Discussion ethical

Chapter3PowerPointslides-1.pptx

Home >Business & Finance homework help >Accounting homework help >Discussion ethical

Organizational Ethics and Corporate Governance

Chapter 03

© 2023 McGraw Hill, LLC. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written consent of McGraw Hill, LLC.

Because learning changes everything.®

Learning Objectives

L O 3-1: Describe the causes of fraud, detection methods, and preventative controls.

L O 3-2: Describe the signs that an organization has collapsed ethically.

L O 3-3: Discuss compliance, integrity, and employee views about ethics in the workplace.

L O 3-4: Describe the scope and role of corporate governance systems in the ethical decision-making process.

L O 3-5: Explain the models of corporate governance and ethical expectations of organizations.

L O 3-6: Explain how the provisions of the Sarbanes-Oxley Act relate to corporate governance, including relationships with key parties.

L O 3-7: Discuss whistleblowing procedures under Dodd-Frank and concerns about the program.

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.

Fraud is not the same as an error, which can occur innocently. Fraud is a purposeful act to mislead others.

A common element of fraud is it leads to (material) misrepresentation of the financial statements.

How Fraud is Detected

According to the ACFE study of Occupational Fraud, the most common method of detection was a “tip,” (43%).

In organizations with hotlines, 49% come from a tip but declines to 31% percent in organizations with no hotline.

Internal audit was next with 15% followed by management review (12%).

The results indicate the need for strong internal controls and an effective audit committee.

Fraud Detection Methods

Detection Method	Percentage Reported	Median Loss
Tip	43%	$145,000
Internal Audit	15%	$100,000
Management Review	12%	$100,000
Other	6%	N/A
By Accident	5%	$200,000
Account Reconciliation	4%	$81,000
Document Examination	3%	$101,000
External Audit	4%	$150,000

Red Flag Warnings of Fraud

Individual behavioral traits/warning signs include living beyond one’s means (42%) and financial difficulties (26%).

The question is how can the anti-fraud controls identify these behavioral indicators of fraud?

Red flags might show up through internal and external relationships.

Frequency of Anti-Fraud Controls 1

Internal controls do not guarantee protection against fraud, however

They can help to both mitigate losses and deter some potential fraudsters.

With 43 percent of frauds being detected by tips, hotlines should play an essential role in organizations’ anti-fraud programs.

However, only 64% had a hotline mechanism in place and 13% provided rewards for whistleblowers.

Frequency of Anti-Fraud Controls 2

Anti-Fraud Control	Percentage Reported
External Audit of Financial Statements	83%
Code of Conduct	81%
Internal Audit Department	79%
Management Certification of Financial Statements	73%
External Audit of Internal Controls over Financial Reporting	68%
Management Review	65%
Hotline	64%
Independent Audit Committee	62%

Behavioral Indicators of Fraud

Behavioral Indicators of Fraud	Percentage Reported
Living Beyond Means	42%
Financial Difficulties	26%
Unusually Close Association with Vendor/Customer	19%
Control Issues, Unwillingness to Share Duties	15%
No Behavioral Red Flags	15%
"Wheeler-dealer" Attitude	13%
Irritability, Suspiciousness, or Defensiveness	13%
Divorce/Family Problems	12%

Financial Statement Fraud

A variety of factors discourage the reporting of fraud:

Poor tone at the top.

Dominating and intimidating personalities.

Mistrust.

Excessive team loyalty.

Management does not want to hear about problems.

A lack of sound policies and procedures.

Perception that wrongdoing will not be addressed if misconduct is reported.

Why Employees Don’t Come Forward

Fear of the unknown.

Fear that the report will not be handled anonymously or confidentially.

Fear that the reporter’s identity will be revealed to others in the organization.

Concern that the person perpetrating the misconduct will not be held responsible.

Possible Consequences of Reporting Fraud

Retaliation by co-workers.

Termination.

Future reputation.

Impact on others.

Results of investigation determine that the misconduct is unsubstantiated.

Emotional cost of whistleblowing.

How Financial Statement Fraud Occurs

Revenue Overstatement

Recording gross, rather than net, revenue.

Recording of revenues of other companies, 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.

Expense Understatement

Recording cost of sales as a non-operating expense.

Capitalizing operating costs.

Not recording some expense at all.

Improper Asset Valuations

Manipulating reserves.

Changing the useful lives of assets.

Failing to take a write-down when needed.

Manipulating estimates of fair market value.

Why Does Financial Statement Fraud Occur

Situational pressure

May prompt an otherwise honest person to commit fraud.

Typically occurs as a result of immediate pressure within the internal or external environment.

Perceived opportunity

The opportunity to commit fraud and conceal it must exist.

Rationalization

People who commit financial statement fraud are able to rationalize the act.

Being able to justify the act makes it possible.

Seven Signs of Ethical Collapse

“Occurs when any organization has drifted from the basic principles of right and wrong” Marianne Jennings

Pressure to maintain numbers.

Fear and silence.

Bigger than life C E O.

Weak board of directors.

Conflicts of interests overlooked or unaddressed.

Innovation like no other company.

Goodness in some areas atones for evil in others.

Pressure to Maintain Numbers and Fear of Reprisals

Ethical collapse occurs when there is an unreasonable and unrealistic obsession with meeting quantitative goals

“Financial results at all costs.”

Companies manipulate earnings to meet financial analyst expectations.

Those who report wrongdoing are ignored.

Fear of Reprisals

A culture of fear and silence can easily mask ethical problems.

Employees may be reluctant to raise issues of ethical concern because they may be ignored, treated badly, transferred, or worse.

The whistleblowing process in many organizations does not work because there is no hotline to report anonymously.

The whistleblowing process does not work because allegations are not taken seriously.

A “kill the messenger syndrome” exists when the organization does not want to hear about wrongdoings, so it responds negatively to the messenger.

Loyalty to the Boss and Weak Board of Directors

Young people selected by the C E O for their position based on inexperience, possible conflicts of interest, and unlikelihood to question the boss’s decisions.

Weak board of directors exists because of conflicts of interest arise from relationships between board members and the company/top management.

Ethics in the Workplace

A code of conduct goes beyond what is legal for an organization and provides normative guidelines for ethical conduct. Support for ethical behavior from top management is a critical component of fostering an ethical climate.

Measures that should be taken to establish an ethical culture:

Clear policies on ethical conduct including a code of ethics.

Ethics training program that instills a commitment to act ethically and explains the code provisions.

A top-level officer (Chief Ethics and Compliance Officer) to oversee ethics and compliance.

Use internal auditors to investigate whether ethics policies are followed.

Strong internal controls to prevent and detect unethical behaviors.

Whistleblowing policies, including reporting outlets.

Ethics hotline for anonymous tips.

Ethics statement signed by employees.

Enforce ethics policies fairly and take immediate action against violators.

Reward ethical behavior and include in performance evaluation system.

K P M G Integrity Survey

Employees asked what they would do if they observed a violation of their organization’s standards of conduct:

78% would notify their supervisor or another manager.

54% would try resolving the matter directly.

53% would call the ethics or compliance hotline.

26% would notify someone outside the organization.

23% would look the other way or do nothing.

75% would inform their supervisor.

Employee Perception About Ethics in the Workplace

When organizations prioritize integrity, employees are:

Less likely to feel pressure to violate ethics standards;

Less likely to observe misconduct;

More likely to report misconduct they observe; and,

Less likely to experience retaliation for reporting.

Using Social Media to Criticize the Employer

Employees sometimes feel inclined to post negative comments about their employer outline.

When those comments are solely made by the individual with no input from others, the N L R B treats it as a “personal gripe” and it’s not protected speech.

When others comment on the posting, it is protected because it is deemed to be a “concerted effort,” — that is, more representative of the group, not one’s individual feelings.

Ethical and Legal Responsibilities of Officers and Directors

Directors and officers are fiduciaries of the corporation as their relationship with the corporation and its shareholders is one of trust and confidence.

Duty of Care – act in good faith, exercise the care that an ordinarily prudent person would exercise in a similar situation.

Duty of Loyalty – act in the best interest of corporation’ loyalty can be defined as faithfulness to one’s obligations and duties.

Role of Corporate Governance Systems

Maximize shareholder wealth

Problems of agency costs.

Executive compensation packages/stock options.

Represent all stakeholders

Investors, creditors, employees and other interests considered.

Stewardship Function

Fiduciary duty of managers.

More consistent with stakeholder views.

Corporate Governance Oversight and Regulation

Independent directors

Executive versus nonexecutive directors.

Audit committee responsibilities.

Oversee financial reporting

Work with internal and external auditors.

Monitor internal controls.

Key Audit Committee Responsibilities

Meet at least annually with the independent auditor and review the audit report describing independent auditor’s internal quality control procedures.

Discuss all relationships between the independent auditor and the company to enable assessment of the auditor’s independence.

Discuss earnings press releases and financial information and earnings guidance given to analysts and rating agencies.

Discuss policies with respect to risk assessment and risk management.

Meet separately, from time to time, with management, with internal auditors, and with independent auditors.

Review with the independent auditor any audit problems or difficulties and management’s response to such issues.

Report regularly to the board of directors.

Evaluate work of the audit committee annually.

Corporate Social Responsibilities

Refers to the ethical expectations that society has for business.

Ethical responsibilities are those things that we ought to, or should do, even if we prefer not to.

Corporations have an ethical responsibility to prevent harm.

Sexual harassment.

Other forms of discrimination.

Workplace safety.

Sustainability

Forerunner of conscious capitalism.

Sustainability describes the ability to maintain various systems and processes.

Environment.

Social responsibilities.

Social equality.

Economic.

Triple Bottom Line

The three “Ps”

People.

Planet.

Profit.

Describing the scope of reporting in three broad areas affecting society:

Economic including financial reporting.

Ecological including the environment.

Social including social responsibility.

Economic Model of C S R

Businesses’ sole social responsibility is to fulfill the economic functions they were designed to serve.

Managers must work to further the owners’ interests.

Dominant model of C S R: “managerial capitalism.”

Places shareholders at the center of the corporation.

Ethical responsibility is to serve those shareholders.

Argued for by Milton Friedman as the one and only social responsibility of business.

Increase profits by pursuing profits without deception while playing within the rules.

Stakeholder Model of C S R

Business Stakeholders.

Investors and shareholders, creditors, employees, customers, suppliers, government agencies, communities and others.

Have a “stake” or a claim in some aspect of a company’s products, operations, markets, industry, and outcome.

Stakeholder orientation is the degree to which an organization understands and addresses stakeholder demands, consists of:

Generation of data about stakeholder groups and assessment of the firm’s effects on these groups.

Distribution of this information throughout the firms.

The responsiveness of the organization to this information.

Example of Good C S R?: The Case of the Ford Pinto

Subcompact car.

Unsafe gas tanks could burst into flames.

Initial ethical legalism defense.

Risk/cost benefit analysis.

Too costly to replace the fuel tanks.

Compliance with law versus ethical behavior – met all safety requirements.

Utilitarian reasoning.

Focus on costs and benefits.

Ignores rights of various stakeholders.

Ignores cost of potential lawsuits.

Corporate Governance Structures and Relationships: Sarbanes Oxley

Section 301

Independent audit committee.

Receive whistleblower complaints.

Section 302

Certification of financial statements by C E O & C F O.

Section 404

External auditor report on management assessment of effectiveness of internal controls.

Sarbanes-Oxley Act

Section 406

Code of ethics for financial officers.

Section 806

Prohibits retaliation against whisteblowers.

Section 906

Written statement by the C E O and C F O about compliance with S E C reporting requirements.

Financial statements present, in all material respects, the financial condition and results of operations.

Liability for False Certifications

S E C’s increased focus on identifying and penalizing misstatements in public company financials.

Analyzing patterns of internal control problems even absent a restatement of the financials.

Quality Services Group Inc. (Q S G I) C E O and C F O held responsible for alleged misrepresentations in public disclosures about the company’s internal controls environment.

Signed Form 10-Ks with management reports on internal controls that falsely omitted issues.

Signed certifications in which they falsely represented that they had evaluated the management report on internal controls and disclosed all significant deficiencies to auditors.

Transparency with the company’s audit committee and with external auditors regarding evaluations of the company’s internal controls and whether it protects the company, its investors, and its officers.

Internal Control Relationships

With internal auditors.

Should have direct and unrestricted access to the audit committee.

Audit committee.

Financial statement certification process.

Establish disclosure controls.

Responsible for channeling employees to submit confidential concerns over accounting and auditing matters.

Whistleblower hotline.

Audit Committee

Independent directors with one having financial expertise.

Oversight of financial reporting.

Internal audit function.

External auditors.

C E O and C F O financial statement certification process.

Review formal announcements of earnings, significant financial reporting judgments, internal controls and risk management procedures, whistleblower and compliance program, external auditor’s independence and objectivity and effectiveness of audit process.

Seen as the one body that should be able to prevent identified fraudulent financial reporting.

Committee should meet separately with the senior executives, the internal auditors, and the external auditors.

Internal Auditors

Monitor corporate governance activities and compliance with organization policies.

Review effectiveness of the organization’s code of ethics and whistle-blower provisions.

“Eyes and ears” of audit committee.

Assess audit committee effectiveness and compliance with regulations.

Oversee internal controls and risk management processes.

Assurance on how effectively the organization assesses and manages its risk.

Assurance on data security and privacy controls.

External Auditors

An obligation to the public interest that underlies their corporate governance responsibilities.

Protect the interests of shareholders.

Conduct audits independent of any influence of management or the company.

Communicate effectively with the audit committee: accounting policies and procedures, estimates by management, quality of financial reporting, potential violations of laws.

Ensure accountability for financial reporting process.

Internal Controls

Prevent and detect errors and fraud.

Asset misappropriations.

Materially false and misleading financial reports.

Inadequate disclosures.

Ensure management policies are followed.

Ethical systems built into corporate governance.

Can be overridden by top management.

Do what C E O says, not what he does.

Creates cynical attitude.

Managers need to “walk the talk” of ethics.

C O S O Internal Control – Integrated Framework

Emphasizes roles of B O D, management, internal auditors, and personnel.

Designed to provide reasonable assurance.

Effectiveness and efficiency of operations.

Reliability of financial reporting.

Compliance with laws and regulations.

Framework.

Control environment: ethics of the organization.

Risk assessment.

Control activities.

Monitoring.

Information and communication.

Internal Control Weaknesses

Internal control includes all of the processes and procedures that management puts in place to help make sure that its assets are protected and that company activities are conducted in accordance with the organization’s policies and procedures.

An effective system of internal controls is critical to establish an ethical corporate culture that should be supported by the tone at the top.

An internal control system, no matter how well conceived and operated, can provide only reasonable – not absolute – assurance to management and the board of directors regarding achievement of an entity’s objectives.

Management override of internal controls may be a problem.

Whistleblowing

Employees (former or current) who report suspected violations to persons or organizations that may be able to effect action.

Illegal.

Immoral.

Illegitimate.

Four elements:

The whistleblower.

The whistleblowing act or complaint.

The party to whom the complaint is made.

The organization involved with the complaint.

“Organizational Dissidence” – similar to civil disobedience.

Whistleblower laws protects employees who provide information on a fraud against retaliation.

Morality of Whisteblowing 1

Organizational policies should be designed to encourage moral autonomy, individual responsibility, and organizational support for whistleblowers.

Moral agency is important for the determination of moral behavior.

Autonomy means to act according to reasons and motives that are taken as one’s own and not the product of policies, laws, etc.

If pressure exists in an organization not to report wrongdoing, a rational, moral person will withstand such pressure, even with perceived retaliation, because it is a moral requirement to do so.

Morality of Whisteblowing 2

Michael Davis considers whistleblowing to be morally required when it is required at all; a moral obligation to prevent serious harm to others if it can be done with little cost to the individual.

Application of a rule utilitarian perspective could lead to the conclusion that a categorical imperative exists to do whatever it takes to stop fraudulent behavior regardless of whether the action might bring more harm than good to the stakeholders.

DeGeorge thinks “corporations have a moral obligation not to harm.” His criteria for when whistleblowing is morally permitted include:

Firm’s actions will do serious and considerable harm to others.

Whistleblowing is justifiable once the employee reports it to her supervisor and makes her moral concerns known.

Absent any action by the supervisor, the employee should take the matter all the way up to the board.

Documented evidence must exist that would convince a reasonable and impartial observer that one’s view of the situation is correct and that serious harm may occur.

The employee must reasonably believe that going public will create the necessary change to protect the public and is worth the risk to oneself.

Rights and Duties

Whistleblowers hope and believe their speaking out will achieve correction of what they perceive as the organizational wrongdoing.

“Retaliatory climate” in the organization is the primary barrier to blowing the whistle on corporate wrongdoing.

When organizations establish an ethical culture and anonymous channels to report wrongdoing, it creates an environment that supports whistleblowing and whistle-blowers while controlling for possible retaliation.

Exhibit 3.12 Whisteblower Reporting Mechanisms

Mechanism	Percentage Reported
Telephone Hotline	33%
Email	33%
Web-based/online form	32%
Mailed letter/form	12%
Other	9%
Fax	1%

Exhibit 3.13 To Whom Did Whisteblowers Initially Report?

Reporting method	Percentage Reported
Direct supervisor	28%
Other	15%
Fraud investigation team	14%
Internal audit	12%
Executive	11%
Coworker	10%
Law Enforcement or regulator	7%
Owner	7%
Board or audit committee	6%
Human resources	6%
In-house counsel	4%
External audit	1%

Menendez v Halliburton, Inc.

Menendez was the Director of Technical Accounting Research and Training.

Only months before that Halliburton had settled with the S E C after a two-year accounting probe.

Menendez realized the company was violating very basic accounting revenue recognition rules.

Accountants were counting the full value of the equipment right away as revenue, even before it had assembled the equipment, customer could walk away until delivery, and Halliburton was liable for loss on damaged equipment.

Menendez tried to get Halliburton to change accounting method, but no action was taken.

He then spoke to the S E C and was told to go to the audit committee.

Halliburton’s general counsel circulated Menendez’s complaints to the C F O, K P M G, other top executives and accounting department.

He was stripped of his responsibilities and became a pariah at the firm.

Appeals court panel ruled that Menendez had been retaliated against for blowing the whistle.

Compliance Function

Organization’s ethics officer.

Ensures that the organization is in compliance with the laws and regulations, including S E C securities laws, S O X, and Dodd Frank.

May report to the audit committee, C E O, or general counsel.

Official member of the c-suite.

Addresses existing requirements and anticipates regulatory changes and their likely impact.

Ethics and Compliance Officer Association (E C O A).

Ethics officer plays a critical role in helping create a positive ethical tone in organizations.

Dodd-Frank Wall Street Reform and Consumer Protection Act

2010 passage of Dodd-Frank established benefits for whistleblowers who aid in recovery of $1M or more and they can receive 10-30% of the recovery.

Defines a whistleblower as any individual who voluntarily provides information to the S E C relating to a violation of federal securities laws, is ongoing or is about to occur.

Voluntarily means the whistleblower has not provided the information previously to the government, a self-regulatory organization, or the P C A O B.

Concern: Will whistleblowers go external rather than internal with the information in order to receive an award (“bounty hunter”)?

Employees have a loyalty obligation to their employers, but loyalty should not be used to mask one’s ethical obligation to maintain integrity and protect the public interest.

Whistleblowing in conformity with Dodd-Frank rules sets aside confidentiality requirement.

Internal Accountants’ Eligibility

Internal accountants, including compliance and internal auditors, are excluded from receiving whistleblower awards under Dodd-Frank because of pre-existing legal duty and job responsibilities to report suspicion of illegal acts and fraud to management.

Under the following circumstances, internal accountants are eligible to become Dodd-Frank whistleblowers:

Disclosure to the S E C is needed to prevent “substantial injury” to the financial interest of an entity or its investors.

The whistleblower “reasonably believes” the entity is impeding investigation of the misconduct (for example, destroying evidence or improperly influencing witnesses).

The whistleblower has first reported the violation internally and at least 120 days have passed with no action.

External Auditor Eligibility

Whistleblower rules allow the auditor or an employee associated with the auditor to make a whistleblower submission alleging that the firm failed to assess, investigate or report wrongdoing in accordance with Section 10A, or that the firm failed to follow other professional standards.

Concerns about permitting C P As to obtain monetary rewards for blowing the whistle on their own firms’ performance of services for clients create significant problems including:

Undermining the ethical obligations of CPAs not to divulge confidential client information.

Harming the quality of external audits because client management might restrict access to client information for fear the financial incentive for whistleblowing could lead to report client-specific information to the S E C.

Overriding the firms’ internal reporting mechanisms for audit-related disagreements.

Incentivizing an individual to bypass existing programs to report disagreements including hotlines.

Integrity Considerations

It is the integrity standard that establishes the basis for moral action of auditors and avoids subordinating judgment.

Reporting procedures for accountants and auditors under the A I C P A Code (Exhibit 3.11).

The C P A should seek legal advice when difference of opinion exists on how best to handle disagreements with the client and the firm refuses to make the required adjustments.

The auditor should consider whether the relationship with the organization should be terminated including possibly resigning one’s position.

Resignation from the audit firm does not negate the auditor’s disclosure responsibilities to the S E C.

Accountants’ Obligations for Whisteblowing

Dodd-Frank contains provisions to encourage accountants and auditors to report corporate wrongdoing, and Section 10A of the S E C 19 34 Act requires reporting of fraud.

Whistleblowing in accounting is a duty when it is motivated by a desire to protect the public, confidentiality obligation not withstanding.

Process in deciding to report fraud.

Whether the violations have a material effect on the financial statements.

Has management or B O D taken remedial action?

If not, auditor must report to B O D. The board has one business to inform the S E C and provide copy to external auditor.

If auditing firm does not receive a copy within one business day.

Provide a copy of its own report to the S E C within one business day, or

Resign from the engagement and provide copy of report to the S E C within one business day of resigning.

The process must be handled through the client’s internal compliance system before external auditors turn to whistleblowing.

Whisteblowing Payouts

June 4, 2020, $50 million whistleblower award.

Largest ever rewarded to one whistleblower.

Since its inception in 2011, S E C’s whistleblower program has paid more than $175 million to whistleblowers.

Whistleblowing program is the right thing to do to protect the public interest, but concerns are:

A self-interested and opportunistic person may be induced to reveal company information to the S E C, with inadequate safeguards as to the quality of information provided.

Permitting compliance officers to become whistleblowers solely on the passage of time rather than case-specific considerations can erode corporate culture and trust in compliance officials who may subvert the objectives of preventing, detecting, and remediating corporate misconduct on an enterprise-wide basis.

Whisteblowers and Confidential Information

Erhart v. BofI Holdings.

Clarifies that employer confidentiality agreements do not supersede federal whistleblower rights.

Signals that retaliatory lawsuits against whistleblowers are unlikely to succeed.

Provides guidance to corporate whistleblowers concerning the use of company documents to blow the whistle.

Conclusion: Creating an Ethical Culture

Creating an ethical culture is a necessary but insufficient condition to ensure that ethical behavior occurs.

Individuals within the organization may attempt to subvert the systems and pressure others to look the other way or go along with wrongdoing under the guise of being a team player or accepting a one-time fix to a perceived problem.

In these situations, outlets should exist for employees to voice their values when they believe unethical or fraudulent behavior has occurred.

Discussion ethical

image1.png