the position of examining and reporting on his or her own work. The client’s management should prepare the financial statements. Typically, this means the account- ing department prepares the statements with oversight by the controller. In most publicly owned companies, the controller reports to the CFO. Recall that AICPA Interpretation 102-4 requires that when there is a difference of opinion between a controller and the CFO, specific steps should be taken to explore all avenues of change, including taking the matter to the audit committee of the board of directors.

The situation is a bit more complicated with respect to internal audit outsourcing services. SOX prohibits these services for audit clients because it might appear that the CPA is render- ing an independent opinion on work performed internally for the client in the form of internal auditing services. We might conclude that it is reasonable to expect a CPA firm that performs internal auditing services for an audit client to point out deficiencies in some area of the internal audit as part of the external examination—but will the CPA do so? The fact is that it doesn’t matter; the appearance that the CPA might not do it is enough to impair indepen- dence. A similar restriction exists for public companies reporting to the SEC. However, the AICPA is more lenient on these services and, instead of an outright ban, provides guidelines when such services can and cannot be provided. To perform internal audit assistance for a client and maintain independence, the CPA/CPA firm may not act—or appear to act—as a member of the client’s management. For example, the CPA/firm may not do the following: 34

• Make decisions on the client’s behalf • Report to the client’s governing body

To maintain independence, the client must do the following:

• Designate an individual or individuals who possess suitable skill, knowledge, and expe- rience to oversee the internal audit function

• Determine the scope, risk, and frequency of internal audit activities • Evaluate the findings and results of internal audit activities • Evaluate the adequacy of the audit procedures performed and related findings

The PCAOB oversees the audits of public companies in order to protect the interests of investors and further the public interest in the preparation of informative, accurate, and independent audit reports. The PCAOB establishes audit standards, ethics rules, independence requirements, quality controls for registered firms, and attestation stan- dards. Under Rule 2100, each public accounting firm that (1) prepares or issues any audit report with respect to any issuer, or (2) plays a substantial role in the preparation or furnishing of an audit report with respect to any issuer must be registered with the board. 35 We discuss PCAOB ethics standards later in this chapter and auditing standards in Chapter 5.

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AICPA and IFAC Principles of Professional Conduct

We discussed the Principles of the AICPA Code of Professional Conduct in Chapter 1. The principles include independence, integrity and objectivity, due care, and acting in the public interest. The ethical reasoning methods discussed in Chapters 1 and 2 help accounting professionals to reason through conflict situations, such as when the public interest conflicts with the interests of the client, and come to a decision consistent with the profession’s ethical standards. Ethical reasoning and judgment are critical components of ethical decision making. These skills can be learned through the application of philosophical reasoning methods. CPAs should use these techniques when the accounting rules are unclear, where there is a difference of opinion with an employer or client on an accounting issue, and when there are conflicts between the interests of stakeholder groups. The Integrity Principle best illustrates the link between ethical reasoning and professional judgment.

According to the AICPA Code, “ [Integrity] is measured in terms of what is right and just. In the absence of specific rules, standards, or guidance, or in the face of conflicting opinions, a [CPA] should test decisions and deeds by asking: “Am I doing what a person of integrity would do? Have I retained my integrity?” Integrity requires a [CPA] to observe both the form and the spirit of technical and ethical standards; circumvention of those standards constitutes subordination of judgment.” 36

The Handbook of the Code of Ethics for Professional Accountants (IFAC Code) issued by the IESBA in 2012 previously mentioned in this chapter provides what we believe to be a more foundational approach to defining the principles of professional behavior. These fundamental principles include Integrity, Objectivity, Professional Competence and Due Care, Confidentiality, and Professional Behavior. While the IFAC Code Principles may appear to be virtually the same as those in the AICPA Code, basic differences exist. Exhibit 4.2 summarizes the IFAC Principles.

Fundamental Principles 37 A professional accountant shall comply with the following fundamental principles:

a. Integrity—to be straightforward and honest in all professional and business relationships.

b. Objectivity—to not allow bias, conflict of interest, or undue influence of others to override professional or business judgments.

c. Professional Competence and Due Care—to maintain professional knowledge and skill at the level required to ensure that a client or employer receives competent professional services based on current developments in practice, legislation and techniques and act diligently and in accordance with applicable technical and professional standards.

d. Confidentiality—to respect the confidentiality of information acquired as a result of professional and business relationships and, therefore, not disclose any such information to third parties without proper and specific authority, unless there is a legal or professional right or duty to disclose, nor use the information for the personal advantage of the professional accountant or third parties.

e. Professional Behavior—to comply with relevant laws and regulations and avoid any action that discredits the profession.

EXHIBIT 4.2 IFAC Code Foundational Principles

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One difference is the explicit recognition of a standard for professional behavior that includes compliance with relevant laws and regulations and avoiding actions that bring discredit on the profession. Perhaps the AICPA took it for granted that the Principles in the AICPA Code implicitly addresses following laws and regulations, and these issues are addressed elsewhere, such as in the definition of the practice of public accounting. Nevertheless, explicit recognition highlights the point that ethical behavior is a combina- tion of following laws and exercising ethical and professional judgment as recognized in the IFAC Objectivity principle.

Another difference is the explicit recognition of a Confidentiality principle, rather than its treatment as a rule of conduct in the AICPA Code that tries to identify virtually all situations where disclosure of confidential client information may be an issue. The important point here is, unlike a rule of conduct that defines what can and cannot be done, a principles-based approach establishes the guidelines within which decisions are made about disclosure with the use of professional judgment to support that decision.

Conceptual Framework for AICPA Independence Standards

The AICPA uses a risk-based approach to assess whether a CPA’s relationship with a client would pose an unacceptable risk to the member’s independence. In the following discus- sion, we refer to “CPA” to replace the AICPA’s reference to “member.”

Risk is unacceptable if the relationship would compromise (or would be perceived as compromising by an informed third party knowing all the relevant information) the CPA’s professional judgment when rendering an attest service to the client (i.e., audit, review, or attestation engagement). Key to that evaluation is identifying and assessing the extent to which a threat to the CPA’s independence exists, and if it does, whether it would be reasonable to expect that the threat would compromise the CPA’s professional judgment and, if so, whether it can be effectively mitigated or eliminated. Under the risk-based approach, steps are taken to prevent circumstances that threaten independence from compromising the professional judgments required in the performance of an attest engagement. 38

The risk-based approach involves the following steps: 39

1. Identifying and evaluating threats to independence. 2. Determining whether safeguards already eliminate or sufficiently mitigate identified

threats and whether threats that have not yet been mitigated can be eliminated or sufficiently mitigated by safeguards.

3. If no safeguards are available to eliminate an unacceptable threat or reduce it to an acceptable level, independence would be considered impaired.

Threats to Independence Independence in fact is defined as the state of mind that permits the performance of an attest service without being affected by influences that compromise professional judgment, thereby allowing an individual to act with integrity and professional skepticism. To appear to be independent, the CPA should avoid circumstances that might cause an informed third party to reasonably conclude that the integrity, objectivity, or professional skepticism of a firm or member of the audit (attest) engagement team has been compromised.

Threats to independence include a self-review threat, advocacy threat, adverse interest threat, familiarity threat, intimidation threat, financial self-interest threat, and management participation threat. A brief description of each threat is given below, and Exhibit 4.3 provides examples of each threat.

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Self-Review Threat A self-review threat occurs when a CPA reviews evidence during an attest engagement that is based on her own or her firm’s nonattest work. An example would be preparing source documents used to generate the client’s financial statements.

Advocacy Threat An advocacy threat occurs when a CPA promotes an attest client’s interests or position in such a way that objectivity may be, or may be perceived to be, compromised.

Adverse Interest Threat An adverse interest threat occurs when a CPA takes actions that are in opposition to an attest client’s interests or positions.

Familiarity Threat A familiarity threat occurs when a close relationship is formed between the CPA and an attest client or its employees, members of top management, or directors of the client entity, including individuals or entities that performed nonattest work for the client (i.e., tax or consulting services).

Undue Influence Threat An undue influence threat results from an attempt by the management of an attest client or other interested parties to coerce the CPA or exercise excessive influence over the CPA.

Financial Self-Interest Threat A financial self-interest threat occurs when there is a potential benefit to a CPA from a financial interest in, or from some other financial relationship with, an attest client.

Management Participation Threat A management participation threat occurs when a CPA takes on the role of client manage- ment or otherwise performs management functions on behalf of an attest client.

Threat Example Self-Review Threat Preparing source documents used to generate the client’s

financial statements.

Advocacy Threat Promoting the client’s securities as part of an initial public offering or representing a client in U.S. tax court.

Adverse Interest Threat Commencing, or the expressed intention to commence, litigation by either the client or the CPA against the other.

Familiarity Threat A CPA on the attest engagement team whose spouse is the client’s CEO.

Undue Influence Threat A threat to replace the CPA or CPA firm because of a disagreement with the client over the application of an accounting principle.

Financial Self-Interest Threat Having a loan from the client, from an officer or director of the client, or from an individual who owns 10 percent or more of the client’s outstanding equity securities.

Management Participation Threat Establishing and maintaining internal controls for the client.

EXHIBIT 4.3 Examples of Threats to Independence

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Safeguards to Counteract Threats Safeguards are controls that eliminate or reduce threats to independence. These range from partial to complete prohibitions of the threatening circumstance to procedures that counteract the potential influence of a threat. The nature and extent of the safeguards to be applied depend on many factors, including the size of the firm and whether the client is a public interest entity. To be effective, safeguards should eliminate the threat or reduce to an acceptable level the threat’s potential to impair independence. 40

There are three broad categories of safeguards. The relative importance of a safeguard depends on its appropriateness in light of the facts and circumstances.

1. Safeguards created by the profession, legislation, or regulation. For example, continuing education requirements on independence and ethics and external review of a firm’s quality control system.

2. Safeguards implemented by the attest client, such as a tone at the top that emphasizes the attest client’s commitment to fair financial reporting and a governance structure, such as an active audit committee, that is designed to ensure appropriate decision making, oversight, and communications regarding a firm’s services.

3. Safeguards implemented by the firm, including policies and procedures to implement professional and regulatory requirements.

Financial Relationships That Impair Independence To avoid violating the independence standard, a CPA should not own a direct or material indirect financial interest in the client. This would create a financial self-interest threat. The ownership of even one share of stock precludes independence. The CPA also should not own a material indirect financial interest in a client, such as through ownership of a mutual fund that includes the client entity’s stock. The problem with owning direct and material indirect financial interests is that these arrangements might create the impression in the mind of an outside observer that the CPA cannot make decisions without being influenced by the stock ownership, even if that is not the case for any specific CPA. The logical conclusion is that the auditor’s opinion would be tainted by the existence of these relationships.

Another example of a financial self-interest threat is when a CPA becomes involved in a loan transaction to or from a client, including home mortgage loans from financial institution clients. This type of loan is prohibited under Interpretation 101-5. According to 101-5, independence is considered to be impaired if during the period of the profes- sional engagement, a covered member, such as a CPA on the attest engagement team or an individual in a position to influence the attest engagement team, has any loan to or from a client, any officer or director of the client, or any individual owning 10 percent or more of the client’s outstanding equity securities or other ownership interests.

Examples of permitted loans include automobile loans and leases collateralized by the automobile, loans fully collateralized by cash deposits at the same financial institution (e.g., “passbook loans”), and aggregate credit card balances from credit cards and over- draft reserve accounts that are reduced to $10,000 or less on a current basis, taking into consideration the payment due and any available grace period. 41

Perhaps no other situation illustrates the danger of a CPA accepting loans from a client more than that of Jose Gomez, the lead partner of Alexander Grant (now Grant Thornton) during its audit of ESM Government Securities from 1977 to 1984. Over the eight-year period, ESM committed fraud and, in the process, used its leverage against Gomez from $200,000 in loans to him so he would keep silent about the fact that ESM’s

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financial statements did not present fairly financial position and the results of operations. Top management of ESM also threatened to pull the audit from Gomez’s firm if he spoke out about the fraud. Gomez compromised his integrity, and the event ruined his reputa- tion. Ultimately, Gomez was sentenced to a 12-year prison term and served 4½ years, and the firm paid approximately $175 million in civil payments. 42

AICPA Interpretation 101-1 extends the Independence rule to certain family members of the CPA. The detailed provisions of this Interpretation are beyond the scope of this book, but we do want to emphasize two points to provide examples of familiarity threats to independence. First, when a CPA is part of the attest engagement team, which includes employees and contractors directly involved in an audit and those who perform concurring and second partner reviews, the rules extend to that CPA’s immediate family members and close relatives. The former include the CPA’s spouse, spousal equivalent, and dependents (whether or not they are related). These family members come under the Independence rules. The rules also extend to the CPA’s close relatives, including parents, siblings, or nondependent children if they hold a key position with the client (that is, one that involves direct participation in the preparation of the financial statements or a position that gives the CPA the ability to exercise influence over the contents of the financial statements). Close relatives are subject to the Independence rule if they own a financial interest in the client that is material to that person’s net worth and of which the CPA has knowledge, or if they own a financial interest in the client that enables the close relative to exercise significant influence over the client. The potential danger in these family relationships is that the family member’s financial or employment relationship with the client might influence the perception that the CPA can be independent in fact or appearance. One problem with the rule is that the CPA might feign ignorance of the ownership interest even though he is aware of it—an unethical act.

There are other relationships that will bring a CPA under the Independence rules, including when a partner or manager provides 10 hours or more of nonattest services to the attest client. The problem is it may appear to an outside observer that the partner or manager may be able to influence the attest work because of the significant number of hours devoted to the nonattest services.

Let’s stop at this point and consider that the Independence rule is a challenging standard for the CPA and family members to meet, and it might present some interesting dilemmas. For example, imagine if a CPA knows that his or her father owns a financial interest in a client entity but does not know if that interest is material to the father’s net worth. Should the CPA contact the father to find out? Or, might the CPA reason that it is better not to know because the Independence rule applies only if the CPA has knowledge of the extent of the father’s financial interest in the client? From an ethical perspective, the CPA should make a good-faith effort to determine the extent of the father’s financial interest in the client entity.

Providing Nonattest Services to an Attest Client As previously mentioned in our review of congressional investigations, the issue of when should a CPA be permitted to provide nonattest services to an attest client has been exam- ined for many years. The concern is that by providing certain nonattest services for an attest client, the CPA risks creating a conflict of interest that gives the client leverage over the CPA firm and its audit opinion. An example of a prohibited activity under AICPA and SEC rules is that a CPA should not perform management functions or make management decisions for an attest client. The relationship creates a management participation threat that places the CPA in the compromising position of making decisions for the client and then auditing those decisions. On the other hand, the CPA may provide advice, research

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Chapter 4 AICPA Code of Professional Conduct 195

materials, and recommendations to assist the client’s management in performing its func- tions and making decisions.

Interpretation 101-3 establishes requirements that must be met during the period covered by the financial statements and the period of the attest engagement by the CPA in order to conduct nonattest services for the client without impairing audit independence. The client must agree to perform the following functions in connection with the nonattest engagement: (1) make all management decisions and perform all management functions; (2) designate an individual who possesses suitable skill, knowledge, and/or experience, preferably within senior management, to oversee the services; (3) evaluate the adequacy and results of the services performed; and (4) accept responsibility for the results of the services. 43

SEC Position on Auditor Independence

Publicly owned companies have been obligated to follow SEC rules since the passage of the Securities Act of 1933 and the Securities and Exchange Act of 1934. The PCAOB has taken some of that responsibility away from the SEC, while at the same time requiring the SEC to adopt final rules on auditor independence. We will examine the PCAOB rules later in this chapter.

The SEC approach to independence emphasizes independence in fact and appear- ance in three ways: (1) proscribing certain financial interests and business relationships with the audit client, (2) restricting the provision of certain nonauditing services to audit clients, and (3) subjecting all auditor conduct to a general standard of indepen- dence. The general standard of independence is stated as follows: “The Commission will not recognize an accountant as independent, with respect to an audit client, if the accountant is not, or a reasonable investor with knowledge of all relevant facts and circumstances would conclude that the accountant is not, capable of exercising objective and impartial judgment on all issues encompassed within the accountant’s engagement.”

The general standard of independence is evaluated by applying four principles that are similar to the AICPA’s conceptual framework and that indicate when auditor independence may be impaired by a relationship with the audit client. If a situation results in any of the following, the auditor’s independence may be impaired: (1) creates a mutual or conflict- ing interest between an accountant and his audit client, (2) places an accountant in the position of auditing her own work, (3) results in an accountant acting as management or an employee of the audit client, and (4) places an accountant in a position of being an advocate for the audit client. 44

The SEC believes that these principles are “general guidance and their application may depend on particular facts and circumstances . . . [but they do] provide an appropriate framework for analyzing auditor independence issues.” To provide further guidance on implementing the principles, the SEC identified three basic overarching principles that underlie auditor independence: (1) an auditor cannot function in the role of management, (2) an auditor cannot audit her own work, and (3) an auditor cannot serve in an advocacy role for his client.

SEC Actions Against Auditing Firms Over the years, the SEC has brought actions against auditing firms for violating the independence rules. The cases are instructive and illustrate the failure of the auditing profession to adhere to both the form and the spirit of the independence rules, and therefore violate the public trust. We use the PeopleSoft case and an insider trading case as illustrations.

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196 Chapter 4 AICPA Code of Professional Conduct

The PeopleSoft Case On April 16, 2004, the SEC sanctioned Ernst & Young LLP (EY) because it was not independent in fact or appearance when it audited the financial statements of PeopleSoft for fiscal years 1994–1999. The SEC’s sanctions included a six-month suspension from accepting new SEC audit clients, disgorgement of audit fees (more than $1.6 million), an injunction against future violations, and an independent consultant report on its indepen- dence and internal quality controls. 45

The SEC found independence violations arising from EY’s business relationships with PeopleSoft while auditing the company’s financial statements. These relationships created a mutuality of interests between the firm and PeopleSoft, resulting in a financial self-interest threat.

The SEC action against EY states that the firm violated independence standards in its business dealings with PeopleSoft as a result of the relationship that developed between the two entities with respect to EY’s Global Expatriate Management System (EY/GEMS). EY’s Tax Group developed this in-house software program for assisting clients with the tax consequences of managing employees with international assignments. The EY/GEMS system was enhanced with the use of PeopleTools, a software product created by EY’s audit client, PeopleSoft. A business relationship was created whereby a license to use PeopleTools was granted to EY in return for a payment to PeopleSoft of 15 percent of each licensee fee that EY received from outside customers purchasing the new software, 30 percent of each license renewal fee, and a minimum royalty of $300,000, payable in 12 quarterly payments of $25,000 each.

The licensing agreement provided that EY would make PeopleSoft a third-party ben- eficiary of each sublicense. PeopleSoft agreed to assist EY’s efforts by providing technical assistance for a $15,000 quarterly fee. The agreement provided that EY could not distribute the derivative software to PeopleSoft’s direct competitors. The agreement permitted EY to use PeopleSoft trademarks and trade names in marketing materials. PeopleSoft maintained a degree of control over the product by restricting EY’s distribution rights and requiring the firm to work closely with PeopleSoft to ensure the quality of the product.

The SEC found that EY and PeopleSoft had a “symbiotic relationship” engaging in joint sales and marketing efforts and sharing considerable proprietary and confidential business information, and that EY partnered with PeopleSoft to accomplish increased sales and boost consulting revenues for EY. The findings of the SEC indicate that EY and PeopleSoft entered into a direct business relationship and shared a mutual interest in the success of EY/GEMS for PeopleSoft and acted together to promote the product so that a reasonable investor with knowledge of all the facts would conclude that EY was closely identified in fact and appearance with its audit client.

Brenda P. Murray, the chief administrative law judge at the SEC, wrote in her opinion that “Ernst’s day-to-day operations were profit-driven and ignored considerations of auditor inde- pendence.” She pointed out some failings in EY’s quality control monitoring system, includ- ing that (1) EY did not give its employees any formal training on a regular basis concerning the independence rules on business dealings with an audit client; (2) EY had no procedures in place that could reasonably be expected to deter violations and ensure compliance with the rules on auditor independence with respect to business dealings with audit clients; and (3) EY maintained a self-reporting system for firm partners and employees to report whether they abided by the firm’s independence policies. There was no threat of random verification, a control that the SEC believes is essential to an effective independence compliance system.

Insider Trading Scandals Damage the Reputation of the Accounting Profession: Former KPMG Audit Partner, Scott London What possesses an audit partner to trade on inside information and violate the account- ing profession’s most sacred ethical standard of audit independence? Is it carelessness,

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greed, or ethical blindness? In the case of Scott London, the former partner in charge of the KPMG’s Southern California’s regional audit practice, it was a bit of each fueled by egoistic behavior that motivated him to violate ethical standards and, in the course of doing so, causing the audit opinions signed by London on Skechers and Herbalife to be withdrawn by the accounting firm.

On April 11, 2013, the SEC charged London with leaking confidential information to his friend, Brian Shaw, about Skechers, and Herbalife. The leak of information about quarterly earnings information led to Shaw’s unjust enrichment of $1.27 million. Shaw, a jewelry store owner and country club friend of London, repaid London with $50,000 in cash and a Rolex watch, according to legal filings. Shaw was also charged in the case. 46

It did not take long for both Shaw and London to admit their guilt in the insider trad- ing matter. On May 21, 2013, Shaw pleaded guilty to a conspiracy charge and agreed to turn over $1.27 million of ill-gotten stock gains. Just one week later on May 28, London pleaded guilty to securities fraud for providing confidential information about KPMG clients to Shaw.

The leaking of financial information about a company to anyone prior to its public release affects the level playing field that should exist with respect to personal and business contacts of an auditor and the general public. It violates the fairness doctrine in treating equals, equally, and it violates basic integrity standards. Such actions cut to the core values of integrity and trust—the foundation of our free enterprise system.

Former Deloitte & Touche Management Advisory Partner, Thomas Flannigan In 2010, Deloitte and Touche found itself involved in an SEC investigation of repeated insider trading by Thomas P. Flanagan, a former management advisory partner and a vice chairman at Deloitte and Touche LLP. Flanagan traded in the securities of multiple Deloitte clients on the basis of inside information that he learned through his duties as a Deloitte partner. The inside information concerned market-moving events such as earnings results, revisions to earnings guidance, sales figures and cost cutting, and an acquisition. Flanagan’s illegal trading resulted in profits of more than $430,000.

Flanagan also tipped his son, Patrick, to certain of this material nonpublic information. Patrick then traded based on that information. Patrick’s illegal trading resulted in profits of more than $57,000. Here is a summary of the facts of the filing by the SEC: 47

• Defendants Thomas and Patrick Flanagan directly and indirectly engaged in transac- tions, acts, practices, and courses of business that violated Section 10(b) of the Securities Exchange Act of 1934.

• The commission brought the action seeking a permanent injunction, disgorgement of trading profits plus prejudgment interest, and civil penalties.

• Between 2003 and 2008, Thomas Flanagan made 71 purchases of stock and options in the securities of Deloitte audit clients. Flanagan made 62 of these purchases in the securities of Deloitte audit clients while serving as the advisory partner on those audits.

• On at least nine occasions between 2005 and 2008, Thomas Flanagan traded on the basis of material nonpublic information of Deloitte clients, including Best Buy, Motorola, Sears, and Option Care.

The SEC charged that Thomas and Patrick Flanagan, in connection with the purchase and sale of the securities of these Deloitte clients, “by use of the means and instrumen- talities of interstate commerce and of the mails, directly and indirectly employed devices, schemes, and artifices to defraud, made untrue statements of material facts, and omitted to state material facts necessary in order to make the statements made, in the light of the cir- cumstances under which they were made, not misleading; and engaged in acts, practices,

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and courses of business which operated as a fraud and deceit upon the purchasers and sellers of such securities.” 48

These cases illustrate the risk to audit independence when audit engagement team mem- bers, including partners, trade on information that is not publicly available. Beyond that, the use of sensitive financial information about a client for personal reasons violates the independence requirement because it creates a financial self-interest relationship between the partner and the client.

SOX Provisions

Similar to AICPA and SEC rules, SOX prohibits CPAs and CPA firms from providing certain nonattest services for public company attest clients. The potential for a conflict of interest exists because of a self-review threat to independence that occurs when a CPA reviews, as part of an attest engagement, evidence that results from the CPA’s own nonat- test services. 49

As previously discussed, the accounting profession had successfully fought challenges to restrict nonattest services for attest clients up until the passage of SOX in 2002. The Enron scandal was the tipping point in the relationship between auditors and their cli- ents. Andersen’s revenue from Enron in its last year was $25 million in audit fees and $27 million in nonaudit fees. The firm had performed significant internal auditing work for Enron, creating a self-review threat. Given that the firm seemed to have adopted a hands-off approach on certain accounting issues, the impression was that the firm had lost its independence. Perhaps the close relationship between Andersen professionals and Enron employees was attributable to the internal audit services. If so, the relationship may have affected Andersen’s ability to approach audit issues with the professional skepticism required by audit standards and essential in making ethical judgments. It didn’t help that dozens of former Andersen employees worked for Enron, or that both entities had offices in the same building.

Restrictions on Nonattest Services Section 201 of SOX provides that the following nonattest services may not be performed for attest clients in addition to bookkeeping or other services related to the accounting records or financial statements of the audit client:

1. Financial information systems design and implementation 2. Appraisal or valuation services, fairness opinions, or contribution-in-kind reports 3. Actuarial services 4. Internal audit outsourcing services 5. Management functions or human resources 6. Broker or dealer, investment adviser, or investment banking services 7. Legal services and expert services unrelated to the audit 8. Any other service that the board of directors determines, by regulation, is impermissible

The Act also requires that tax services provided for the audit client should be pre- approved by the audit committee. Tax services are not restricted under the Act, but an audit committee may decide to help gain the public trust by not permitting the auditing firm to do taxes. As will be mentioned later in the chapter, the PCAOB restricts certain kinds of tax services and fee payment arrangements.

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Corporate Responsibility for Financial Reports Under SOX At the conclusion of an audit, it has been customary for the CEO and CFO to sign a letter of representation or other communication to the external auditor on behalf of the client about the GAAP conformity of the financial statements. This management representation is similar to the requirement in Section 302 of SOX that the CEO and CFO certify the financial statements filed with the SEC. The certification states that “based on the officer’s knowledge, the report does not contain any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements, in light of the circumstances under which such statements were made, not misleading.” Section 906 of SOX establishes penalties for the false certification of financial statements under Section 302. The maximum fine is $1 million and maximum imprisonment is 10 years, or both. If the false certifica- tion was made willfully, the penalties go up to $5 million and 20 years, or both. 50 An officer who signs such a compliance statement while knowing that the financial statements contain a material misstatement compromises the relationship of trust that should exist between top management and the external auditor.

An important issue to consider is whether SOX’s certification requirement serves as a deterrent to fraudulent financial statements. Karen Seymour was the chief of the criminal division of the U.S. Attorney’s Office in Manhattan in 2002 when SOX was passed by Congress. The U.S. Attorney’s Office in Manhattan is regarded as the country’s most prolific prosecutor of financial crimes. Seymour had high hopes for the Act when it was passed. In an interview with Reuters news agency on July 27, 2012, about the effectiveness of the Act during the 10-year period since it became law, Seymour shared that when she read SOX’s certification provisions, which specify that CEOs and CFOs can be sent to prison for falsely certifying corporate financial reports and reports on internal controls, she thought she finally had a way of getting at wrongdoing by top officials. “I thought it was going to be a really good tool, but it never really developed,” she said. 51

Seymour stated that in practice, exceedingly few defendants have even been charged with false certification, and fewer still have been convicted. The most notorious SOX criminal case, against former HealthSouth CEO Richard Scrushy that is discussed below (and was covered to some extent in Chapter 3 as well), ended in an acquittal in 2005. In 2007, the former CFO of a medical equipment financing company called DVI pleaded guilty to mail fraud and false certification and was sentenced to 30 months in prison. In a more recent case, a SOX false certification charge against former Vitesse CEO Louis Tomasetta was dismissed. (Tomasetta’s trial on other charges ended in a mistrial in April 2012.) 52 The Justice Department doesn’t directly track SOX prosecutions, so there may be other cases. Nevertheless, with only four or five criminal cases in 10 years, we have to wonder about the effectiveness of the law.

HealthSouth: The Case of Richard Scrushy The first major test case of Section 302 occurred in 2003 when the SEC charged the CEO of HealthSouth Corporation, Richard Scrushy, and the CFO, William T. Owens, with certifying financial statements filed with the SEC on August 14, 2002, that they knew (or were reckless in not knowing) contained materially false and misleading information. Other accounting personnel also were charged with participating in the falsification of HealthSouth’s financial statements during the 1999–2002 reporting periods. The alleged fraud led to an earnings restatement of about $2.7 billion. 53

The HealthSouth story is a sad one, in that Scrushy was acquitted of all charges that he participated in the fraud and cover-up. Scrushy served as chair of the board at HealthSouth from 1984 through early 2003. He also served as CEO during that time, except for periods in late 2002 and early 2003. Still, the jury chose to believe Scrushy’s claims of ignorance,

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even though five HealthSouth financial and accounting officers (including William Owens) had admitted to their roles in the fraud and had accused Scrushy of knowing about it. As U.S. District County Judge Sharon Lovelace Blackburn stated on December 9, 2005, before sentencing Owens to five years in prison for his part in the financial scandal, “life is not always fair” and the sentence “should be sufficient to serve as a deterrent and provide just punishment.” 54

Even though Scrushy was acquitted in state court, the SEC brought a federal action against him that was successful and that led to the following sanctions/penalties:

• Permanently barred Scrushy from serving as an officer or director of a public company • Permanently enjoined Scrushy from committing future violations of the antifraud and

other provisions of the federal securities laws • Required Scrushy to pay $81 million in disgorgement and civil penalties 55

The HealthSouth case is discussed in greater detail in Case 4-8 at the end of this chapter.

Integrity and Objectivity

We discussed the Integrity and Objectivity Principles in Chapter 1. Rules of conduct exist to describe the requirements of these standards and when they might be violated under AICPA Code Section 100. Rule 102 of the Code provides that in the performance of any professional service, a CPA should maintain objectivity and integrity, be free of conflicts of interest, and not knowingly misrepresent facts or subordinate her judgment to others. Recall that Interpretation 102-4 provides specific steps to be taken by internal accountants and auditors who are CPAs and members of the AICPA when differences exist over the proper reporting of financial statement items to avoid subordinating judgment to a superior and top management, a violation of integrity. The Standards of Ethical Professional Practice of the Institute of Management Accountants, which was also discussed in Chapter 1, provides a procedure to resolve ethical conflict that mirrors the steps in Interpretation 102-4. The Code of Ethics of the Institute of Internal Auditors, which was discussed in Chapter 3, also includes the ethical requirements of integrity and objectivity.

Interpretations of the Integrity and Objectivity rules in the AICPA Code identify specific instances when the integrity and objectivity standards may be violated, including:

Interpretation 102-1. • Knowingly misrepresenting facts by making, or permitting or directing others to make,

materially false and misleading entries in an entity’s financial statements or records; failing to correct an entity’s financial statements or records that are materially false and misleading when authority exists to record an entry; or signing, or permitting or directing another to sign, a document containing materially false and misleading information.56 A good example is the knowing certification of financial statements by the CEO and CFO of financial statements in violation of Rule 302 of SOX.

Interpretation 102-2. • Becoming involved in a conflict of interest relationship with another party, such as

when a CPA performs a professional service for a client or employer and the CPA or his or her firm has a relationship with another person, entity, product, or service that could, in the CPA’s professional judgment, be viewed by the client, employer, or other appropriate parties as impairing the member’s objectivity. If the CPA believes that the professional service can be performed with objectivity, and the relationship is disclosed

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Chapter 4 AICPA Code of Professional Conduct 201

to and consent is obtained from such client, employer, or other appropriate parties, the professional service can be performed.57 One example is when a CPA is asked to perform litigation services for the plaintiff in connection with a lawsuit filed against a client of the member’s firm. This would create an adverse interest threat to objectivity and inde- pendence, if audit services are provided. Another example is when a CPA recommends or refers a client to a service bureau in which the CPA or partner(s) in the CPA firm hold material financial interest(s). This type of relationship creates a financial self-interest threat because of the material joint business arrangement with the client.

Interpretation 102-3. • This interpretation relates to Interpretation 102-4 that has been discussed previously

in Chapter 1 in this chapter and provides that in dealing with an employer’s external accountant, an internal accountant and internal auditor must be candid and not know- ingly misrepresent facts or knowingly fail to disclose material facts.58 This would include, for example, responding to specific inquiries for which his or her employer’s external accountant requests written representation . The failure of an internal accoun- tant to respond truthfully to requests for information from the external auditor makes it extremely difficult for the external auditor to carry out her professional responsibilities in accordance with the profession’s ethical standards.

Let’s pause for a moment and return to the ethical standards of the IESBA. In describing its conceptual framework approach, the IESBA takes a broader view than the AICPA, stat- ing that “the circumstances in which professional accountants operate may create specific threats to compliance with fundamental principles. 59 The IESBA takes a broader approach to these threats linking their existence to basic principles, not just independence. This makes more sense to us because threats to objectivity may exist when certain relationships exist between auditor and client, or when client management creates conflicts of interest. Even though auditing services may not be performed for the client and independence is not required, a possible impairment of objectivity (and integrity) exists because of these conflicting relationships.

Principles of Professional Practice

Section 200 of the AICPA Code defines the basic principles that establish requirements to follow professional standards in the practice of public accounting. By following these require- ments, the CPA can demonstrate adherence to the technical standards of the profession includ- ing GAAP, generally accepted auditing standards (GAAS), standards for accounting and review services (SSARS), and the AICPA Statements on Standards for Tax Services (SSTS).

Due Care in the Performance of Professional Responsibilities Underlying the requirement to follow technical and professional standards is the Due Care requirement under Rule 201. Exercising due care means to perform services competently, accurately, and completely. It relates to the quality of an audit and is a critical component of virtue because the pursuit of excellence relies on a careful, thoughtful process of deci- sion making when forming professional judgments.

Whereas independence, integrity, and objectivity relate to the quality of the individual CPA who performs professional services, the Principle of Due Care addresses the quality of services performed by the CPA. The codes of the Institute of Management Accountants (IMA) and Institute of Internal Auditors (IIA) that were first discussed in Chapters 1 and 3 contain competency standards that are similar to the AICPA’s Due Care standard.

Rule 201 of the AICPA Code establishes standards for professional competence, due professional care, planning and supervision, and obtaining of sufficient relevant data. Interpretation 201-1 of the rule also requires that a CPA gain the competence to perform

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services, if necessary, by consulting with experts in the area of those services. If a CPA is unable to gain sufficient competence, then an option exists, “in fairness to the client and the public,” to engage “someone competent to perform the needed professional service, either independently or as an associate.” 60

CPAs should be sensitive to situations when one’s capabilities are limited and the con- servative action is to recommend another practitioner to perform the services. For example, a CPA or CPA firm should not undertake an audit of a school district without sufficient knowledge of generally accepted government accounting and auditing standards. Think of it this way: An accounting student who works on a group project with other students to develop a business plan might feel comfortable working on the financial plan, but presum- ably that student would not want to be responsible for developing the marketing plan. He would expect a marketing student to assume that responsibility. Professional and technical standards address a variety of services performed by CPAs including audits, reviews and compilations, consulting and tax standards.

Rule 202 obligates a CPA to follow the technical standards of the profession previ- ously mentioned. Rule 203 obligates CPAs to ensure that the financial statements and disclosures conform to GAAP before rendering an opinion that the statements comply with those accounting standards. On July 1, 2009, the FASB issued the FASB Standards Codification, which became the official source of authoritative, nongovernmental GAAP. A new research structure to access GAAP exists. There are now two sources of GAAP: (1)  authoritative standards (i.e., FASB Standards and Interpretations and Technical Bulletins), represented by the Codification; and (2) nonauthoritative standards, represented by all other literature.

Interpretation 203-1 emphasizes that there is a strong presumption that adherence to GAAP would, in nearly all instances, result in financial statements that are not misleading. Rule 203 recognizes that, in some (limited) cases, there may be unusual circumstances when the literal application of GAAP would have the effect of making financial statements misleading. In such cases, the CPA should choose an accounting treatment that will ren- der the financial statements not misleading. The question then becomes what constitutes “unusual circumstances.” According to Rule 203, the decision is a matter of “professional judgment involving the ability to support the position that adherence to a promulgated principle within GAAP would be regarded generally by reasonable persons as producing misleading financial statements.” 61

An interesting element of this non-GAAP compliance exception is that it relies on professional judgment. Recall our discussions about professional judgment and its link to ethical behavior. In Rest’s model, discussed in Chapter 2, the ability to make ethical, professional judgments by applying moral reasoning methods is an essential component of ethical decision making. So, here is another link between our discussion of the philosophy of ethics and the ethical behavior of accountants.

Interpretation 203-4 emphasizes that GAAP requirement applies equally to internal and external accountants. 62 Rule 203 provides, in part, that a CPA shall not state affirmatively that financial statements or other financial data of an entity are presented in conformity with GAAP if such statements or data contain any departure from an accounting principle promulgated by a body designated by the AICPA Council to establish such principles that has a material effect on the statements or data taken as a whole (i.e., FASB).

Rule 203 applies to all CPAs with respect to any statement that financial statements or other financial data are presented in conformity with GAAP. Representation regarding GAAP conformity included in a letter or other communication from a client entity to its auditor or others related to that entity’s financial statements is subject to Rule 203 and may be considered an affirmative statement within the meaning of the rule with respect to CPAs who signed the letter or other communication (for example, signing reports to regulatory

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Chapter 4 AICPA Code of Professional Conduct 203

authorities, creditors, and auditors). This would include SOX certifications under Section 302 of the Act previously discussed.

Interpretation 203-5 recognizes the importance of international accounting standards in preparing financial reports. We discuss IFRS further in Chapter 8. This interpretation does not preclude a CPA from preparing or reporting on financial statements that have been prepared pursuant to financial reporting frameworks other than GAAP, such as (1) financial reporting frameworks generally accepted in another country, including juris- dictional variations of IFRSs such that the entity’s financial statements do not meet the requirements for full compliance with IFRSs as promulgated by the IASB; (2) financial reporting frameworks prescribed by an agreement or a contract; or (3) another compre- hensive basis of accounting, including statutory financial reporting provisions required by law or a U.S. or foreign governmental regulatory body to whose jurisdiction the entity is subject. When financial statements are prepared under a non-GAAP reporting framework, the CPA should not indicate in any way that those statements are GAAP-compliant, and it should be made clear which financial reporting framework(s) have been used. 63

Responsibilities to Clients

Section 300 of the AICPA Code establishes important standards that directly address a CPA’s responsibilities to clients. The first, Rule 301 on confidential client information, emphasizes the CPA’s obligation not to divulge client information. The second, Rule 302 on contingent fees, clarifies when contingent fees can and cannot be accepted as a form of payment for services.64

Confidentiality of Client Information Generally, a CPA should not divulge confidential client information unless the client spe- cifically agrees. The client may consent, for example, when there is a change of auditor and the successor auditor approaches the client for permission to discuss matters related to the audit with the predecessor. This step is required by GAAS. Of course, the client can always deny permission and cut off any such contact, in which case the successor auditor probably should run in the opposite direction of the client as quickly as possible. In other words, the proverbial “red flag” will have been raised. The CPA should be skeptical and wonder why the client may have refused permission.

Rule 301 also permits the CPA to discuss confidential client information without violating the rule in the following situations: (1) in response to a validly issued subpoena or summons, or to adhere to applicable laws and government regulations (i.e, Dodd-Frank Financial Reform Act); (2) to provide the information necessary for a review of the CPA’s professional practice (inspection/quality review) under PCAOB, AICPA, state CPA society, or board of accountancy authorization; and (3) to provide the information necessary for one’s defense in an investigation of the CPA in a disciplinary matter. 65

Conflicts of interest can arise in the course of deciding confidentiality issues. A clas- sic case occurred in the early 1980s— Fund of Funds Ltd. v. Arthur Andersen & Co. In that case, Arthur Andersen had issued an unqualified opinion on the audit of Fund of Funds, and then essentially the same audit team began the audit of King Resources, a natural resource company whose stock was part of the mutual funds holdings of Fund of Funds. Andersen had learned during its audit of King Resources that King’s natural resource holdings were overvalued, which affected the investment’s value as it related to Fund of Funds. Rather than withdrawing from the audit upon learning that there was a relationship between two of Andersen’s clients, the firm decided not to tell Fund of Funds. Andersen was probably concerned about a lawsuit if it had told the mutual fund company; instead, the firm gambled that the company would not find out that King’s

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natural resource properties were overstated, thereby rendering the company’s investment much less valuable. 66

King Resources went bankrupt, and the investors in Fund of Funds sued Andersen, claiming that the auditors should have disclosed that the properties were overvalued. The firm claimed a confidentiality obligation to King Resources in its defense, but the court did not buy it. The court found that the auditors were liable of, among other things, failing to use information that they had obtained from another client (King) to determine which of the two clients’ financial statements accurately portrayed the facts of the same transac- tion. 67 At the time, it was thought that a legal precedent might exist for holding an auditor liable for failing to disclose and use information obtained from services rendered to one client that is relevant to the audit of another client.

While the above case illustrates where silence was deemed inappropriate, Cashell and Fuerman 68 point out there have been several cases that support the CPA’s lack of obligation to disclose fraud to outsiders. One common characteristic in these cases is that the CPA was either not engaged to, or did not, report on the fraudulent financial information. Two such cases of note are Fischer v. Kletz and Gold v. DCL.

In Fischer v. Kletz, 69 Peat, Marwick, Mitchell, & Co. (now KPMG), subsequent to issu- ing its audit report on the 1963 annual financial statements of Yale Express System, Inc., discovered that they were substantially false and misleading. The firm also discovered that several 1964 interim statements, with which it was not associated, were also false and mis- leading. The firm delayed disclosing its findings to the SEC and the public until May 1965.

One of the plaintiff’s claims against Peat Marwick was that it aided and abetted Yale’s scheme to defraud with respect to the interim statements. The court reasoned that there was no basis in law for imposing a duty upon the firm to disclose its knowledge of the misleading interim statements because it was not associated with the statements. † In the second case, Gold v. DCL Inc., 70 Price Waterhouse, & Co. (now Pricewater houseCoopers) informed DCL in December 1971 that it intended to qualify its audit report on DCL’s 1971 financial statements. DCL was in the business of leasing computers, and the firm believed that DCL’s ability to recover their computer equipment costs was impaired due to the impending release of a new line of more powerful computers by IBM. On February 8, 1972, DCL announced earnings without mentioning Price Waterhouse’s concern, and on February 15, prior to issuing their opinion, the firm was replaced.

In this case, the plaintiff claimed Price Waterhouse failed to inform the public that the financial information released by DCL on February 8 was, in its opinion, incomplete and misleading. The court, in dismissing this claim, ruled that there is no basis in principle or authority for extending an auditor’s duty to disclose beyond cases where the auditor is giving or has given some representation or certification, and the silence and inaction of the defendant auditors did not make them culpable. In holding that the auditors had no duty to disclose, the court reasoned that because the auditors had issued no public opinion, rendered no certification, and in no way invited the public to rely on their financial judg- ment, there was no special relationship that imposed a duty of disclosure.

† For reviews of interim periods ending before November 15, 2007, the SEC now requires a registrant (publicly owned company) to engage an independent accountant to review the registrant’s interim financial information before the registrant files its quarterly report with the commission. The SEC also requires management, with the participation of the principal executive and financial officers (the certifying officers) to make quarterly certifications (similar to annual ones under SOX Section 302) with respect to the company’s internal control over financial reporting. Although an accountant is not required to issue a written report on a review of interim financial information, the SEC requires that an accountant’s review report be filed with the interim financial information if, in any filing, the entity states that the interim financial information has been reviewed by an independent public accountant.

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Chapter 4 AICPA Code of Professional Conduct 205

Accountants’ legal liability cases can raise complex issues about confidentiality, duty to disclose, and whether professional standards have been followed. More will be said about these issues in Chapter 6.

Confidentiality and Whistleblowing In Chapter 1, we pointed out that while internal whistleblowing is the expected standard of behavior under AICPA Interpretation 102-4 and the IMA ethical standards to resolve ethical conflicts, to go outside the company and externally blow the whistle on wrongdo- ing violates the confidentiality obligation to the client. If a CPA even contemplates such an action, legal advice should be sought out before making a final decision. However, this does not mean that a CPA should never go outside the company and bring certain matters to the attention of the SEC. For example, when the auditor believes a client has committed an illegal act that has a material effect on the financial statements, the matter must be reported to the audit committee. The board then has one business day to inform the SEC. If the board decides not to inform the SEC, the auditor must provide the same report to the SEC within one business day or resign from the engagement. A brief explanation follows, and more will be said about illegal acts in Chapter 5.

Louwers et al. provide useful guidelines with respect to the auditors’ obligations to blow the whistle about clients’ illegal practices under auditing standards. If a client refuses to accept an auditors’ report that has been modified in any of the following situations, the public accounting firm should withdraw from the engagement and give its reasons in writing to the board of directors: (1) the inability to obtain sufficient appropriate evidence about a suspected illegal act; (2) failure to account for or disclose properly a material amount connected with an illegal act; or (3) the inability to estimate amounts involved in an illegal act. As the authors point out, the information in these cases is not consid- ered confidential if its disclosure is necessary to prevent financial statements from being misleading. 71

Louwers also points out that while auditors are not legally obligated to blow the whistle on clients in general, there are circumstances in which auditors are legally justified in mak- ing disclosures to a regulatory agency or a third party. As pointed out above, such action is allowed for under Rule 301. A good example is the requirement under Dodd-Frank discussed in Chapter 3 that specifically permits disclosure to the SEC to prevent “substantial injury” to the financial interest of an entity or its investors. Disclosure also is justified when the whistleblower reasonably believes that the entity is impeding investigation of the misconduct, or when the whistleblower has first reported the violation internally and at least 120 days have passed.

Additional examples where disclosure may be justified as noted by Louwers include (1) when a client has, intentionally and without authorization, associated or involved a CPA in its misleading conduct, such as by using the CPA’s name on financial state- ments; (2) when a client has distributed misleading draft financial statements prepared by a CPA for internal use only; or (3) when a client prepares and distributes in an annual report or prospectus misleading information for which the CPA has not assumed any responsibility. 72

Contingent Fees Years ago in the accounting profession, it was a violation of the rules of conduct for a CPA to accept a contingent fee for services performed for a client or for recommending a product or service to the client. These forms of payment were thought to be “unprofessional” and could potentially compromise the CPA’s professional judgment. Over the years, however, professional accountants have become more involved in performing nonattest services (i.e., advisory services) in which, unlike audits, reviews, and other attestation services where an independent opinion is provided to third parties, the nonattest services are provided

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solely for the client’s benefit. Thus, there is no third-party reliance on the work of the accountant. Moreover, CPAs who provide these nonattest services to clients are competing with non-CPAs who perform similar services and are not bound by a professional code of conduct such as the AICPA Code. The result has been a loosening of the rules to permit the acceptance of contingent fees and commissions when performing advisory-type services for a non-audit client. Certain restrictions do apply, as discussed next.

Under Rule 302 of the AICPA Code, a CPA is prohibited from performing for a con- tingent fee any professional services for, or to receive such a fee from, a client for whom the CPA or CPA firm performs any of the following services: (1) an audit or review of a financial statement; (2) a compilation of a financial statement when the CPA expects, or reasonably might expect, that a third party will use the financial statement and the compi- lation report does not disclose a lack of independence; or (3) an examination of prospective financial information. 73

The reason for prohibiting contingent fee payments in these instances is the requirement for independence in each case when also performing attest services (i.e., audit) for the client. This raises the bar with respect to not becoming involved in any relationship with the client or a third party that may threaten independence, such as when a financial self-interest exists as a result of the contingent fee arrangement. For example, if an accounting firm and audit client were to agree that the firm would receive 30 percent of any tax savings to the client resulting from tax advice provided by the firm, the fee would be a contingent fee and impair the auditor’s independence, notwithstanding an expectation that a govern- ment agency would consider issues related to the client’s taxes as explained below. In the tax-savings case, the firm and client, not a court or government agency, would have agreed to the determination of the fee. The fact that a government agency might challenge the amount of the client’s tax savings, and thereby alter the final amount of the fee paid to the firm, heightens rather than lessens the mutuality of interest between the firm and client. Accordingly, such fees impair an auditor’s independence. Contingent fees for preparation of amended tax returns or refund claims are permitted as long as the CPA has a reasonable expectation the claim would be the subject of a substantive review by the taxing authority. Finally, a contingent fee can be accepted when filing an amended federal or state income tax return (or refund claim) claiming a tax refund in an amount greater than the threshold for review by the Joint Committee on Internal Revenue Taxation ($1 million at March 1991) or state taxing authority. 74 In these instances, the fee is determined not by the parties but by courts or government agencies acting in the public interest so that it is less likely that such fees would be used to create a mutual financial interest between the auditor and audit client.

Other Responsibilities and Practices

Commissions and Referral Fees Section 500 of the AICPA Code establishes rules for commissions and referral fees that are similar to those for contingent fees. Unlike a contingent fee, which is conditioned on the outcome of a service, a commission is typically paid to a CPA for recommend- ing or referring to a client any product or service of another party, such as an investment product whereby the CPA receives a commission from the investment company if the client purchases the product. A similar arrangement exists when a CPA, for a commission, recommends or refers any product or service to be supplied by a client to another party. The restricted services identified under Rule 302 apply to Rule 503 on commissions and referral fees. The same independence concerns as with contingent fee payments apply when accepting a commission or referral fee for products or services provided to a client or of the client to another party. 75

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Imagine, for example, that a CPA is engaged to perform financial planning services for a client and to recommend a financial product or products based on the service. Now, if one of three products pays a commission to the CPA, assuming that the client purchases the product, while the other two do not, it may appear that the CPA can no longer be independent with respect to providing audit or other attest services for the client. The key point is that it doesn’t matter if the CPA can, in fact, make independent decisions. The perception may be in the mind of a reasonable observer that such an independent mindset is no longer possible because of the commission arrangement. What if, for example, during the course of the audit and valuation of the investment product, the CPA discovers a flaw in the logic used to recommend the commission-based product to the client? Would the CPA disclose that fact to the client?

One requirement under the commission and referral fee rule that does not exist for con- tingent fees is to disclose permitted commissions and referral fees to any person or entity to whom the CPA recommends or refers a product or service to which the commission relates. In other words, the disclosure meets the CPA’s ethical obligation when accepting such forms of compensation, and the objectivity rule applies in making product and service recommendations.

Once again we point out that students should be informed of their state board rules of conduct in the commissions area because there may be more restrictive requirements that must be followed such as exists in Texas. The Texas State Board of Public Accountancy’s commissions rule requires that a “person [licensed CPA] who receives, expects or agrees to receive, pays, expects, or agrees to pay other compensation in exchange for services or prod- ucts recommended, referred, or sold by him shall , no later than the making of such recom- mendation, referral, or sale, disclose to the client in writing the nature, source, and amount, or an estimate of the amount when the amount is not known, of all such other compensation.

Advertising and Solicitation Rule 502 of the AICPA Code establishes guidelines when a CPA can advertise profes- sional services or solicit clients. While advertising and solicitation is permitted, these forms of communication cannot be done in a manner that is false, misleading, or deceptive. Solicitation by the use of coercion, overreaching, or harassing conduct is prohibited under the rule. 76

Advertising and solicitation practices of CPAs should never cross the line, as might occur if they (1) create false or unjustified expectations of favorable results; (2) imply the ability to influence any court, tribunal, regulatory agency, or similar body or offi- cial; (3) contain a representation that specific professional services in current or future periods will be performed for a stated fee, estimated fee, or fee range when it was likely at the time of the representation that such fees would be substantially increased and the prospective client was not advised of that likelihood; and (4) contain any other representations that would be likely to cause a reasonable person to misunderstand or be deceived.

A final observation about advertising practices is to emphasize that the rules also apply to advertising and public communications on CPA and CPA firm websites, e-mails, and other electronic or Internet marketing, as well as all other forms of advertising, marketing, and public communications. In recent years, like so many professional service provid- ers, CPAs have increasingly used the Internet and developed CPA firm websites. Prior to the advent of the Internet and universal access to marketing and advertising information, such information may have been in brochures or other printed material. Traditionally, such material was disseminated only by hand or mail and was not as available for general refer- ence or scrutiny. Now, the information is available with one click, so the rules have had to catch up with the technology.

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We have observed that state boards have become concerned in recent years with the proliferation of advertisements and public communications that contain false, fraudulent, misleading, deceptive, or unfair statements or claims. The Louisiana Board of Accountancy issued a “Statement of Position” on such matters to guide licensed CPAs in that state. Basically, the statement reminds licensees that

“[the] Board’s Rules of Professional Conduct relative to advertising and public communica- tions apply to all forms of marketing, advertising and public communication . . . inclusive of the content on a licensee’s website, or other marketing content, disseminated by or on behalf of a licensee, by e-mail or otherwise through the Internet. The Rules apply to printed adver- tisements, verbal communications, letterhead stationery, business cards, telephone directory advertisements, brochures, letters, radio and television advertisements, websites, e-mails, other electronic or Internet marketing or advertisement, and any other form of advertisement or public communications disseminated by or on behalf of a licensed CPA or CPA Firm.” 77

Perhaps it is not surprising to learn that CPAs are “pushing the envelope” with respect to advertising and soliciting clients. The competition for professional services has increased dramatically over the past 40 years or so as CPAs have entered new areas of professional service such as consulting, advisory, financial planning, and other nonattest service areas. CPAs now routinely compete with non-CPAs for the same clients; the latter are not constrained by a strict code of conduct. Moreover, the new forms of media to advertise services create additional challenges to the ethics of CPAs, who may erroneously assume that state boards are having difficulty keeping up with the new technology. As we have said throughout the book, a commitment to ethics in one’s professional services should also apply to other areas, including ethical advertising practices. The initial contact between a CPA and prospective client often sets the tone for the relationship and establishes a basis of trust that should carry over to those services.

Form of Organization and Name Ethics rules apply not only to individual CPAs who are licensed by state boards but also to accounting firms and certain members of alternative practice structures, networks, and affiliate firms. The forms of organization used by CPA firms over the years have changed to recognize the importance of nonattest services to the revenue flow of firms and competi- tion with non-CPA firms in providing such services. Years ago, CPAs had to own 100 percent of a firm’s equity interests. Today, most states simply require a majority ownership in the hands of CPA firms. The rules now accommodate non-CPA owners who perform a variety of advisory services and want a partial ownership interest in the firm. Toffler, in her book on the demise of Arthur Andersen that was mentioned in the opening section of this chapter, laid blame on the proliferation of nonattest services at Andersen and non- CPA-consultants, who operated under a less strict culture of ethical behavior than their CPA-attest colleagues. She claims that corners were cut and decisions were made that were in the interests of the client and firm, at the sacrifice of the public interest, as a result of compromises to independence and objectivity in audit services so as not to upset clients and possibly lose lucrative consulting services.

State boards need to have regulatory authority over practice units as well as CPAs because the members of a CPA firm might pressure an individual CPA within that firm to do something unethical. The firm should be sanctioned for the inappropriate behavior, and so should the CPA if she gives in to the pressure. For example, let’s assume that you are working for a CPA firm in your hometown and your supervisor-CPA tells you to ignore a material sales return at year-end and wait to record it as a reduction of revenue until the first of next year. It seems that the client needs that revenue to meet targeted amounts that trigger bonuses to top management. If you go along with your supervisor, then you, the supervisor, and the firm itself can be cited for violating the ethics rules.

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Rule 505 of the Code provides that CPAs may practice public accounting only in a form of organization permitted by state law or regulation. 78 For example, in Texas, the legal forms of ownership must contain the names of a corporation, professional corporation, limited liability partnership, or professional limited liability company. A sole-proprietor CPA firm must contain the name of the sole proprietor. The AICPA and virtually all state board rules prohibit the use of a firm name that is misleading.

In recent years, the AICPA has become concerned over the different ways that state boards interpret the term misleading. These concerns prompted the AICPA to issue guid- ance about CPA firm names by issuing Interpretation 505-4. According to the Interpretation, a firm name would be considered misleading if the name contains any representation that would be likely to cause a reasonable person to misunderstand, or be confused about, the legal form of the firm or who the owners or members of the firm are, such as a reference to a type of organization or an abbreviation of the name that does not accurately reflect the form under which the firm is organized. 79

The overarching principle set forth is that a CPA firm’s name should allow the users of the firm’s services, as well as the public at large, to recognize the firm’s identity. The reason that this is a problem today is the varying ways in which a firm is established, including intertwined networks and affiliates that may perform different services for the same client, and alternative business structures, where one firm performs audit services and the other entity performs nonattest services for the same client. Additional concerns include the manner in which a CPA firm markets or advertises its services and capabilities to the public, the responsibilities of the public to consider the CPA firm’s attributes other than its name, or any potential legal implications related to the use of a CPA firm name. 77 For example, states generally require firms to have at least two partners in order to be called “CPA and Company” or “CPA and Associate,” and at least three partners in order to be called “CPA and Associates.”

One major shift in the form and organization of providing accounting and auditing services to the public in the last 20 years has been to provide professional services through the formation of alternative practice structures (APSs). Typically, a CPA firm is purchased by an entity that is not majority owned by CPAs, a so-called APS. The latter assumes the nonattest services, while the CPA firm continues to provide attest services (sometimes as a shell entity). The CPA firm may be making payments to the APS, such as for leasing space and payments for the use (in audit work) of former CPA firm members who now perform nonattest services for the APS. 80

Imagine, for example, that a tax preparation entity purchased a small CPA firm. The tax entity (now called an APS) cannot do audit work because it is not majority CPA owned. It can, however, perform all nonattest services while the original CPA firm does the audit work. The CPA firm and the APS have a relationship as a result of the sale, and that may cause some problems. A potential danger is when the APS performs its services for the same client who uses the related CPA firm for audit services. Independence of CPA firm members may be impaired by virtue of the relationship because the APS has some control over the CPA firm and its members as a result of the acquisition.

To control for the possibility that a top management official of the APS may attempt to influence the decision making of a member of the CPA firm, the AICPA rules extend to direct superiors of the APS, who can directly control the activities of those in the CPA firm, and indirect superiors, who might influence the decisions made by the CPA in its audit work for mutual clients. Interpretation 101-14 subjects direct superiors to Rule 101 and its interpretations while indirect superiors are included only if they have material financial relationships as defined under Rule 101 and its interpretations. 81

AICPA Interpretations 101-17 and 101-18 recognize network and affiliate forms of organization and the potential for independence impairments. While these standards go

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beyond the scope of this chapter, we do want to make certain important points because students may find themselves working for one of these non-traditional CPA firms. Perhaps most important is to recognize the size and scope of these organizations.

CBIZMHM, LLC (CBIZ) is the largest non–Big Four firm in size of revenues that pro- vides management advisory services according to a 2012 survey by Accounting Today. 82 On its website, CBIZ describes itself as providing a wide range of accounting and business management services to assist both individuals and small to medium-sized businesses in meeting all their diverse needs. CBIZ has over 140 offices and 6,000 associates in major metropolitan and suburban cities throughout the United States.

Interpretation 101-17 83 points out that a firm may join a larger group to enhance its ability to provide professional services. These may be membership associations that are separate legal entities that are otherwise unrelated to their members. The associations facilitate their members’ use of association services and resources; they do not themselves typically engage in the practice of public accounting or provide professional services to their members’ clients or to other third parties. For example, a firm may become a member of an association in order to refer work to, or receive referrals from, other association members.

A network firm is required to be independent of financial statement audit and review clients of the other network firms if the use of the audit or review report for the client is not restricted, as defined by professional standards. For all other attest clients, consideration should be given to any threats that the firm knows or has reason to believe may be created by network firm interests and relationships. If those threats are not at an acceptable level, safeguards should be applied to eliminate the threats or reduce them to an acceptable level. The independence requirements apply to any entity within the network that meets the definition of a network firm . 84

The characteristics of a network include sharing common brand name, sharing common control, sharing profits or costs, sharing common business strategy, sharing significant professional resources, and sharing common quality control policies and procedures.

Interpretation 101-18 defines affiliates as entities with financial interests in, and other relationships with, entities that are related in various ways to a financial statement attest client that may impair independence. This interpretation provides guidance on which enti- ties should be considered an affiliate of a financial statement attest client and subject to the independence provisions of the AICPA Code of Professional Conduct. 85

Acts Discreditable—Client Books and Records; CPA Workpapers A variety of acts discreditable are considered to be a violation of Rule 501. In general, the acts discreditable rule is designed to hold CPAs accountable for personal and professional actions that bring disrepute on the individual and profession.

Interpretation 501-1 establishes the standards of behavior for CPAs when responding to requests by clients and former clients for records. First, we review important definitions under the interpretation: 86

• Client-provided records are accounting or other records belonging to the client that were provided to the member [CPA] by or on behalf of the client, including hardcopy or electronic reproductions of such records.

• Member-prepared records are accounting or other records that the member was not specifically engaged to prepare and that are not in the client’s books and records or are otherwise not available to the client, with the result that the client’s financial information is incomplete. Examples include adjusting, closing, combining, or consolidating journal entries (including computations supporting such entries) and supporting schedules and documents that are proposed or prepared by the member as part of an engagement (e.g., an audit).

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• Member’s work products are deliverables as set forth in the terms of the engagement, such as tax returns.

• Member’s working papers are all other items prepared solely for purposes of the engagement and include items prepared by the CPA, such as audit programs, analytical review schedules, and statistical sampling results and analyses.

Licensed CPAs must comply with the rules and regulations of authoritative regulatory bodies, such as the state board of accountancy. For example, as previously mentioned, the state board may not permit a licensed CPA to withhold certain records pending fee payment from the client for the work performed. Failure to comply with the more restrictive provisions contained in the rules and regulations of the applicable regula- tory body concerning the return of certain records would constitute a violation of this interpretation.

The rules are summarized as follows: 87

1. Client-provided records in the custody or control of the CPA should be returned to the client at the client’s request.

2. Unless a CPA and the client have agreed to the contrary, when a client makes a request for member-prepared records, or a member’s work products that are in the custody or control of the member or the member’s firm (member) that have not previously been provided to the client, the member should respond to the client’s request as follows: a. Member-prepared records relating to a completed and issued work product should be

provided to the client, except that such records may be withheld if there are fees due to the member for the specific work product.

b. Member’s work products should be provided to the client, except that such work products may be withheld in any of the following circumstances:

• If there are fees due to the member for the specific work product • If the work product is incomplete • For purposes of complying with professional standards (for example, withholding

an audit report due to outstanding audit issues) • If threatened or outstanding litigation exists concerning the engagement or mem-

ber’s work • For purposes of complying with professional standards (for example, withholding

an audit report due to outstanding audit issues) • If threatened or outstanding litigation exists concerning the engagement or mem-

ber’s work

State board rules on these matters can be confusing. The New York State Rules of the Board of Regents provide that certain information should be provided to a client upon request, such as: copies of tax returns, copies of reports, or other documents that were previously issued to or for such client; copies of information that are contained in the accountant’s working papers, if the information would ordinarily constitute part of the cli- ent’s books and records and is not otherwise available to the client including client-owned records or records that the licensee receives from a client, and any records, tax returns, reports, or other documents and information that are contained in an accountant’s working papers that were prepared for the client by the accountant and for which the accountant has received payment from the client. 88 Thus, it can be assumed the information can be withheld if payment has not been received. On the other hand, we previously mentioned that Texas State Board Rule 501.76 provides that a person’s work papers (to the extent that such work papers include records that would ordinarily constitute part of the client’s or former client’s books and records and are not otherwise available to the client or for- mer client) should be furnished to the client within a reasonable time (promptly, not to

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exceed 20 business days) after the client has made a request for those records. The person can charge a reasonable fee for providing such work papers. 89 The question is whether a “reasonable fee” precludes withholding working papers that constitute client books and records due to nonpayment of client service fees. As the saying goes, a word to the wise should be sufficient. Check with your state board rules on these matters once you become a licensed CPA.

The complexities of work-product privilege were brought to the forefront in a U.S. Supreme Court decision on May 24, 2010. In United States v. Textron Inc., the Supreme Court declined to review a lower court opinion and let stand the decision by the First Circuit Court of Appeals that a corporation’s tax accrual workpapers were not protected from an IRS summons by the work product privilege. 90 Exhibit 4.4 summarizes the facts of this case.

Acts Discreditable—Negligence in the Preparation of Financial Statements or Records Briefly, other discreditable acts that can lead to disciplinary action include discrimination and harassment in employment practices; failure to follow standards and/or procedures or other requirements in governmental audits; failure to follow requirements of govern- mental bodies, commissions, or other regulatory agencies; negligence in the prepara- tion of financial statements or records; solicitation or disclosure of CPA examination questions and answers; failure to file tax returns or pay tax liability (i.e., personal tax returns); and false, misleading, or deceptive acts in promoting or marketing professional services. 91

The case results from an IRS administrative summons for Textron’s tax accrual workpapers with respect to the company’s 1998–2001 tax returns. The workpapers were spreadsheets prepared by persons (some of whom were lawyers) in Textron’s tax department to support Textron’s calculation of its tax reserves for its audited financial statements. Textron refused to supply the workpapers to the IRS, and the dispute ended up in litigation.

In district court, Textron argued that its tax accrual workpapers were protected by either the attorney-client privilege, the tax practitioner privilege, or the work product privilege. Textron acknowledged at trial that the documents’ primary purpose was to support its reserve amounts for contingent tax liabilities, but it argued that they also analyzed the prospects for litigation over individual tax positions. The district court rejected Textron’s attorney-client and tax practitioner privilege claims, saying that Textron waived those privileges by showing the documents to its outside accountants ; however, it held that Textron’s tax accrual workpapers were protected by the work product privilege ( Textron Inc. v. United States , 507 F. Supp. 2d 138 (D.R.I. 2007)).

A contentious issue in the case was whether Textron created the workpapers “in anticipation of litigation,” because the work product privilege does not protect documents prepared in the ordinary course of business. The district court concluded that although Textron undeniably created the workpapers to satisfy its financial audit requirements, but for the prospect of litigation, the documents would not have been created at all, and therefore they were protected by the work product privilege.

On appeal, a three-judge panel of the First Circuit affirmed the district court. The court then granted an IRS petition to hear the case. The full court reversed the district court and held that the work-product privilege did not apply to Textron’s tax accrual workpapers because the documents sought were prepared not for litigation, but for a statutorily required purpose of financial reporting, and so were prepared in the ordinary course of business; therefore, they were not protected by the privilege.

The Supreme Court decided not to review the case by denying a writ of certiorari.

EXHIBIT 4.4 Supreme Court Declines to Hear Textron Work Product Privilege Case

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Interpretation 501-4, Negligence in the Preparation of Financial Statements or Records, merits additional discussion. According to the interpretation, it is an act discreditable to the profession if a CPA does any of the following: 92

• Makes, or permits or directs another to make, materially false and misleading entries in the financial statements or records of an entity

• Fails to correct an entity’s financial statements that are materially false and misleading when the member has the authority to record an entry

• Signs, or permits or directs another to sign, a document containing materially false and misleading information

These provisions of 501-4 tie into those of Interpretations 102-4 on subordination of judgment and 203-4 on statements about the GAAP-conformity of financial statements.

This completes our discussion of the rules of conduct and interpretations of the AICPA Code. The key point is that professional judgments and ethical behavior are integral parts of adhering to both the form and substance of the requirements under the AICPA Code. Ethical decision making does not occur in a vacuum. Accounting professionals are part of an organization and should adhere to its standards and policies, including codes of ethics (as discussed in Chapter 3). They also belong to the accounting profession, and as such, are expected to follow rules of conduct of state boards of accountancy that grant licenses to practice public accounting, as well as the AICPA Code of Professional Conduct. Even if CPAs decide not to join the AICPA, their standards of conduct are similar to most rules of conduct of state boards and in many states, the boards refer to the AICPA Code as providing authoritative statements on ethical conduct.

Ethics and Tax Services

Students who graduate from college and take positions with accounting and professional services firms might end up providing tax advice for a client at some time in their careers. While the discussion below emphasizes the AICPA Statements on Standards for Tax Services (SSTS) that establish required standards of practice in the tax area, we start by briefly discussing U.S. Treasury Department Circular No. 230 (Circular 230). Circular 230 contains the U.S. Department of the Treasury regulations that govern a CPA’s practice before the IRS. Those who practice before the IRS include attorneys, CPAs, and those meeting the requirements to become an enrolled agent. 93

Essentially, the IRS is concerned with practices in providing advice to clients and in pre- paring, or assisting in the preparation of, information submitted to the IRS. They include:

• Communicating clearly with the client regarding the terms of the engagement • Establishing the facts, determining their relevance, evaluating the reasonableness of

assumptions and representations, relating the applicable law to the relevant facts, and arriving at a conclusion supported by the law and facts

• Advising the client of the importance of the conclusions reached under the IRS Code • Acting fairly and with integrity in practice before the IRS

Recall that the rules of professional conduct in the AICPA Code apply to CPAs in the performance of all professional responsibilities, including tax services. The relevant AICPA rules are discussed in the next sections.

Rule 101—Independence A tax practitioner must adhere to requirements in Rule 101 because audit independence may be impaired by performing certain tax services. An example would be when a CPA

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214 Chapter 4 AICPA Code of Professional Conduct

performs year-end tax planning and prepares the tax returns for an attest client. Such services would be considered nonattest services and therefore subject to the requirements of Interpretation 101-3, including the CPA’s understanding with the client with respect to the tax services and documentation of understandings with the client with respect to the objectives of the engagement, services to be performed, client’s acceptance of its responsi- bilities, CPA’s responsibilities, and any limitations of the engagement.

Rule 102—Integrity and Objectivity Interpretation 102-6, Professional Services Involving Client Advocacy, recognizes that tax services involve acting as an advocate for the client. An advocacy threat to independence may exist when representing a client in U.S. tax court. However, this does not preclude providing tax services for an attest client. Instead, CPAs are cautioned to follow Rules 101, 102, 201, 202, and 203 when providing tax services.

Rule 201—Professional Competence and Due Care CPA-tax practitioners should understand the requirements of the SSTS and perform tax services with care, including proper planning and supervision of those involved in per- forming such services. Knowledge of the tax law is a challenging element of providing tax services for a client. Rule 201 includes keeping up with changes in the law, tax court deci- sions in relevant situations, city, state, and federal tax laws, and participation in continuing education in the tax area.

Rule 202—Compliance with Professional Standards Rule 202 obligates CPAs to follow professional standards, including SSTS.

Other rules apply as well, including confidentiality requirements (Rule 301) and the acceptance of contingent fees in performing tax services (Rule 302).

Tax Compliance Services Interpretation 101-3 establishes rules when providing tax compliance services, 94 which include preparation of a tax return, transmittal of a tax return and transmittal of any related tax payment to the taxing authority, signing and filing of a tax return, and authorized representation of clients in administrative proceedings before a taxing authority. Preparing a tax return and transmitting the tax return and related tax payment to a taxing authority, whether in paper or electronic form, would not impair a CPA’s independence provided that she does not have custody or control over the client’s funds and the individual designated by the client to oversee the tax services (1) reviews and approves the tax return and related tax payment; and (2) if required for filing, signs the tax return prior to the member trans- mitting the return to the taxing authority.

Authorized representation of a client in administrative proceedings before a taxing authority would not impair a member’s independence provided that the CPA obtains client agreement prior to committing the client to a specific resolution with the taxing authority. However, representing a client in a court or in a public hearing to resolve a tax dispute would impair audit independence because it establishes an advocacy relationship between the CPA and the client that may create the appearance of a loss of independence with respect to the audit of a client’s financial statements.

Statements on Standards for Tax Services (SSTS) The AICPA has issued seven Statements on Standards for Tax Services (SSTS) that explain CPAs’ responsibilities to their clients and the tax systems in which they practice.95 The statements demonstrate a CPA’s commitment to tax practice standards that balance advocacy and plan- ning with compliance.

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Tax services differ from audit services in two important respects. First, the independence requirement for an auditor does not generally pertain to the tax practitioner, although a CPA firm that performs both services would be required to be independent to conduct the audit. Under SOX requirements, the audit committee of a public client must approve the tax services. This is a check in the system to ensure that the board of directors is comfort- able with the auditing firm also performing tax services.

The second difference is due to the way in which objectivity relates to tax services. Auditors must maintain an unbiased attitude in conducting the audit. An auditor should never do what the client asks just because the client asks it. The final decision must be made by the CPA based on ethical considerations and using her professional judgment informed by ethical reasoning. Generally speaking, when a CPA serves as an advocate for the client’s tax position, she must be sure that a reasonable level of support exists for that position, as discussed below. The tax practitioner still has to be objective in determining the supportability of that position. However, once supportability has been affirmed, the CPA can advocate that position in tax and legal proceedings.

The SSTSs establish required ethics rules for tax practitioners. Given the complexity of the area, we focus on the most important standards under SSTS No. 1, as well as some related issues, such as requirements for taking a tax position and tax-planning issues.

SSTS No. 1—Tax Return Positions This statement sets forth the applicable standards for members (i.e., CPAs) when recom- mending tax return positions or preparing or signing tax returns (including amended returns, claims for refund, and information returns) filed with any taxing authority. The following definitions apply:

• A tax return position is a position reflected on a tax return on which a CPA has spe- cifically advised a taxpayer, or a position about which a CPA has knowledge of all material facts and, on the basis of those facts, has concluded whether the position is appropriate.

• A taxpayer is a client, a CPA’s employer, or any other third-party recipient of tax services.

This statement also addresses a CPA’s obligation to advise a taxpayer of relevant tax return disclosure responsibilities and potential penalties. In addition to the AICPA and IRS tax regulations, various taxing authorities at the federal, state, and local levels may impose specific reporting and disclosure standards with regard to recommending tax return positions or preparing or signing a tax return. A CPA should determine and comply with the standards, if any, that are imposed by the applicable taxing authority with respect to recommending a tax return position, or preparing or signing a tax return.

If the applicable taxing authority has no written standards with respect to recommend- ing a tax return position or preparing or signing a tax return, or if its standards are lower than the standards set forth in this paragraph, the following standards will apply.

A CPA should not recommend a tax return position or prepare or sign a tax return taking a position unless he has a good-faith belief that the position has at least a realistic possibility of being sustained administratively or judicially on its merits if challenged. This is known as the realistic possibility of success standard under SSTS Interpretation No. 101-1. It requires that the tax return position should not be recommended unless the position satisfies applicable reporting and disclosure standards.

Notwithstanding the previous statement, a CPA may recommend a tax return position if she concludes that there is a reasonable basis for the position and advises the taxpayer to disclose that position appropriately. An interesting aspect of the standard is the prohibition against recommending a tax return position or preparing or signing a tax return reflecting a

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216 Chapter 4 AICPA Code of Professional Conduct

position that the CPA knows exploits the “audit selection process of a taxing authority,” or serves as a mere arguing position advanced solely to obtain leverage in a negotiation with a taxing authority. The former refers to the fact that a tax practitioner might recommend an overly aggressive position to a client hoping that the IRS does not choose to examine the client’s tax return. Clearly, that would be a violation of basic ethical standards, including honesty (non-deceptiveness) and integrity.

SSTS Interpretation No. 1-1—Reporting and Disclosure Standards ‡ SSTS No. 1-1 describes various tax reporting standards to provide a context for making determinations with respect to the realistic possibility of success standard. After all, what one tax practitioner decides might meet that standard could be different from another prac- titioner. In an effort to satisfy the objectivity standard in the AICPA Code, the following definitions of tax positions are provided in 1-1.

More Likely Than Not The more likely than not standard generally is satisfied if it is reasonable to conclude in good faith that there is a greater than 50 percent likelihood that the position will be upheld on its merits if it is challenged.

Substantial Authority The substantial authority standard is an objective standard and is satisfied if the weight of the authorities supporting the position is substantial compared to the weight of authorities supporting a contrary treatment. In practice, the substantial authority standard generally is interpreted as requiring approximately a 40 percent likelihood that the position will be upheld on its merits if it is challenged.

Realistic Possibility of Success The realistic possibility of success standard is generally satisfied if there is approximately a one-in-three (33 percent) likelihood that the position will be upheld on its merits if it is challenged.

Reasonable Basis The reasonable basis standard is satisfied if the position is reasonably based on one or more authorities, taking into account the relevance and persuasiveness of those authori- ties. The reasonable basis standard is lower than the realistic possibility of success stan- dard but is significantly higher than not frivolous or not patently improper, and it is not satisfied by a return position that is merely arguable or that is merely a colorable claim. In practice, the reasonable basis standard generally is interpreted as requiring that there be approximately a 20 percent likelihood that the position will be upheld on its merits if it is challenged.

Now, these standards may seem as though tax return positions are decided using a “casino-based” mentality. There is no doubt that a strong sense of right and wrong—that is, what constitutes ethical behavior—is essential for not abusing these rather loosely defined standards. From an ethical perspective, it would be wrong to recommend a tax position to a client that one knows is not supportable, regardless of the chances of prevailing in a tax matter with the IRS. Still, we recognize the difficulty of establishing a right and wrong position in tax matters, especially when the rules are nonexistent or unclear and no precedents might be set for a client’s specific return situation.

‡ SSTS No. 1-1 and 1-2 were undergoing a thorough review at the time of writing and will be changed.

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Chapter 4 AICPA Code of Professional Conduct 217

SSTS Interpretation No. 1-2—Tax Planning § Tax planning encompasses a wide variety of situations. It includes situations in which the CPA provides advice on prospective or completed transactions, whether the advice reflects favorable or unfavorable treatment to the taxpayer. When providing professional services that include tax planning, a CPA should determine and comply with any applicable stan- dards for reporting and disclosing tax return positions or for providing written tax advice.

For purposes of this Interpretation, tax planning includes, both with respect to prospective and completed transactions, recommending or expressing an opinion (whether written or oral) on a tax return position or a specific tax plan developed by the CPA, the taxpayer, or a third party. The realistic possibility standard in these matters provides that a CPA may still recommend a position that does not satisfy the realistic possibility standard if all of the following are true:

• A reasonable basis exists for the position. • The CPA recommends appropriate disclosure. • A higher standard is not required under applicable taxing authority rules.

When issuing an opinion to reflect the results of the tax planning service, a CPA should do all of the following:

1. Establish the relevant background facts. 2. Consider the reasonableness of the assumptions and representations. 3. Consider applicable regulations and standards regarding reliance on information and

advice received from a third party. 4. Apply the pertinent authorities to the relevant facts. 5. Consider the business purpose and economic substance of the transaction, if relevant to

the tax consequences of the transaction (mere reliance on a representation that there is a business purpose or economic substance generally is insufficient).

6. Consider whether the issue involves a listed transaction or a reportable transaction (or their equivalents) as defined by the applicable taxing authority.

7. Consider other regulations and standards applicable to written tax advice promulgated by the applicable taxing authority.

8. Arrive at a conclusion supported by the authorities.

A listed transaction is defined by the IRS as a transaction that is the same as or sub- stantially similar to one of the types of transactions that the IRS has determined to be a tax avoidance transaction. Such actions are identified by notice, regulation, or other form of published guidance as listed transactions. Tax avoidance transactions are sometimes labeled tax shelters. It is complicated, but basically the term prohibited tax shelter transaction means listed transactions, transactions with contractual protection, or confidential transactions.

The IRS guidelines for listed transactions identify participation in any of the following:

• A tax return reflects tax consequences or a tax strategy described in published guidance that lists the transaction.

• The CPA knows or has reason to know that tax benefits reflected on the tax return are derived directly or indirectly from such tax consequences or tax strategy.

• The client is in a type or class of individuals or entities that published guidance treats as participants in a listed transaction.

In other words, under IRS rules, any transaction that is the same or “substantially simi- lar” to a transaction identified as a tax avoidance transaction by IRS notice, regulation, or other published guidance is a reportable transaction—it must be reported to the IRS.

§ SSTS No. 1-1 and 1-2 were undergoing a thorough review at the time of writing and will be changed.

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Tax Shelters One of the most controversial aspects of the Enron collapse was the alleged involvement of Andersen in marketing aggressive tax planning ideas that the IRS and the courts subse- quently found to be abusive. After the Enron scandal, the accounting profession received a second serious blow in 2005, when KPMG settled a criminal tax case with the Department of the Treasury and the IRS for $456 million to prevent the firm’s prosecution over tax shelters sold between 1996 and 2002. This is the largest criminal tax case ever filed.

The creation of tax shelter investments to help wealthy clients avoid paying taxes has been part of tax practice for many years. The difference in the KPMG case, according to the original indictment, is that tax professionals in the firm prepared false documents to deceive regulators about the true nature of the tax shelters. There appeared to be a clear intent to deceive the regulators, and that makes it fraud. 96

The indictment claimed that the tax shelter transactions broke the law because they involved no economic risk and were designed solely to minimize taxes. The firm had collected about $128 million in fees for generating at least $11 billion in fraudulent tax losses, and this resulted in at least $2.5 billion in tax evaded by wealthy individuals. On an annual basis, KPMG’s tax department was bringing in for the firm nearly $1.2 billion of its $3.2 billion total U.S. revenue. Ultimately, the $128 million in fees were forfeited as part of the $456 million settlement. 97

Perhaps the most interesting aspect of the KPMG tax shelter situation is the culture that apparently existed in the firm’s tax practice during the time the shelters were sold. In 1998, the firm had decided to accelerate its tax services business. The motivation prob- ably was the hot stock market during the 1990s and increase in the number of wealthy taxpayers. The head of the KPMG’s tax department, Jeffrey M. Stein, and its CFO, Richard Rosenthal, created an environment that treated those who didn’t support the “growth at all costs” effort as not being team players. From the late 1990s, KPMG established a telemar- keting center in Fort Wayne, Indiana, that cold-called potential clients from public lists of firms and companies. KPMG built an aggressive marketing team to sell tax shelters that it created with names like Blips, Flip, Opis, and SC2. 98

In an unusual move, the Justice Department brought a lawsuit against two former KPMG managers on 12 counts of tax evasion using illegal tax shelters. On April 1, 2009, John Larson, a former senior tax manager, was sentenced to more than 10 years and ordered to pay a fine of $6 million. Robert Plaff, a former tax partner at KPMG, was sentenced to more than 8 years and fined $3 million. A third person convicted in the case, Raymond J. Ruble, a former partner at the law firm Sidley Austin, was sentenced to 6 years and 7 months. In handing down the rul- ing in the U.S. District Court in Manhattan, Judge Lewis A. Kaplan stated: “These defendants knew they were on the wrong side of the line,” adding later that they had cooked up “this mass-produced scheme to cheat the government out of taxes for the purposes of enriching themselves.” The losses through the scheme were estimated at more than $100 million.

In a more recent case that illustrates the danger for CPAs of developing tax shelter arrangements for their clients, on June 18, 2012, BDO USA LLP (BDO), the seventh- largest U.S. accounting firm, agreed to pay a civil penalty of $34.4 million to the IRS and forfeit $15.6 million to the U.S. government as part of a deferred prosecution agreement. BDO admitted that it helped U.S. citizens evade about $1.3 billion in income taxes from 1997 to 2003 by failing to register various tax shelters, as required by law, in an effort to conceal them from the IRS. Some of these tax shelters were deemed abusive and fraudulent.

The settlement and payment resulted from the following determinations, according to the IRS: 99

• Between 1997 and 2003, BDO violated federal tax laws concerning the registration and maintenance and turning over to the IRS of tax shelter investor lists involving abusive and fraudulent tax shelters.

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Chapter 4 AICPA Code of Professional Conduct 219

• Primarily through a group within the firm known as the Tax Solutions Group, BDO devel- oped, marketed, sold, and implemented fraudulent tax shelter products to high-net-worth individuals, who had, or expected to have, reportable income or gains in excess of $5 million.

• These fraudulent tax shelters, although designed to appear to the IRS to be investments, in fact were a series of preplanned steps that assisted BDO’s high-net-worth clients to evade individual income taxes of approximately $1.3 billion.

• The fraudulent tax shelters were sometimes known under the following names: SOS, Short Sale, BEST, BEDS, Spread Options, Currency Option Investment Strategy (COINS), Digital Options, G-1 Global Fund, FC Derivatives, Distressed Asset Debt, POPS, OPIS, Roth IRA, and OID Bond.

The tax shelter case against KPMG and insider trading scandal that was discussed earlier in the chapter raise questions about the quality controls in existence at the firm to prevent violations of ethical standards.

Perhaps Yogi Berra said it best: “It’s déjà vu all over again.” One more time, as with the audit investigations mentioned earlier, the government had to step in to right a wrong. We would like to see the day when the profession truly regulates itself and operates at the high- est ethical standards. Admittedly, what we read about most are firms that get caught after the fact of an accounting or tax fraud, while the vast majority of firms operate honestly and in the public interest. Nevertheless, the accounting profession, now known as the account- ing industry, may have lost sight of why the SEC entrusted it with the independent audit and sole responsibility to protect the public interest.


The PCAOB has issued a variety of standards that pertain to ethics and independence. We briefly review them below. 100

Rule 3520—Auditor Independence Rule 3520 establishes the requirement for the accounting firm to be independent of its audit client throughout the audit and professional engagement period, as a fundamental obligation of the auditor. Under Rule 3520, a registered public accounting firm or an associated person’s independence obligation with respect to an audit client that is an issuer encompasses not only an obligation to satisfy the independence criteria set out in the rules and standards of the PCAOB, but also an obligation to satisfy all other independence cri- teria applicable to the engagement, including the independence criteria set out in the rules and regulations of the commission under the federal securities laws.

Rule 3521—Contingent Fees Rule 3521 treats registered public accounting firms as not independent of their audit clients if the firm, or any affiliate of the firm, during the audit and professional engagement period, provides any service or product to the audit client for a contingent fee or a commission, or receives from the audit client, directly or indirectly, a contingent fee or commission. This rule mirrors Rules 302 and 503 of the AICPA Code that prohibits contingent fees, commissions, and referral fees for any service provided to an attest client.

Rule 3522—Tax Transactions Under Rule 3522, a rule that was issued in the aftermath of the tax shelter transactions, a registered public accounting firm is not independent of its audit client if the firm, or any affiliate of the firm, during the audit and professional engagement period, provides any non-auditing service to the audit client related to marketing, planning, or opining in favor of the tax treatment of either a confidential transaction or an “aggressive tax position”

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transaction. An aggressive tax position transaction is one that was initially recommended, directly or indirectly, by the registered public accounting firm and a significant purpose of which is tax avoidance, unless the proposed tax treatment is at least more likely than not to be allowable under applicable tax laws.

Rule 3523—Tax Services for Persons in Financial Reporting Oversight Roles Rule 3523 treats a registered public accounting firm as not independent if the firm provides tax services to certain members of management who serve in financial reporting oversight roles at an audit client or to immediate family members of such persons unless any of the following apply:

1. The person is in a financial reporting oversight role at the audit client only because she serves as a member of the board of directors or similar management or governing body of the audit client.

2. The person is in a financial reporting oversight role at the audit client only because of the person’s relationship to an affiliate of the entity being audited: a. Whose financial statements are not material to the consolidated financial statements

of the entity being audited b. Whose financial statements are audited by an auditor other than the firm or an asso-

ciated person of the firm 3. The person was not in a financial reporting oversight role at the audit client before a

hiring, promotion, or other change in employment and the tax services are provided pursuant to an engagement in process before the hiring, promotion, or other change in employment completed not after 180 days after the hiring or promotion event.

We are skeptical of ethics rules that build in exceptions, such as for members of the board of directors. From an ethical perspective, a practice is wrong if it violates certain standards of behavior, and it doesn’t matter if the relationship with the other party is not deemed to be significant. After all, members of the board of directors at most companies today have ratcheted-up responsibilities under SOX and NYSE listing requirements. There does not appear to be a reasonable basis to exclude board members from the rule that prohibits providing tax services for persons in financial reporting oversight roles.

Rule 3524—Audit Committee Pre-Approval of Certain Tax Services In connection with seeking audit committee pre-approval to perform for an audit cli- ent any permissible tax service, a registered public accounting firm should do all of the following:

1. Describe, in writing, to the audit committee of the issuer 1. The scope of the service, the fee structure for the engagement, and any side letter or

other amendment to the engagement letter, or any other agreement (whether oral, written, or otherwise) between the firm and the audit client, relating to the service

2. Any compensation arrangement or other agreement, such as a referral agreement, a referral fee, or a fees-sharing arrangement, between the registered public accounting firm (or an affiliate of the firm) and any person (other than the audit client) with respect to the promoting, marketing, or recommending of a transaction covered by the service

2. Discuss with the audit committee of the issuer the potential effects of the services on the independence of the firm.

3. Document the substance of its discussion with the audit committee of the issuer.

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Chapter 4 AICPA Code of Professional Conduct 221

Rule 3525—Audit Committee Pre-Approval of Nonauditing Services Related to Internal Control over Financial Reporting Rule 3525 provides that when seeking audit committee pre-approval to perform for an audit client any permissible nonauditing service related to internal control over financial reporting, a registered public accounting firm should describe, in writing, to the audit com- mittee the scope of the service, discuss with the committee the potential effects of the service on the independence of the firm, and document the substance of its discussion with the audit committee of the issuer.

Rule 3526—Communication with Audit Committees Concerning Independence Rule 3526 establishes guidelines when an accounting firm should discuss with the audit committee of the client information with respect to any relationships between the firm and the entity that might bear on auditor independence. Under the rule, a registered public accounting firm must do the following:

1. Prior to accepting an initial engagement, pursuant to the standards of the PCAOB, describe in writing, to the audit committee of the issuer, all relationships between the registered public accounting firm or any affiliates of the firm and the potential audit client or persons in financial reporting oversight roles at the potential audit client that, as of the date of the communication, may reasonably be thought to bear on independence.

2. Discuss with the audit committee the potential effects of the relationships on the independence of the firm, should it be appointed as the entity’s auditor.

3. Document the substance of its discussion with the audit committee.

These requirements would also apply annually subsequent to being engaged as the auditor. An additional requirement annually is to affirm to the audit committee of the issuer of the communication that the registered public accounting firm is still independent in compliance with Rule 3520.

An important question is whether the PCAOB has made a difference in reducing audit- ing failures. Perhaps the most valuable part of the PCAOB’s work has been in the audit inspections of registered auditing firms. Prior to establishing the PCAOB under SOX, these inspections were conducted as part of the accounting profession’s own peer review program. Once it was determined that firms such as Andersen that conducted audits at com- panies like Enron and WorldCom had been given clean reviews by other public accounting firms, the SEC realized that the inspection process had to be carried out by an independent body such as the PCAOB. The answer to this question has yet to be determined, although we have observed that the process seems to be more rigorous and is helping to identify deficient audit procedures at CPA firms, as we will discuss in Chapter 5.

Concluding Thoughts

Independence is the backbone of the accounting profession. The usefulness of the audit opinion depends on it. Yet, auditors are subjected to pressures that threaten to compromise independence. The key is to never lose sight of the fact that the public interest must come before all others, includ- ing that of an employer, client, or one’s own self-interest. If accountants and auditors allow them- selves to be influenced by employer and client demands, then they place the public trust at risk, as occurred for Andersen in their audits of Enron and WorldCom.

Auditors must be independent in appearance as well as in fact because factual independence is difficult to assess. Threats to independence caused by relationships with a client must be managed carefully. The marketing of professional services creates other challenges that may lead to accepting forms of payment such as commissions and contingent fees that may, under certain circumstances, impair objectivity and threaten audit independence. Alternative business structures have created a new culture in the accounting industry that threatens to place profits, client retention, and a never-ending

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222 Chapter 4 AICPA Code of Professional Conduct

appetite for new forms of service ahead of serving the public interest. The growth of tax services and expansion into providing tax-advantaged investments, such as tax shelters, tests the commitment of accounting professionals to make ethical decisions.

The profession has been investigated by Congress on a number of occasions following a series of financial frauds accompanied by audit failures. Recently, there have been calls for Congress to begin a new investigation of the industry’s role in the financial meltdown of 2007–2008. On April 6, 2011, Congress held a hearing on the role of the accounting profession in preventing another financial cri- sis, listening to testimony from accounting regulators, standard-setters, and critics.

In his testimony before the Subcommittee on Securities, Insurance, and Investment of the Senate Committee on Banking, Housing, and Urban Affairs, SEC chief accountant James Kroeker said:

There is reason to consider the extent to which improper, fraudulent, or inadequate financial reporting relating to GAAP reported results or to disclosures outside of the audited financial statements played a role in the financial crisis. SEC enforcement teams continue to pursue cases stemming from actions that contributed to the financial crisis, following settled enforcement actions involving Countrywide Financial, American Home Mortgage, New Century, IndyMac Bancorp, and Citigroup. When poorly performed audits contribute to or fail to detect financial reporting abuses, there are existing mechanisms for dealing with such misconduct, including SEC or PCAOB enforcement actions. For our part, we will continue to prosecute those who fail to comply with their obligations. 101

Anton Valukas, the examiner in the Lehman Brothers bankruptcy, told the committee about his report on Ernst & Young’s audits of the failed investment bank, but he cautioned, “I want to empha- size at the outset that I did not make any finding as to whether regulators or auditors necessarily could have prevented Lehman’s collapse. Lehman failed in part because it was unable to retain the confidence of its lenders and counterparties and because it did not have sufficient liquidity.” 102

Perhaps that is the moral of the story for CPAs and their ethical obligations to clients: It is some- times difficult to know whether a business failure is caused by the abusive business practices and fraudulent financial reporting of transactions entered into by management or because auditing firms failed in their responsibilities to raise the red flag about these practices in a timely manner to stop them in their tracks, or at least before so many innocent shareholders, employees of failed entities, and the general public are harmed.

We conclude by citing Valukas’s statement to Congress:

Nevertheless, and wholly apart from the claims involving Lehman’s auditors, we must recognize the general principle that auditors serve a critical role in the proper functioning of public companies and financial markets. Boards of directors and audit committees are entitled to rely on external auditors to serve as watchdogs—to be important gatekeepers who provide an independent check on management. And the investing public is entitled to believe that a “clean” report from an independent auditor stands for something. The public has every right to conclude that auditors who hold themselves out as indepen- dent will stand up to management and not succumb to pressure to avoid rocking the boat. 103

All we can say is “Amen to that.”

1. It has been said that independence is the cornerstone of the accounting profession. Explain what this means. How do auditors protect against impairments of independence?

2. Do you think independence with respect to a client would be impaired if a partner leaves a CPA firm and is subsequently employed by a client of the firm that the partner audited? Why or why not? Are there any procedures that might be put into place to deal with any identified threat to independence? If so, what are these procedures?

3. Comment on the statement, “Independence is not easily achieved where an auditor is hired, paid, and fired by the same corporate managers whose activities are the subject of the audit.” How might financial incentives in the form of client services unconsciously introduce auditor bias into the independent audit function?

4. Assume that a CPA serves as an audit client’s business consultant and performs each of the following services for the client. Discuss whether independence would be impaired in each instance and why.

a. Advising on how to structure its business transactions to obtain specific accounting treatment under GAAP

Discussion Questions

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Chapter 4 AICPA Code of Professional Conduct 223

b. Advising and directing the client in the accounting treatment that the client employed for numerous complex accounting, apart from its audit of the client’s financial statements

c. Selecting the audit client’s most senior accounting personnel by directly interviewing appli- cants for those positions

5. States require accounting students, CPA candidates, and licensed CPAs to complete different forms of ethics education. Go to the Internet and look up the rules and regulations of the state board of accountancy in your state. Does your state have a requirement to complete a specified number of hours in ethics education prior to taking the CPA Exam? Is there a separate exami- nation in ethics given after passing the Uniform CPA Exam prior to licensing? What are your state’s requirements with respect to continuing education in ethics? What is the purpose of ethics requirements in each area?

6. Assume that you complete tax returns for clients. You were engaged to file the 2013 individ- ual and corporate tax returns for a client. The client provided her records and other tax infor- mation to you on February 1, 2014, to help prepare the 2013 tax return. Your client paid you $12,000 to prepare those returns. On April 1, 2014, after repeated requests by the client to return her records, you informed the client that her tax returns for 2013 were soon to be completed. However, you did not complete the returns by April 15. Consequently, your client paid another accountant $6,000 to complete the returns after the deadline. Your failure to complete the 2013 individual and corporate tax returns for the client caused her to incur substantial federal and state tax penalties. In retrospect, do you believe that you violated any of the rules of conduct in the AICPA Code? Explain which rules were violated and why. If you do not believe that any rules were violated, explain your reasons for reaching this conclusion.

7. In the fall of 2012, KPMG’s Columbus, Ohio office was auditing JobsOhio’s books while, at the same time, an out-of-state office of the firm was seeking $1 million in taxpayer money from JobsOhio for an unnamed client. As the state’s lead economic-development agency, JobsOhio is charged with recommending financial incentives for companies seeking to relocate in the state. On November 5, 2012, about the time that the audit was being conducted, KPMG was also listed on a sheet of eight pending grant commitments from the state for fiscal year 2013, one of which was for the unnamed client. 104 Do you think KPMG violated any independence standards in this situation? Be specific about the standards and any threats to independence that may have existed.

8. It has been said that ethical people try to observe both the form and spirit of ethical standards in making professional judgments. What does this mean? How does this relate to the realistic pos- sibility of success standard in tax practice?

9. In the course of researching whether a particular tax position of your tax client satisfies the real- istic possibility of success standard, you discover that another taxpayer took the same position on a tax return several years ago and that the return was audited by the IRS. You discover that the IRS agent who conducted the audit was aware of the position and decided the treatment on the return was correct. The revenue agent’s report, however, made no mention of the position. Do you believe the determination by the revenue agent provides sufficient authority for purposes of the realistic possibility of success standard with respect to your client’s tax position? Explain why or why not, in light of SSTS No. 1. Assume you adopt that position, what should your tax client do as a result and why?

10. Assume that the CPA firm of Giants & Jets LLP audits Knickerbocker Systems Inc. (the Knicks). The controller of the Knicks happens to be a tax expert. During the current tax season, Giants & Jets gets far behind in processing tax returns for wealthy clients. It does not want to approach clients and ask permission to file for an extension to the April 15 deadline. One alternative is for the firm to hire the Knicks controller as a consultant just for the tax season. Discuss the ethical issues that should be considered by Giants & Jets before deciding whether to hire the controller of a client, including possible threats to independence.

11. The managing partner of a CPA firm is approached by the CEO of a major client in the firm’s headquarters in New York City. The CEO can’t use two tickets to the Super Bowl between the Denver Broncos and the New York Giants. The CEO knows that the partner is a huge New York Giants football fan and is looking forward to the Peyton Manning versus Eli Manning matchup. While both quarterbacks have won the Super Bowl in different years, the Manning brothers have never played against each other in the Super Bowl. In a gesture of gratitude for

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224 Chapter 4 AICPA Code of Professional Conduct

services rendered, the CEO offers the tickets to the partner. At first, the partner is excited about the prospects of going to the Super Bowl but she also realizes that there may be some ethical issues to consider before deciding whether to accept the tickets. Assume that the partner asks for your help. You are a CPA and a longtime friend of the partner. You hate football, so your advice will be completely objective. What are the ethical issues that you would raise with the partner to help in deciding whether to accept the Super Bowl tickets? Would your advice be different with respect to accepting the tickets if the firm provides only nonauditing services to the client? What if it provides both nonauditing and auditing services? Be sure to cite specific ethics rules in the AICPA Code of Professional Conduct that would guide your actions.

12. Can a CPA be independent without being objective? Why or why not? Can a CPA be objective without being independent? Why or why not? Does your answer matter, assuming that you provide only nonauditing services to the client? What if you provide both audit and nonauditing services?

13. With respect to the Armadillo Foods case in this chapter, let’s assume that the controller is being instructed by the CFO that to “make the numbers,” the company must increase earnings per share (EPS) by $.02. This sounds innocent enough, and it is only a 5 percent increase. Does the relative size of the increase make any difference in deciding whether to increase EPS by $.02? Would you go along with the demand of the CFO? What ethical issues should you consider in deciding on a course of action? Assume that you discover that top management supports the CFO’s position because it would lead to bonuses for themselves. Under what circumstances might you consider blowing the whistle in this case?

14. What is the danger from an ethical perspective of having a CPA firm that conducts the audit of a public company also engaged in consulting with the company on the installation of a new finan- cial information system? What about giving tax advice to an audit client? What are the possible ethical dangers of having the tax practitioners at a CPA firm that audits a client entity prepare the tax return for members of management of the client who have a financial reporting oversight role?

15. In 2004, the Government Accountability Office (GAO) conducted an investigation of the tax shelters of 61 Fortune 500 users of tax shelters provided by accounting firms that were their external auditors covering more than one year between 1998–2003. In each case, the company received benefits from the tax shelter: 61 companies had 82 transactions worth about $3.4 billion in estimated potential tax losses generally reportable to the IRS.

What are the potential ethical dangers for an auditing firm that provides tax shelters for an audit client? Is it ethically appropriate to do so under the profession’s ethical standards?

16. The IRS contacted your client as part of an examination of its tax return and proposed that the client owes an extra $100,000. As the client’s tax accountant and a CPA, can you agree to handle the matter with respect to deliberations with the IRS for 40 percent of what you save the client? Under what circumstances might this be an acceptable form of payment for services rendered, and when might it be unacceptable and in violation of the AICPA rules of conduct and/or SSTS? Notwithstanding the AICPA rules and SSTS, is there anything ethically improper with agreeing to handle the matter for 40 percent of what you save the client?

17. A large, national accounting firm decides that it is time to outsource the preparation of income tax returns to an organization in India that has performed outsourced services for other U.S. CPA firms. The firm will transmit income tax information necessary to prepare the returns elec- tronically and staff accountants in India will prepare the return. The return will then be transmit- ted back to the United States for final review and approval and then given to clients. Assume that the cost savings for the CPA firm are significant because of the lower salaries paid to chartered accountants in India, and that the quality of work in India is as good as or better than that of U.S. tax accountants. Would you recommend that the firm outsource? Why or why not? Be sure to address ethical considerations with respect to the AICPA Code.

18. In August 2008, Ernst & Young LLP (EY) agreed to pay more than $2.9 million to the SEC to settle charges that it violated ethics rules by coproducing a series of audio CDs with a man who was also a director at three of EY’s audit clients. According to the SEC, EY collaborated with Mark C. Thompson between 2002 and 2004 to produce a series of audio CDs called The Ernst & Young Thought Leaders Series. Thompson served on the boards at several of EY’s clients during the period when the CDs were produced. What threat to independence existed in the relationship between EY and Thompson? What are the potential harms of EY or any other accounting firm of engaging in this kind of relationship?

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Chapter 4 AICPA Code of Professional Conduct 225

19. On January 16, 2008, the SEC charged two former employees of PricewaterhouseCoopers (PwC) LLP with insider trading. According to the SEC’s complaint, Gregory B. Raben, a former PwC auditor, and William Patrick Borchard, a former senior associate in PwC’s Transaction Services Group, used their access to sensitive information about PwC’s clients to allow Raben to buy stock ahead of a series of corporate takeovers. According to the complaint, Raben netted trading profits of more than $20,000 by buying stock ahead of public announcements disclosing the acquisitions and then selling his shares. Assume that the actions of Raben and Borchard had no effect on the client or its operations. What is wrong with allowing the actions of Raben and Brochard from an ethical perspective? Would disclosure of the acquisition of client stock to the client solve the problem that you identified? What about disclosing it to the public?

20. In the aftermath of the collapse of financial institutions like Lehman Brothers and audit deficien- cies of investment banking firms, a great deal of attention has been devoted to requiring manda- tory auditor rotation. Some critics of the audit profession are concerned about a breakdown in external auditor independence, objectivity, and professional skepticism. Others point out the inherent conflict of interests in the “issuer pays” model for auditing firms.

Kenneth Daly, president and CEO of the National Association of Corporate Directors (NACD), told the PCAOB in its hearings on these matters that there should be a rigorous annual evaluation of the external auditor led by the audit committee, endorsed by the board, and com- municated to shareholders.

Do you think such an annual process negates the need to consider mandatory auditor rota- tion? What are some of the possible unintended consequences of instituting a mandatory auditor rotation requirement? What are the costs and benefits of mandatory auditor rotation from an ethical perspective? Do you believe auditors should be required to rotate off a client’s audit engagement after a specific period of time? Why or why not?

Endnotes 1. Barbara Ley Toffler with Jennifer Reingold, Final Accounting: Ambition, Greed, and the Fall of Arthur Andersen (New York: Broadway Books, 2003).

2. The description of Andersen’s demise is taken from an online document titled “The Demise of Arthur Andersen,”…/Final%20Arthur%20Andersen%20Paper.doc .

3. U.S. Supreme Court, No. 04-368, Arthur Andersen LLP v. U.S. on Writ of Certiorari to the U.S. Court of Appeals for the Fifth Circuit (May 31, 2005), .ZO.html .

4. United States v. Arthur Young, 465 U.S. 805, . 5. American Institute of CPAs, AICPA Professional Standards. Volume 2 as of June 1, 2012,

AICPA Code of Professional Conduct (New York: AICPA, 2012). 6. Marty J. Stuebs and Brett M. Wilkinson, “Restoring the profession’s public interest role,” The

CPA Journal (2009) 79(11), pp. 62–66. 7. James E. Copeland Jr. “Ethics as an imperative,” Accounting Horizons (2005) 19(1), pp. 35–43. 8. International Federation of Accountants (IFAC), Rebuilding Public Confidence in Financial

Reporting: An International Perspective. (New York: IFAC, 2003). 9. International Federation of Accountants (IFAC), A Public Interest Framework for the

Accountancy Profession. IFAC Policy Position Paper #4. (New York: IFAC, 2010). 10. Catherine Allen, “Comparing the ethics codes: AICPA and IFAC,” Journal of Accountancy

(October 2010), . 11. International Accounting Education Standards Board (IAESB), Proposed Revised International

Education Standard IES 4, Professional Values, Ethics, and Attitudes (New York: IFAC, 2011). 12. IAESB, Approaches to the Development and Maintenance of Professional Values, Ethics and

Attitudes in Accounting Education Programs. Information Paper (New York: IFAC, 2006). 13. Mike Brewster, Unaccountable: How the Accounting Profession Forfeited a Public Trust

(Hoboken, NJ: Wiley, 2003). 14. William F. Messier Jr., Steven M. Glover, and Douglas F. Prawitt, Auditing & Assurance

Services: A Systematic Approach (New York: McGraw-Hill Irwin, 2010). 15. American Institute of CPAs, Journal of Accountancy: AICPA Centennial Issue 1987, May 1987.

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16. Brewster, pp. 153–154. 17. Jeff Baily, “Continental Illinois Dismisses Ernst & Whinney,” Wall Street Journal, November 2,

1984, D1. 18. “Hearings Focus on ZZZZ Best,” Journal of Accountancy, April 1988. 19. Timothy Curry and Lynn Shibut, “The Cost of the Savings and Loan Crisis: Truth and

Consequences,” . 20. National Commission on Fraudulent Financial Reporting (Treadway Commission Report),

Report of the National Commission on Fraudulent Financial Reporting, October 1987. 21. Donald E. Tidrick, “A Conversation with COSO Chairman Larry Rittenberg,” The CPA Journal

(November 2005); . 22. Tidrick. 23. Alison Frankel, “Sarbanes-Oxley’s Lost Promise: Why CEOs Haven’t been Prosecuted,”

July 27, 2012, why-ceos-havent-been-prosecuted/.

24. . 25. . 26. . 27. . 28.

reform-proposals-in-the-headlines.pdf . 29.

reform-proposals-in-the-headlines.pdf . 30. Tammy Whitehouse, “House Vote Blocks PCAOB Action on Auditor Rotation,” July 9, 2013,

Available at: rotation/article/302191/.

31. California Board of Accountancy, California Code of Regulations. Title 16. Section 68 Retention of Client Records, .

32. Texas State Board of Public Accountancy, Texas Administrative Code, Title 22, Part 22, Chapter 501, Rules of Professional Conduct, Subchapter C Responsibilities to Clients, Rule Section 501.76, Records and Work Papers;$ext .TacPage?sl=R&app=9&p_dir=&p_rloc=&p_tloc=&p_ploc=&pg=1&p_tac=&ti=22&pt=22& ch=501&rl=76.

33. AICPA, Professional Standards Volume 2. 34. AICPA, “AICPA Plain English Guide to Independence,” July 1, 2009;

Areas/ProfessionalEthics/…/plainenglish.doc. 35. Public Company Accounting Oversight Board (PCAOB), Rule 2100, “Registration Requirements

for Public Accounting Firms, rule2100 .

36. AICPA, Professional Standards Volume 2, AU Sections 101.06–07. 37. International Ethics Standards Board for Accountants, Handbook of the Code of Ethics for

Professional Accountants, 2012 Edition (New York: IFAC, 2012). 38. AICPA, Professional Standards Volume 2, ET Section 100-1 Conceptual Framework for

AICPA Independence Standards, New York: AICPA, 2012). 39. AICPA, Professional Standards Volume 2, ET Section 100-1. 40. AICPA, Professional Standards Volume 2, ET Section 100-1. 41. AICPA, Professional Standards Volume 2, AU Section 101.5. 42. Association of Certified Fraud Examiners, “Cooking the Books: What Every Accountant

Should Know About Fraud,” 43. AICPA, Professional Standards, Volume 2, ET Section 101-3. 44. SEC, Final Rule: Revision of the Commission’s Auditor Independence Requirements, February 5,

2001, .

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Chapter 4 AICPA Code of Professional Conduct 227

45. SEC, Release No. 249, File No. 3-10933, In the Matter of Ernst & Young LLP: Initial Decision, April 16, 2004, .

46. Securities and Exchange Commission (SEC), Case CV 13-02558. Filed 04/11/13, United States District Court Central District of California, SEC v. Scott London and Bryan Shaw, http://www .

47. Securities and Exchange Commission (SEC), Case 1:10 cv-04885. Filed 09/04/10, United States District Court Northern District of Illinois Eastern Division, SEC v. Thomas P. Flanagan and Thomas T. Flanagan , .

48. Securities and Exchange Commission (SEC), Case 1:10 cv-04885.

49. HR 3763, One Hundred Seventh Congress of the United States of America: The Sarbanes- Oxley Act, .

50. HR 3763,

51. Alison Frankel, “Sarbanes-Oxley’s Lost Promise,” Reuters News Agency interview with Karen Seymour, July 27, 2012, Q1BY20120727 .

52. SEC, Accounting and Auditing Enforcement Release (AAER) No. 1744, March 20, 2003, .

53. Michael Tomberlin, “Owens Sentenced to 5 Years in Prison,” The Birmingham News, December 10, 2005.…/app? .

54. AAER No. 1744.

55. International Ethics Standards Board for Accountants (IESBA), Handbook of the Code of Ethics for Professional Accountants (New York: IFAC, 2012).

56. AICPA, Professional Standards Volume 2, AU Section 102.02.

57. AICPA, Professional Standards Volume 2, AU Section 102.03.

58. AICPA, Professional Standards Volume 2, AU Section 102.04.

59. AICPA, Professional Standards Volume 2, AU Section 203.06

60. AICPA, Professional Standards Volume 2, AU Section 201.

61. AICPA, Professional Standards Volume 2, AU Section 301.01.

62. AICPA, Professional Standards Volume 2, AU Section 203.02 .

63. AICPA, Professional Standards Volume 2, AU Section 203.06 .

64. AICPA, Professional Standards Volume 2, AU Section 301.

65. AICPA, Professional Standards Volume 2, AU Section 301.01.

66. Louwers, pp. 610–611.

67. James D. Cashell and Ross D. Fuerman, “The CPA’s Responsibility for Client Information,” The CPA Journal (online), September 1995, aud0995.htm.

68. James D. Cashell and Ross D. Fuerman, “The CPA’s Responsibility for Client Information,” The CPA Journal (online), September 1995, aud0995.htm.

69. Fischer v. Kletz, 266 F.Supp. 180 (1967), 6FSupp180_1405.xml&docbase=CSLWAR1-1950–1985.

70. Gold v. DCL Incorporated, 399 F.Supp. 1123 (1973).

71. Timothy J. Louwers, Robert J. Ramsey, David H. Sinason, Jerry R. Strawser, and Jay C. Thibodeau, Auditing and Assurance Services, 5th edition (New York: McGraw-Hill Irwin, 2013).

72. Louwers, pp. 610–611.

73. AICPA, Professional Standards Volume 2, AU Section 302.02.

74. AU Section 302.02.

75. AICPA, Professional Standards Volume 2, AU Section 503.01

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228 Chapter 4 AICPA Code of Professional Conduct

76. AICPA, Professional Standards Volume 2, AU Section 502.01 77. Louisiana Board of Accountancy, “Statement of Position: Advertising and Public Communication,

Revised January 2007, Advertising_Jan-20073.pdf.

78. AICPA, Professional Standards Volume 2, AU Section 505.3. 79. AICPA, Professional Standards Volume 2, AU Section 505.4 80. AICPA, Professional Standards Volume 2, AU Section 505.3. 81. AICPA, Professional Standards Volume 2, AU Section 101.14. 82.

Top-100-Firms-2012.pdf. 83. AICPA, Professional Standards Volume 2, AU Section 101.17. 84. AU Section 101-17 85. AICPA, Professional Standards Volume 2, AU Section 101.18. 86. AICPA, Professional Standards Volume 2, AU Section 501.01. 87. AU Section 501.01. 88. New York State Board of Regents, Rules of the Board of Regents, Part 29, Unprofessional Conduct, 89. Texas State Board of Public Accountancy, Rule 501.76,

readtac$ext.TacPage?sl=R&app=9&p_dir=&p_rloc=&p_tloc=&p_ploc=&pg=1&p_tac=&ti= 22&pt=22&ch=501&rl=76.

90. United States v. Textron Inc., Docket no. 07-2631 (1st Cir., 8/13/09)., pdf .opinions/07-2631EB-01A.pdf.

91. AICPA, Professional Standards Volume 2, AU Section 501.04. 92. AU Section 501.04. 93. IRS Circular No. 230, 94. AICPA, Professional Standards Volume 2, AU Section 101-3. 95. The following discussion of tax standards comes from Statements on Standards for Tax

Services Nos 1–7, issued by the Tax Executive Committee of the AICPA in November 2009, and can be found at StatementsonStandardsforTaxServices/DownloadableDocuments/SSTS,%20Effective%20 January%201,%202010.pdf.

96. “KPMG Superseding Indictment: In Criminal Tax Case Related to KPMG Tax Shelters,”…/kpmgsupersedingindictmentpr.pdf.

97. “KPMG to Pay $456 Million for Criminal Violations,” Statement by IRS Commissioner Mark W. Everson, IR-2005-83, August 29, 2005

98. KPMG Superseding Indictment. 99. These standards can be found on the PCAOB website at

default.aspx. 100. These standards can be found on the PCAOB website at

default.aspx. 101. Michael Cohn, “Congress Probes Accountants’ Role in Financial Crisis,” Accounting Today,

April 6, 2011, Crisis-57948-1.html.

102. Cohn. 103. Cohn. 104. Joe Vardon, “Accounting firm faces claim of conflict of interest in audit of development agency,”

The Columbus Ohio Dispatch, May 1, 2013, accounting-firm-faces-claim-of-conflict-of-interest-in-audit-of-development-agency.

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Chapter 4 Cases

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