Ethics

Text and Cases

Steven M. Mintz, DBA, CPA Professor of Accounting California Polytechnic State University,

San Luis Obispo

Roselyn E. Morris, Ph.D., CPA Professor of Accounting

Texas State University–San Marcos

Fourth Edition

Ethical Obligations and Decision Making in Accounting

ETHICAL OBLIGATIONS AND DECISION MAKING IN ACCOUNTING: TEXT AND CASES,

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FOURTH EDITION

Names: Mintz, Steven M., author. | Morris, Roselyn E., author. Title: 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, Ph.D., CPA, Professor of Accounting Texas State University-San Marcos. Description: Fourth Edition. | New York, NY : McGraw-Hill Education, 2016. | Revised edition of the authors' Ethical obligations and decision making in accounting, 2014. Identifiers: LCCN 2015044426 | ISBN 9781259543470 (alk. paper) Subjects: LCSH: Accountants--Professional ethics--United States--Case studies. Classification: LCC HF5616.U5 M535 2016 | DDC 174/.4--dc23 LC record available at http://lccn.loc.gov/2015044426

“Educating the mind without educating the heart is no education at all.” Aristotle

What Aristotle meant by this statement is intelligence that is not informed by our hearts--by compassion--is not really intelligent at all. We strive in this book not only to educate accounting students to be future leaders in the accounting profession but to stimulate your ethical perception and cultivate virtue thereby awakening your sense of duty and obligation to the public interest.

Dedication

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 has recently been acknowledged by accounting researchers as one of the top publishers in accounting ethics and in accounting education. He was selected for the 2014 Max Block Distinguished Article Award in the “Technical Analysis” category by The CPA Journal. Dr. Mintz received the 2015 Accounting Exemplar Award of the Public Interest Section of the American Accounting Association. He also has received the Faculty Excellence Award of the California Society of CPAs. Dr. Mintz writes two popular ethics blogs under the names “ethicssage” and “workplaceethicsadvice.”

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 chair 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.

About the Authors

Ethical Obligations and Decision Making in Accounting was written to guide students through the minefields of ethical conflict in meeting their responsibilities under the professions’ 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. An expanded discussion of professional judgment highlights the challenges to ethical decision-making for internal accountants and auditors, and external auditors. We hope that this book and classroom instruction will work together to provide the tools to help students to make ethical judgments and carry through with ethical actions.

The fourth edition of Ethical Obligations and Decision Making in Accounting: Text and Cases incorporates a behavioral perspective into ethical decision-making that encourages students to get in touch with their values and learn how to voice them in the workplace when conflicts arise and ethical dilemmas exist. We build on traditional philosophical reasoning methods by taking the process one step further, that is, to convert ethical intent into ethical action. The “Giving Voice to Values” (GVV) approach provides this link. If accounting professionals are successful in voicing values in a way that encourages doubters and detractors to join the effort, then there may be no need for whistle-blowing. We also connect many of the issues discussed in the book with a new final chapter on “Ethical Leadership.” Several states now require their accounting students to complete an ethics course prior to being licensed as a CPA. This book has been designed to meet the guidelines for accounting ethics education including:

What’s New in the 4 Edition? In response to feedback and guidance from numerous accounting ethics faculty, the authors have made many important changes to the fourth edition of Ethical Obligations and Decision Making in Accounting: Text and Cases, including the following:

encouraging students to make decisions in accordance with prescribed values, attitudes, and behaviors providing a framework for ethical reasoning, knowledge of professional values and ethical standards prescribing attributes for exercising professional skepticism and behavior that is in the best interest of the investing and consuming public and the profession.

th

Connect is available for the first time with assignable cases, test bank assessment material, and SmartBook. SmartBook is an excellent way to ensure that students are reading and understanding the basic concepts in the book and it prepares them to learn from classroom discussions. Several of the Chapter Cases are available in an auto-graded format to facilitate grading by instructors. The purpose of using the digital format is to better prepare students ahead of class to free up instructors to discuss a broader range of topics in their lectures and in the give-and-take between teacher and student. Connect Insight Reports will also give the instructor a better view into the overall class’s understanding of core topics prior to class, to appropriately focus lectures and discussion. The Connect Library also offers materials to support the efforts of first-time and seasoned instructors of accounting ethics, including a comprehensive Instructor’s Manual, Test Bank, Additional Cases, and PowerPoint presentations. Learning Objectives have been added and linked to specific content material in each chapter. Giving Voice to Values (GVV) approach is explained in Chapter 2 and used throughout the text. GVV is an innovative pedagogical method that complements the traditional philosophical reasoning

Preface

Chapter 1

Chapter 2

approaches to ethical decision-making by emphasizing developing the capacity to express one’s values in a way that positively influences others. The technique is used post-decision-making and is based on developing and fine-tuning an action plan using scripting and rehearsal. It is ideal for role-playing exercises. International auditing and ethics issues are incorporated into existing chapters. Added five new Discussion Questions to each chapter as well as revised questions with more current topics and issues. Replaced many of the cases with more current and topical issues. Eighteen of the 76 cases have been specifically developed to enable students to practice the “Giving Voice to Values” technique in the context of the decision-making model. Expanded the discussion of whistleblowing obligations of accounting professionals in Chapter 3 including guidelines for reporting under Dodd-Frank and the AICPA rules of conduct. Added a comprehensive section on professional judgment in accounting and auditing to Chapter 4 and models for making judgments and exercising professional skepticism. Updated Chapter 4 to incorporate the Revised AICPA Code of Professional Conduct. Expanded the discussion of the PCAOB inspection process in Chapters 5 and 6 for audits of companies listing stock in the U.S., including Chinese companies and audit deficiencies noted in inspections of U.S. companies. Updated case examples used throughout the text to describe earnings management techniques with expanded coverage in Chapter 7. New Chapter 8 on “Ethical Leadership” that ties together many of the topics in the chapters in the text. Ethical leadership is explored in the context of making ethical decisions and judgments in the performance of professional accounting services. Improved and expanded the scope of major cases that can be used as an end-of-course project to enhance the experiences of upper-division undergraduates and graduate students. Revised and greatly enhanced Instructor’s Resource Materials and supplements.

New discussion of the use of social networks and social media communications, personal responsibility, and workplace ethics. Expanded discussion of moral philosophies and implications for ethical reasoning in accounting and auditing. Expanded discussion of the Principles of the AICPA Code of Professional Conduct, the public interest obligation, and regulation in the accounting profession.

New discussion of moral intensity and influence on ethical decision making. New discussion of Kidder’s Ethical Checkpoints and link to moral action. Expanded discussion of Behavioral Ethics and cognitive development. New and comprehensive discussion of the GVV technique that provides a mechanism for students to act on ethical intent. Chapter 2 discusses the foundation of the approach including examples on applying the methodology. There are five cases in the chapter to engage students in discussions of the GVV approach to ethical action. Subsequent chapters also contain cases with a GVV dimension.

vi Preface

Chapter 3

Chapter 4

Chapter 5

New section on “Organizational Ethics and Leadership.” New discussion of “Character and Leadership in the Workplace.” Updated results from the National Business Ethics Survey, Association of Certified Fraud Examiners Global Survey, and KPMG Integrity Survey. Expanded discussion of financial statement fraud schemes. New discussion of the morality of whistleblowing. Added discussion of major whistleblower case of Anthony Menendez v. Halliburton, Inc. Expanded discussion of Dodd-Frank provisions for whistleblowing by internal accountants and auditors, and external auditors including when external auditors can blow the whistle on their audit firms. Expanded discussion of subordination of judgment rules and their application to whistleblowing.

Extensive new discussion of professional judgment in accounting. Added an explanation of KPMG Professional Judgment Framework. Expanded discussion of professional skepticism. New discussion of professionalism and commercialism. Comprehensive discussion of the Revised AICPA Code of Professional Conduct including: Conceptual Framework for Members in Public Practice and Conceptual Framework for Members in Business. New discussion of ethical conflict requirements and decision-making model under the Revised Code. Expanded discussion of AICPA Conceptual Framework for Independence Standards. Expanded discussion of integrity and subordination of judgment rules. New discussion of confidentiality and disclosing fraud. Expanded discussion of ethics in tax practice. Expanded discussion of “Insider Trading” cases against CPAs. New discussion of Global Code of Ethics.

Expanded discussion of errors, illegal acts, and fraud. New discussion of Private Securities Litigation Reform Act and reporting requirements to the SEC; fraud and confidentiality issues explored. Discussion of Professional Skepticism Scale that measures traits conducive to developing a questioning mind and informed judgment. Discussion of findings of the Center for Audit Quality of audit deficiencies. Expanded discussion of PCAOB audit inspection process and high rate of deficiencies of audit firms.

Preface vii

Chapter 7

Chapter 8 – New Chapter on Ethical Leadership Chapter 8 links back to discussions in Chapters 1 through 7 by incorporating material on “Ethical Leadership.” The purpose is to leave students with a positive message of the importance of being a leader and ethical leadership in building organizational ethics. Leadership in decision-making in accounting, auditing, tax, and advisory services engagements is addressed. The chapter includes 20 discussion questions and 6 new cases. The chapter includes the following major topics:

New cases that explore in depth legal obligations of accountants and auditors. Expanded discussion of auditor legal liabilities. Expanded section on legal liabilities under Sarbanes-Oxley. New discussion of International Financial Reporting Standards and international enforcement. New discussion of principles versus rules-based standards and SEC position on objectives-oriented standards. New section on “Compliance and Management by Values.” New section on “Global Ethics, Fraud, and Bribery” and the Foreign Corrupt Practices Act. Expanded discussion on regulatory issues and PCAOB inspections.

New section on “Non-Financial Measures of Earnings.” Expanded discussion of earnings management and professional judgment. Expanded discussion of the use of accruals and earnings management. Introductory discussion of new revenue recognition standard. Detailed examples of financial statement restatements of Hertz Corporation and Cubic Corporation, and CVS-Caremark merger.

Discussion of moral decision-making and leadership. Exploring different types of leaders: authentic leaders, transformational leadership, followership and leadership, and how social learning theory influences leadership. Revisiting moral intensity in the context of ethical leadership. Ethical leadership and internal audit function. Ethical leadership and tax practice. Gender influences in leadership. Causes of leadership failures. Case studies on ethical leadership. Implications of ethical leadership for whistleblowing activities. Values-based leadership. Ethical leadership and the GVV technique. Ethical leadership competence.

Chapter 6

viii Preface

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Acknowledgments

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.

We also appreciate the assistance and guidance given us on this project by the staff of McGraw-Hill Education, including Tim Vertovec, managing director; Natalie King, senior brand manager; Kyle Burdette, marketing manager; Rebecca Mann, senior product developer; Daryl Horrocks, program manager; Angela Norris, content project manager; Jacob Sullivan and Melissa Homer, content licensing specialists; and Jennifer Pickel, buyer. We greatly appreciate the efforts of Deborah Pfeiffer, copyeditor of the book. Finally, we would like to acknowledge the contributions of our students, who have provided 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 Steve Mintz at [email protected].

Donald Ariail, Southern Polytechnic State University Stephanie Bacik, Wake Tech Community College Charles Bunn, Jr., Wake Tech Community College Kevin Cabe, Indiana Wesleyan University Rick Crosser, Metropolitan State University of Denver Denise Dickins, East Carolina University Dennis L. Elam, Texas A&M University–San Antonio Rafik Elias, California State University–Los Angeles Athena Jones, University of Maryland University College Patrick Kelly, Providence College Lorraine S. Lee, University of North Carolina–Wilmington Stephen McNett, Texas A&M University–Central Texas Kenneth Merchant, University of Southern California Michael Newman, University of Houston Robin Radtke, Clemson University John Sennetti, NOVA Southeastern University Edward Smith, St. John’s University Dale Wallis, University of California–Los Angeles Extension

Preface xi

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

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

1-10 Better Boston Beans Conflict between wanting to do the right thing and a confidentiality obligation to a coworker.

Case # Case Name/Description

2-1 A Team Player (a GVV case) Ethical dilemma for audit staff member who discovers a deficiency in inventory procedures but is unable to convince the group to report it. Application of Giving Voice to Values approach.

2-2 FDA Liability Concerns (a GVV case) Conflict between a chef and CFO over reporting bacteria found in food and FDA inspection results. Application of GVV approach.

2-3 The Tax Return (a GVV case) Tax accountant’s ethical dilemma when asked by her supervisor to ignore reportable lottery winnings. Application of GVV approach.

2-4 A Faulty Budget (a GVV case) Ethical and professional responsibilities of an accountant after discovering an error in his sales budget. Application of GVV approach.

2-5 Gateway Hospital (a GVV case) Behavioral ethics considerations in developing a position on unsubstantiated expense reimbursement claims. Application of GVV approach.

2-6 LinkedIn and Shut Out Small business owner’s inability to gain support from LinkedIn after a contact in his professional network scams him out of $30,000.

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 defer reporting a market loss in earnings.

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

2-10 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.

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 Rite Aid Inventory Surplus Fraud Dilemma of director of internal auditing whether to blow the whistle under Dodd-Frank on Rite Aid’s inventory surplus sales/kickback scheme.

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

3-4 Franklin Industries’ Whistleblowing (a GVV case) Considerations of internal accountant how best to voice her values to convince others to act on questionable payments to a related-party entity.

3-5 Walmart Inventory Shrinkage (a GVV case) Pressure to reduce inventory shrinkage at a Walmart store amidst alleged accounting improprieties and related efforts of the protagonist to voice values.

3-6 Bennie and the Jets (a GVV case) Ethical and professional obligations in reporting accounting wrongdoing to higher-ups in the organization.

3-7 Olympus Major corporate scandal in Japan where Olympus committed a $1.7 billion fraud involving concealment of investment losses through fraudulent accounting.

3-8 Accountant takes on Halliburton and Wins! Violation of confidentiality provision in a whistleblowing case under SOX after Bob Menendez reported retaliation by Halliburton subsequent to informing the audit committee of improper revenue recognition policies using bill-and-hold transactions.

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 KBC Solutions Concerns about professional judgments made by audit senior after the review of workpaper files.

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.

Case Descriptions xiii

4-4 Commercialism and Professionalism (a GVV case) Ethical considerations in an alternative practice structure due to threats to independence; using GVV to resolve conflict.

4-5 Han, Kang & Lee, LLC Pressure between audit partner who wants the client to write down inventory and other partners that want to keep the client happy.

4-6 Tax Shelters Ethical dilemma of tax accountant in deciding whether to participate in tax shelter transactions targeted to top management of a client entity in light of cultural influences within the firm.

4-7 M&A Transaction Ethical issues concerning a decision to provide merger and acquisition advisory services for an audit client.

4-8 Valley View Hospital Ethical obligations of CPA in deciding whether to report a hospital/client for improper Medicare payments to the government because of a faulty Medicare accounting system.

4-9 AOL-Time Warner Fall out after CFO of AOL blows the whistle on improper round-trip accounting procedures in AOL-Time Warner merger and is investigated himself for his part in the fraud by the SEC.

4-10 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.

Case # Case Name/Description

5-1 Loyalty and Fraud Reporting (a GVV case) Employee who embezzles $50,000 seeks out the help of a friend to cover it up. Application of the fraud triangle and GVV.

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

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

5-4 Busy Season Planning Role of review partner in planning an audit.

5-5 Tax Inversion Questions about the use of IFRS in a consolidation with an Irish entity motivated by tax inversion benefits.

5-6 Rooster, Hen, Footer, and Burger Ethical obligations of a CPA following the discovery of an unreported related party transaction and push back by client entity.

5-7 Diamond Foods: Accounting for Nuts Application of the fraud triangle to assess corporate culture and analysis of fraud detection procedures.

5-8 Bill Young’s Ethical Dilemma Options of a friend of an auditor advising the auditor following his inappropriate downloading of client information that shows bribery of foreign officials.

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 and questions about professional judgment by auditors.

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

xiv Case Descriptions

6-1 Advanced Battery Technologies: Reverse Merger Application of legal standards to assess auditor liability following a reverse merger transaction by a Chinese company.

6-2 Heinrich Müller: Big Four Whistleblower? (a GVV case) Ethical dilemma of tax accountant after finding confidential files of a client engaged in tax avoidance transactions in Liechtenstein in view of a culture of strict loyalty to the firm.

6-3 Richards & Co: Year-end Audit Engagement Questions about audit procedures used to assess client’s improper use of a credit received from a client to prop up revenue in one year while agreeing to repay the supplier in the following year.

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 Kay & Lee LLP Auditor legal liability when foreseen third party relies on financial statement.

6-7 Getaway Cruise Lines: Questionable Payments to do Business Overseas (a GVV case) Ethical dilemma of Director of International Accounting in voicing her values with respect to a dispute within the company over how to report “questionable payments” made to a foreign government.

6-8 Con-way Inc. Auditor legal and audit responsibilities to assess facilitating payments and internal control requirements under the FCPA.

6-9 Satyam: India’s Enron Questions about corporate culture and fraud risk assessment surrounding CEO’s falsification of financial information and misuse of corporate funds for personal purposes.

6-10 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).

Case # Case Name/Description

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

7-2 Solutions Network, Inc. (a GVV case) Ethical challenges of a controller in voicing values when the company uses round-trip transactions to meet earnings targets.

7-3 GE: “Imagination at Work” Assessing whether GE used earnings management techniques to accelerate revenue and meet financial analysts’ earnings expectations.

7-4 Harrison Industries (a GVV case) Challenges faced by first-year accountant in voicing values upon questioning the appropriateness of recording an accrued expense.

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

7-6 Tier One Bank Failure of KPMG to exercise due care and proper professional judgment in gathering supporting evidence for loan loss estimates.

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

Case # Case Name/Description

Case Descriptions xv

7-9 The North Face, Inc. Questions about revenue recognition on barter transactions and the role of Deloitte & Touche in its audit of the client.

7-10 Beazer Homes Use of cookie jar reserves to manage earnings and meet EBIT targets.

Case # Case Name/Description

Case # Case Name/Description

8-1 Research Triangle Software Innovations (a GVV case) Advisory services staff member recommends the software package of an audit client to another client and deals with push back from her supervisor who is pushing the firm’s package; issues related to leadership and application of GVV in resolving the matter.

8-2 Cumberland Lumber Difference of opinion between chief internal auditor and aggressive CFO about recording year-end accruals.

8-3 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.

8-4 KPMG Tax Shelter Scandal Major tax shelter scandal case involving KPMG that explores ethical standards in tax practice and in developing tax positions on tax shelter products in a culture that promoted making sales at all costs.

8-5 Krispy Kreme Doughnuts, Inc. Questions about ethical leadership and corporate governance at Krispy Kreme, and audit by PwC, with respect to the company’s use of round-trip transactions to inflate revenues and earnings to meet or exceed financial analysts’ EPS guidance.

8-6 Rhody Electronics: A Difficult Client (a GVV case) Conflict between audit manager and controller over audit planning and execution and implications for ethical leadership.

Major Cases

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 Madison Gilmore’s Ethical Dilemma (a GVV case) Distinguishing between operational and accounting earnings management and efforts of controller to voice values and convince the CFO about inappropriateness of recoding revenue on a bill-and-hold transaction.

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 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.

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.

7-8 Sino-Forest: Accounting for Trees Failure of Ernst & Young to follow generally accepted auditing standards and lapses in professional ethics related to Chinese company’s nonexistent forestry assets; cultural considerations of doing business in China.

xvi Case Descriptions

1 Ethical Reasoning: Implications for Accounting 1

2 Cognitive Processes and Ethical Decision Making in Accounting 61

3 Organizational Ethics and Corporate Governance 111

4 Ethics and Professional Judgment in Accounting 201

5 Fraud in Financial Statements and Auditor Responsibilities 269

Brief Contents 6 Legal, Regulatory, and Professional

Obligations of Auditors 339

7 Earnings Management 405

8 Ethical Leadership and Decision-Making in Accounting 503

MAJOR CASES 547

INDEXES IN-1

Table of Contents Chapter 1 Ethical Reasoning: Implications for Accounting 1 Ethics Reflection 2 Integrity: The Basis of Accounting 4 Religious and Philosophical Foundations of Ethics 5 What Is Ethics? 7

Difference between Ethics and Morals 7

Norms, Values, and the Law 8

Ethical Relativism 9

Situation Ethics 10

Social Networkers and Workplace Ethics 13

Cultural Values 14

The Six Pillars of Character 15 Trustworthiness 16

Respect 18

Responsibility 18

Fairness 19

Caring 19

Citizenship 20

Expectations of Millennials 20

Reputation 21 Civility, Ethics, and Workplace Behavior 22 Modern Moral Philosophies 24

Teleology 25

Deontology 28

Justice 30

Virtue Ethics 32

The Public Interest in Accounting 33 Regulation of the Accounting Profession 34

AICPA Code of Conduct 35

Virtue, Character, and CPA Obligations 36 Application of Ethical Reasoning in Accounting 37

DigitPrint Case Study 37

Scope and Organization of the Text 41 Concluding Thoughts 42 Discussion Questions 43 Endnotes 46 Chapter 1 Cases 51

Case 1-1: Harvard Cheating Scandal 51

Case 1-2: Giles and Regas 52

Case 1-3: NYC Subway Death: Bystander Effect or

Moral Blindness 53

Case 1-4: Lone Star School District 54

Case 1-5: Reneging on a Promise 55

Case 1-6: Capitalization versus Expensing 55

Case 1-7: Eating Time 56

Case 1-8: Shifty Industries 56

Case 1-9: Cleveland Custom Cabinets 57

Case 1-10: Better Boston Beans 58

Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting 61 Ethics Reflection 62 Kohlberg and the Cognitive Development Approach 63

Heinz and the Drug 63

Universal Sequence 67

The Ethical Domain in Accounting and Auditing 67 Moral Reasoning and Moral Behavior 68 Rest’s Four-Component Model of Ethical Decision Making 69

Moral Sensitivity 70

Moral Judgment 70

Moral Motivation 71

Moral Character 71

Moral Intensity 72 Aligning Ethical Behavior and Ethical Intent: Virtue- Based Decision Making 73 Ethical Decision-Making Models 74

Kidder’s Ethical Checkpoints 75

Integrated Ethical Decision-Making Process 77

Application of the Integrated Ethical Decision-Making

Model: Ace Manufacturing 77

Behavioral Ethics 80 Giving Voice to Values 82

Reasons and Rationalizations 83

Basic Exercise in GVV 83

Ace Manufacturing: GVV Analysis 85

Concluding Thoughts 87 Discussion Questions 88 Endnotes 92 Chapter 2 Cases 96

Case 2-1: A Team Player? (a GVV case) 96

Case 2-2: FDA Liability Concerns (a GVV case) 96

Case 2-3: The Tax Return (a GVV case) 98

Case 2-4: A Faulty Budget (a GVV case) 99

Case 2-5: Gateway Hospital (a GVV case) 100

Case 2-6: LinkedIn and Shut Out 101

Case 2-7: Milton Manufacturing Company 102

Case 2-8: Juggyfroot 105

Case 2-9: Phar-Mor 106

Case 2-10: WorldCom 108

Table of Contents xix

Chapter 3 Organization Ethics and Corporate Governance 111 Ethics Reflection 112 Organizational Ethics and Leadership 114

Ethical Issue Intensity 114

Individual Factors 115

Organizational Factors 115

Opportunity 115

Business Ethics Evaluations and Intentions 115

Ethical or Unethical Behavior 116

Organization Influences on Ethical Decision Making 116

Ethical Dissonance Model 117

Seven Signs of Ethical Collapse 118 Pressure to Maintain the Numbers 119

Fear of Reprisals 119

Loyalty to the Boss 119

Weak Board of Directors 120

Stakeholder Orientation 120 The Case of the Ford Pinto 121

Establishing an Ethical Culture 123 Trust in Business 124

Johnson & Johnson: Trust Gained 124

Johnson & Johnson: Trust Deficit 125

Ethics in the Workplace 127 Character and Leadership in the Workplace 128

Integrity: The Basis for Trust in the Workplace 128

Employees Perceptions of Ethics in the Workplace 129

Fraud in Organizations 130 Occupational Fraud 130

Internal Control Weaknesses 134

Financial Statement Fraud 135

Foundations of Corporate Governance Systems 139 Defining Corporate Governance 139

Views of Corporate Governance 140

Corporate Governance Regulation 141

Executive Compensation 142

Corporate Governance Structures and Relationships 145

Ethical and Legal Responsibilities of Officers and

Directors 145

Honest Services Fraud 146

Relationships between Audit Committee, Internal

Auditors, and External Auditors 147

Internal Controls as a Monitoring Device 149

Compliance Function 152

Has SOX Accomplished Its Intended Goal? 152

Whistleblowing 154 Morality of Whistleblowing 154

Rights and Duties 155

Obligation to Report Fraud 157

Dodd-Frank Provisions 158

The Morality of Whistleblowing 161

Whistleblowing Experiences 161

Concluding Thoughts 162 Discussion Questions 163 Endnotes 166 Chapter 3 Cases 171

Case 3-1: The Parable of the Sadhu 171

Case 3-2: Rite Aid Inventory Surplus Fraud 175

Case 3-3: United Thermostatic Controls (a GVV

case) 176

Case 3-4: Franklin Industries’ Whistleblowing (a GVV

Case) 180

Case 3-5: Walmart Inventory Shrinkage (a GVV

Case) 181

Case 3-6: Bennie and the Jets (a GVV Case) 182

Case 3-7: Olympus 183

Case 3-8: Accountant takes on Halliburton and

Wins! 188

Case 3-9: Bhopal, India: A Tragedy of Massive

Proportions 192

Case 3-10: Accountability of Ex-HP CEO in Conflict of

Interest Charges 199

Chapter 4 Ethics and Professional Judgment in Accounting 201 Ethics Reflection 202 What is Professional Judgment in Accounting? 204

Link between Attitudes, Behaviors, and Judgment 204

KPMG Professional Judgment Framework 204

Link between KPMG Framework and Cognitive

Processes 205

Role of Professional Skepticism 206

The Public Interest in Accounting 207 Professionalism versus Commercialism 208

Investigations of the Profession: Where Were the Auditors? 209

Metcalf Committee and Cohen Commission:

1977–1978 209

House Subcommittee on Oversight and Investigations:

1986 210

Savings and Loan Industry Failures: Late 1980s–Early

1990s 211

Treadway Commission Report 211

The Role of the Accounting Profession in the Financial Crisis of 2007–2008 212

xx Table of Contents

AICPA Code: Independence Considerations for Members in Public Practice 214

Introduction to Revised Code 214

Members in Public Practice 215

Conceptual Framework for AICPA Independence

Standards 215

Safeguards to Counteract Threats 217

Global Code of Ethics 218

Relationships That May Impair Independence 218

SEC Position on Auditor Independence 221 SEC Actions Against Big Four CPA Firms 222

Insider Trading Cases 224

“Operation Broken Gate” 225

AICPA Code: Ethical Conflicts 226 Integrity and Objectivity 226

Conflicts of Interest 227

Subordination of Judgment 229

AICPA Code: Conceptual Framework for Members in Business 231

Threats and Safeguards 231

Ethical Conflicts 232

Integrity and Objectivity/Conflicts of Interest 233

Subordination of Judgment 234

Link between Conceptual Framework and Giving Voice

to Values 234

SOX: Nonaudit Services 235 Rules of Professional Practice 236

General Standards Rule (1.300.001) 236

Acts Discreditable (1.400.001) 237

Contingent Fees (1.510.001) 240

Commissions and Referral Fees (1.520.001) 241

Advertising and Other Forms of Solicitation

(1.600.001) 241

Confidential Information (1.700.001) 242

Form of Organization and Name (1.800.001) 244

Commercialism and the Accounting Profession 244

Ethics and Tax Services 245 Statements on Standards for Tax Services (SSTS) 245

Tax Shelters 247

PCAOB Rules 250 Rule 3520—Auditor Independence 250

Rule 3521—Contingent Fees 250

Rule 3522—Tax Transactions 250

Rule 3523—Tax Services for Persons in Financial

Reporting Oversight Roles 250

Rule 3524—Audit Committee Preapproval of Certain Tax

Services 251

Rule 3525—Audit Committee Preapproval of

Nonauditing Services Related to Internal Control over

Financial Reporting 251

Rule 3526—Communication with Audit Committees

Concerning Independence 251

Concluding Thoughts 252 Discussion Questions 253 Endnotes 256 Chapter 4 Cases 258

Case 4-1: KBC Solutions 258

Case 4-2: Beauda Medical Center 259

Case 4-3: Family Games, Inc. 260

Case 4-4: Commercialism versus Professionalism (a

GVV case) 261

Case 4-5: Han, Kang & Lee, LLC 262

Case 4-6: Tax Shelters 262

Case 4-7: M&A Transaction 263

Case 4-8: Valley View Hospital 264

Case 4-9: AOL-Time Warner 265

Case 4-10: Navistar International 266

Chapter 5 Fraud in Financial Statements and Auditor Responsibilities 269 Ethics Reflection 270 Fraud in Financial Statements 271

Nature and Causes of Misstatements 272

Errors, Fraud, and Illegal Acts 272

Reporting Fraud/Illegal Acts 274

The Fraud Triangle 276 Incentives/Pressures to Commit Fraud 277

Opportunity to Commit Fraud 277

Rationalization for the Fraud 278

Tyco Fraud 280

Fraud Considerations and Risk Assessment 282 Fraud Risk Assessment 282

Internal Control Assessment 282

Enterprise Risk Management—Integrated

Framework 283

Audit Committee Responsibilities for Fraud Risk

Assessment 285

Auditor’s Communication with Those Charged with

Governance 285

Management Representations and Financial Statement

Certifications 286

Audit Report and Auditing Standards 287 Background 287

Audit Report 287

Audit Opinions 290

Limitations of the Audit Report 292

Generally Accepted Auditing Standards (GAAS) 295

Professional Skepticism 297

Table of Contents xxi

PCAOB Standards and Inspections 299 PCAOB Standards 299

Audit Deficiencies—SEC Actions 305

PCAOB Inspections Program 305

Concluding Thoughts 308 Discussion Questions 309 Endnotes 312 Chapter 5 Cases 314

Case 5-1: Loyalty and Fraud Reporting (a GVV

case) 314

Case 5-2: ZZZZ Best 315

Case 5-3: Imperial Valley Community Bank 319

Case 5-4: Busy Season Planning 326

Case 5-5: Tax Inversion (a GVV case) 327

Case 5-6: Rooster, Hen, Footer, and Burger 328

Case 5-7: Diamond Foods: Accounting for Nuts 329

Case 5-8: Bill Young’s Ethical Dilemma 330

Case 5-9: Royal Ahold N.V. (Ahold) 331

Case 5-10: Groupon 334

Chapter 6 Legal, Regulatory, and Professional Obligations of Auditors 339 Ethics Reflection 340 Legal Liability of Auditors: An Overview 341

Common-Law Liability 342

Liability to Clients—Privity Relationship 343

Liability to Third Parties 344

Actually Foreseen Third Parties 344

Reasonably Foreseeable Third Parties 345

Auditor Liability to Third Parties 348

Statutory Liability 350 Securities Act of 1933 351

Key Court Decisions 352

Securities Exchange Act of 1934 353

Court Decisions and Auditing Procedures 355 Private Securities Litigation Reform Act (PSLRA) 358

Proportionate Liability 358

“Particularity” Standard 359

SOX and Auditor Legal Liabilities 361 Section 404. Internal Control over Financial

Reporting 361

Section 302. Corporate Responsibility for Financial

Reports 362

Perspective on Accomplishments of SOX 363

Foreign Corrupt Practices Act (FCPA) 363 Regulatory and Professional Issues: An International Perspective 368

Restoring the Public Trust 368

International Financial Reporting 368

Principles- versus Rules-Based Standards 370 Compliance and Ethical Issues 372 Global Ethics, Fraud, and Bribery 372

Global Ethics 372

Global Fraud 373

Global Bribery 373

PCAOB Inspections of Chinese Companies 375 Concluding Thoughts 376 Discussion Questions 376 Endnotes 379 Chapter 6 Cases 384

Case 6-1: Advanced Battery Technologies: Reverse

Merger 384

Case 6-2: Heinrich Müller: Big Four Whistleblower? (a GVV case) 385

Case 6-3: Richards & Co: Year-end Audit

Engagement 387

Case 6-4: Anjoorian et al.: Third-Party Liability 388

Case 6-5: Vertical Pharmaceuticals Inc. et al. v. Deloitte

& Touche LLP 391

Case 6-6: Kay & Lee, LLP 392

Case 6-7: Getaway Cruise Lines: Questionable Payments

to do Business Overseas (a GVV case) 392

Case 6-8: Con-way Inc. 395

Case 6-9: Satyam: India’s Enron 397

Case 6-10: Autonomy 400

Chapter 7 Earnings Management 405 Ethics Reflection 406 Motivation for Earnings Management 408

Earnings Guidance 408

Nonfinancial Measures of Earnings 413

Income Smoothing 414

Characteristics of Earnings Management 416 Definition of Earnings Management 416

Ethics of Earnings Management 417

How Managers and Accountants Perceive Earnings

Management 418

Earnings Quality 420

Accruals and Earnings Management 421

Earnings Management Judgments 422 Acceptability of Earnings Management from a

Materiality Perspective 422

Earnings Management Techniques 427 CVS Caremark Acquisition of Longs Drugstores 428

Definition of “Revenue Recognition” 433

xxii Table of Contents

New Revenue Recognition Standard 434

Earnings Management: One More Thing 435

Financial Shenanigans 436 Financial Statement Effects 436

Red Flags of Earnings Management 439

Examples of Shenanigans 440

Financial Statement Restatements 452 Characteristics of Restatements 452

Hertz Accounting Restatements 453

Restatements Due to Errors in Accounting and

Reporting 456

Concluding Thoughts 458 Discussion Questions 459 Endnotes 462 Chapter 7 Cases 468

Case 7-1: Nortel Networks 468

Case 7-2: Solutions Network, Inc. (a GVV case) 473

Case 7-3: GE: “Imagination at Work” 475

Case 7-4: Harrison Industries (a GVV case) 477

Case 7-5: Dell Computer 478

Case 7-6: TierOne Bank 481

Case 7-7: Sunbeam Corporation 483

Case 7-8: Sino-Forest: Accounting for Trees 488

Case 7-9: The North Face, Inc. 492

Case 7-10: Beazer Homes 496

Chapter 8 Ethical Leadership and Decision-Making in Accounting 503 Ethics Reflection 504 What Is Ethical Leadership? 506

Moral Person and Moral Manager 507

Authentic Leaders 508

Transformational Leadership 509

Followership and Leadership 509

Social Learning Theory 510

Moral Intensity 511

The Role of Moral Intensity, Organizational Culture, and Ethical Leadership in Accounting 511

Ethical Leadership and Audit Firms 512

Gender Influence on Decision Making of Public

Accounting Professionals 513

Ethical Leadership and the Internal Audit Function 514

Ethical Leadership and Tax Practice 515

The Role of CFOs 516

Ethical Leadership Failure 517 Implications for Whistleblowing in Accounting 518

A Case Study in Ethical Leadership 520 Accounting Leaders Discussed in the Text 522

Values-Driven Leadership 522 Ethical Leadership Competence 524 Concluding Thoughts 525 Discussion Questions 526 Endnotes 527 Chapter 8 Cases 531

Case 8-1: Research Triangle Software Innovations (a

GVV case) 531

Case 8-2: Cumberland Lumber 532

Case 8-3: Parmalat: Europe’s Enron 533

Case 8-4: KPMG Tax Shelter Scandal 539

Case 8-5: Krispy Kreme Doughnuts, Inc 541

Case 8-6: Rhody Electronics: A Difficult Client (a GVV

case) 544

Major Cases 547 Major Case 1: Adelphia Communications Corporation 548 Major Case 2: Royal Ahold N.V. (Ahold) 558 Major Case 3: Madison Gilmore’s Ethical Dilemma (a GVV Case) 566 Major Case 4: Cendant Corporation 567 Major Case 5: Vivendi Universal 576 Major Case 6: Waste Management 579

Learning Objectives

After studying Chapter 1, you should be able to:

LO 1-1 Explain how integrity enables a CPA to withstand pressures and avoid subordination of judgment.

LO 1-2 Discuss the relationship between one’s values and ethics, and legal obligations.

LO 1-3 Describe how the pillars of character support ethical decision making. LO 1-4 Di�erentiate between moral philosophies and their e�ect on ethical

reasoning in accounting. LO 1-5 Explain the concept of the public interest in accounting. LO 1-6 Discuss the Principles section of the AICPA Code of Professional Conduct. LO 1-7 Apply the IMA Statement of Ethical and Professional Practice to a case

study.

1 Ethical Reasoning: Implications for Accounting

Chapter

1

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 does a good person act wrongly in a particular situation? These are the ethical questions that arise from the Penn State scandal. Football head coach Joe Paterno and administrators at Penn State University looked the other way and failed to act on irrefutable evidence that former assistant coach Jerry Sandusky had 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, the top administrators at Penn State and Joe Paterno sheltered a child predator harming children for over a decade by concealing Sandusky’s activities from the board of trustees, the university community, and authorities. 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. McQueary testified at the June 2012 trial of Sandusky that he observed the abuse and informed 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.

Reasons for Unethical Actions The report gives the following explanations for the failure of university leaders to take action:

Explanations for Unethical Actions Former Penn State president Graham Spanier, who was fired by the board of trustees in November 2011, is quoted as discussing in an interview with Jeffrey Toobin of the New Yorker about how the university worked that “honesty, integrity, and always doing what was in the best interests of the university [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.”

A culture that fosters organizational interests to the exclusion of others explains what happened at Penn State, and it happens in other organizations as well, such as Enron

1 2

3

The desire to avoid the bad publicity The failure of the university’s board of trustees to have reporting mechanisms in place to ensure disclosure of major risks A president who discouraged discussion and dissent A lack of awareness of the Clery Act, which requires colleges and universities participating in federal financial aid programs to keep and disclose 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

4

Ethics Reflection

Chapter 1 Ethical Reasoning: Implications for Accounting 2

and WorldCom. The culture of an organization should be built on ethical values such as honesty, 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.

Postscript The Penn State case just does not seem to go away. Here is a list of actions subsequent to the initial case:

Ethical Blind Spots Leaders of organizations who may be successful at what they do and see themselves as ethical and moral still cultivate a collection of what Max Bazerman and Ann Trebrunsel call blind spots. 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.

As you read this chapter, think about the following questions: (1) What would you have done if you had been in Joe Paterno’s position, and why? (2) Which ethical reasoning methods can help me to make ethical decisions in accounting? (3) What are my ethical obligations to the public?

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. 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

As of the summer 2015, at least seven civil cases as well as criminal complaints against three former Penn State administrators have been pending. In January 2015, the National Collegiate Athletic Association (NCAA) agreed to restore 111 of former head coach Joe Paterno’s wins between 1998–2011, making Paterno once again the winningest coach in major college football. The Paterno family brought a lawsuit to contest the consent decree’s statement that the head coach covered for Sandusky to protect the school’s football program. The statue of Paterno that was tore down will be replaced by a projected $300,000 life-sized bronze sculpture downtown, about two miles from the original site, after Pennsylvanians overwhelmingly voted to support the school putting the statue out again by a margin of 59 to 25.

5

case.

Chapter 1 Ethical Reasoning: Implications for Accounting 3

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

LO 1-1 Explain how integrity enables a CPA to withstand pressures and avoid subordination of judgment.

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 subordination of judgment.” 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. Cooper approached the chief financial o�cer (CFO), Scott Sullivan, but was dissatisfied with his explanations. The chief executive o�cer (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

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7

Chapter 1 Ethical Reasoning: Implications for Accounting 4

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—the auditors during the fraud—supported Cooper. Sullivan was asked to resign, refused to do so, and was fired.

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.”

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.”

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

8

9

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Chapter 1 Ethical Reasoning: Implications for Accounting 5

is the concept that every person shares certain inherent human rights, which will be discussed later in this chapter. Exhibit 1.1 provides some examples of the universality of the Golden Rule in world religions provided by the character education organization Teaching Values.

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

noitatiCeluR nedloG eht fo noisserpxEnoigileR

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.

Sunnah

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 to another

whatsoever is not good for itself.

Dadisten-I-dinik,

94, 5

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 the judgment of others. Integrity encompasses the whole of the person, and it is the foundational virtue of the ancient Greek philosophy of virtue. 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 philosophers, 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.

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 decision, these philosophies rely

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Chapter 1 Ethical Reasoning: Implications for Accounting 6

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?

LO 1-2 Discuss the relationship between one’s values and ethics, and legal obligations.

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, morals, character.” 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. 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? 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. 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.” We adopt that definition and emphasize that it relies on ethical reasoning to evaluate the effects of actions on others—the stakeholders.

Difference between Ethics and Morals Ethics and morals relate to “right” and “wrong” conduct. While they are sometimes used interchangeably, they are different: ethics refer to rules provided by an external source, such as codes of conduct for a group of professionals (i.e., CPAs), or for those in a particular organization. Morals refer to an individual’s own principles regarding right and wrong and may be influenced by a religion or societal mores. Ethics tend to be more practical than morals, conceived as shared principles promoting fairness in social and business interactions. For example, a CEO involved in a sex scandal may involve a moral lapse, while a CEO misappropriating money from a company she is supposed to lead according to prescribed standards of behavior is an ethical problem. These terms are close and often used interchangeably, and both influence ethical decision making. In this text we oftentimes use the terms synonymously while acknowledging differences do exist. Another important distinction can be thought of this way: When we form a moral judgment, we are employing moral standards—principles against which we compare what we see in order to form a conclusion. Such judgments might be about particular conduct, which includes a person’s actions, or it might be about a person’s character, which includes their attitudes and beliefs. Ethics, on the other hand, involve the study and application of those standards and judgments which people create or are established by organizations. So, we could say that ethics are the operational side of morality.

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Norms, Values, and the Law Ethics deal 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 honesty, 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.

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

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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. 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 philosophies 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:

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 ethical considerations such as how one’s actions affect others. Nothing could be further from 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 service 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

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

Ethical relativism is the philosophical view that what is right or wrong and good or bad is not absolute

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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 agreement 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.

Moral Relativism in Accounting Accountants record and report financial truths. Their conduct is regulated by state boards of accountancy, professional codes of behavior, and moral conventions directed towards fairness and accountability. However, moral dilemmas and conflicts of interest inevitably arise when determining how best to present financial information. Betty Vinson is a case in point. She rationalized that in her circumstances going along with the improper accounting was justified because if Scott Sullivan, one of the foremost chief financial officers in the country, thought the accounting was all right, who was she to question it. After all, ethical judgments can be subjective and, perhaps, this was one of those situations. Clearly, Vinson suffered from moral blindness because she failed to consider the negative effects on shareholders and other stakeholders and moral failings of Sullivan’s position. There was a gap between the person she truly was and how she acted in the WorldCom fraud brought about by pressures imposed on her by Sullivan.

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 generalizes 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, claiming the moral codes are strictly subjective, situational ethicists recognize the existence of normative principles but question whether they should be applied as strict directives (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 generalizations 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.” A problem with a situation ethics perspective is that it can be used to rationalize actions such as those in the Penn State scandal.

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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.

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. In 1997, McCabe and Treviño surveyed 6,000 students in 31 academic institutions and found contextual factors, such as peer influence, had the most effect on student cheating behavior. Contextual appropriateness, rather than what is good or right, suggests that situations alter cases, thus changing the rules and principles that guide behavior.

It used to be that professors only had to worry about students copying from each other during exams and on assignments handed in, as well as bringing “notes” to an exam that are hidden from view. Plagiarizing also has been a concern. In extreme cases, students might gain unauthorized access to exams. A persistent problem has been access to past exams that some professors use over again. Here, the individual professor needs to take responsibility for changing exams and not blame students for behaviors that, while unethical, could be prevented by actions of the professor. Now, with the advent of electronic access to a variety of online resources, term papers can be acquired or other people found to write them for a student. A disturbing trend is the availability of the solutions manual and test bank questions online. Instructors have historically relied on these resources to assess student learning. All that may be assessed now is whether an otherwise unproductive student has suddenly become productive as a result of acquiring instructor’s resource materials or accessing previous exams. Here, students are to blame for irresponsible behavior and basically cheat themselves out of learning materials needed in the workplace and for the CPA Exam. Other forms of e-cheating include using cell phones to store data and cameras to zoom in and take pictures of test questions and then posting them on Web sites where other students can access the questions for later testing. Programmable calculators have been used for awhile to store information pertinent to potential test questions. In a study of cheating in business schools, of the 40 percent of students who indicated they used various electronic methods of cheating, 99 percent indicated from occasional use up to half the time.

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 circumstances, reflecting a situational ethic.

Student Cheating at the University of North Carolina If you’re a sports fan, by now you have heard about the paper-class scandal that we call “Tar Heel Gate” in which 3,100 student-athletes at the University of North Carolina in Chapel Hill (UNC) were essentially

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allowed to take classes without attending classes and given grades good enough to keep them eligible to play men’s football and basketball during a 20-year period.

For five years, UNC had insisted the paper classes were the doing of one rogue professor: the department chair of the African-American studies program, Julius Nyang’oro. However, an independent report found that five counselors actively used paper classes, calling them “GPA boosters,” and that at least two counselors suggested to a professor the grade an athlete needed to receive to be able to continue to play.

Many of the academic-athletic staff who were named and implicated were also named by university learning specialist Mary Willingham. Willingham said that she had worked with dozens of athletes who came to UNC and were unable to read at an acceptable level, with some of them reading on par with elementary schoolchildren. She also said there were many members of the athletic staff who knew about the paper classes, and her revelations contradicted what UNC had claimed for years—that Nyang’oro acted alone in providing the paper classes.

Willingham went public with detailed allegations about paper classes and, after an assault on her credibility by the university, filed a whistleblower lawsuit. In March 2015, UNC announced it would pay Willingham $335,000 to settle her suit.

In an unusual twist to the story, the director of UNC’s Parr Center for Ethics, Jeanette M. Boxill, was accused of steering athletes into fake classes to help them maintain their eligibility with the NCAA. Moreover, she covered up her actions after the fact. Boxill violated the most basic standards of academic integrity.

Although different in kind, Tar Heel Gate and the abuse scandal at Penn State have one common element: protecting the sports programs. At UNC, the goal was to keep student athletes eligible so that the sports programs would continue to excel and promote and publicize the school, not to mention earn millions of dollars in advertising. The NCAA investigation of the program is ongoing. In June 2015, five charges were leveled against UNC including a lack of institutional control for poor oversight of an academic department popular with athletes and the counselors who advised them. In August 2015, UNC notified

The university’s own report on the matter is highly critical of a program that knowingly steered about 1,500 athletes toward no-show courses that never met and were not taught by any faculty members, and in which the only work required was a single research paper that received a high grade no matter the content. Still, the only sanction imposed by the board of Southern Association of Colleges and Schools’ Commission on Colleges was a one-year probation. The board stopped short of imposing the harshest penalty, which would have blocked the country’s oldest public university from receiving federal funds, including student loan proceeds. We believe this is a slap on the wrist for such gross violations and the accrediting agency should be ashamed.

The violations of ethics by UNC raise many important questions. How could such a reputable college sports program get away with the behavior for 20 years? Who was responsible for keeping a watchful eye out for violations of NCAA rules? Where were the managers of the affected sport programs; what did they know; when did they know it; what actions, if any, did they take?

UNC suffered from ethical blindness. It failed to see the ethical violations of its actions in establishing a route for student-athletes to remain academically eligible. It acted in its own self-interest regardless of the impact of its behavior on the affected parties. The blind spots occurred because of a situational ethic whereby those who perpetrated the fraud and covered it up came to believe their actions were for the

the NCAA’s enforcement staff that it identified two new pieces of information regarding NCAA violations, including a lack of institutional control when it allowed athletes to participate in years’ worth of phony paper courses.

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greater good of those involved in the athletic program and the UNC community, much like at Penn State, but failed to see the effects of their actions on other stakeholders including other colleges that were at a competitive disadvantage. Honesty was ignored, integrity was not in the picture, and the athletes were not provided with the education they deserved. Ironically, in the end the very stakeholders who allegedly would benefit the greatest from student-athletes taking paper classes suffered the most.

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. 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 workplace 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. In 2006, McCabe, Butterfield, and Treviño reported on their findings regarding the extent of cheating among MBA students compared to nonbusiness graduate students at 32 universities in the United States and Canada. The authors found that 56 percent of business students admitted to cheating, versus 47 percent of nonbusiness students.

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’ propensity to cheat in an academic setting and their attitude toward unethical behavior in the business world.” 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.

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.

Social Networkers and Workplace Ethics The Ethics Resource Center conducted a survey of social networkers in 2012 to determine the extent to which employees use social networking on the job. The survey points out that social networking is now the norm and that a growing number of employees spend some of their workday connected to a social network. More than 10 percent are “active social networkers,” defined as those who spend at least 30 percent of their workday linked up to one or more networks.

One concern is whether active social networkers engage in unethical practices through communications and postings on social media sites. Survey respondents say they think about risks before posting online and consider how their employers would react to what they post. But, they do admit to discussing company information online: 60 percent would comment on their personal sites about their company if it was in the news; 53 percent share information about work projects once a week or more; greater than one-third say they often comment, on their personal sites, about managers, coworkers, and even clients. The survey concludes that nothing is secret anymore and, unlike in Las Vegas, management must assume that what happens at work does not stay at work and may become publicly known. An interesting result of the survey is active social networkers are unusually vulnerable to risks because they witness more misconduct and experience more retaliation as a result when they report it than their work colleagues. A majority (56 percent) of active social networkers who reported misdeeds

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experienced retaliation compared to fewer than one in five (18 percent) of other employee groups. An encouraging result is that effective training on the use of social networks and an ongoing commitment to an ethical culture in which employees act with integrity can mitigate the risks presented by social networking at work. The survey found that in companies with both social networking policies and training, employees are more aware of what they post, think more carefully about the implications of online activity, and spend less of their worktime online. Moreover, where policies are in place, half of the social networkers say it is unacceptable to publicly post comments about their company even when they do not identify it. Without policies, only 40 percent say such posts are unacceptable. In companies with social networking policies, 88 percent consider their employer’s reaction before making work-related posts, compared to the 76 percent in companies without such policies.

Our conclusion about using social networking sites at work is that the burden falls both on the employees, who should know better than to discuss company business online where anyone can see it, and employers who have the responsibility to establish a culture that discourages venting one’s feelings about the employer online for all to see. Organizational codes of ethics need to be expanded to create policies for the use of social networking sites, training to reinforce those policies, and consequences for those who violate the policies.

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 similarities and differences in cultures around the world: (1) individualism, (2) power distance, (3) uncertainty avoidance, and (4) masculinity. In 2001, a fifth dimension, long-term orientation—initially called Confucian dynamism—was identified. 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. 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.

EXHIBIT 1.2 Hofstede’s Cultural Dimensions

Countries/Scores

.S.U.K.UnapaJanihCaidnIaissuRlizarBselbairaV larutluC

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

19986402849383)VDI( msilaudividnI

26665966656394)SAM( ytinilucsaM

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 toward the cultural variable; low scores indicate the opposite.

Individualism (IDV) focuses on the degree that the society reinforces individual or collective 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

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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 work group 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 in order to “save face”, 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 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 essential ingredient in establishing workplace values and may affect ethical behavioral patterns.

The Six Pillars of Character

LO 1-3 Describe how the pillars of character support ethical decision making.

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 contact information. 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

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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.”

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.

Trustworthiness The dimensions of trustworthiness include being honest, acting with integrity, being reliable, 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 decisions. 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.” 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. Ultimately, integrity means to act on principle rather than expediency. If my superior tells me to do something wrong, I will not do it because it violates the ethical value of honesty. If my superior pressures me to compromise my values just this one time, I will not agree. I have the courage of my convictions and am true to the principles of behavior that guide my actions. 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. You know it’s wrong to plagiarize another writer’s material. Someone worked hard to get this report published. You would not want another

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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 attend the meeting because you are sick. Now you’ve also lied. You’ve started the slide down the proverbial 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 your supervisor and discuss the matter and, if necessary, 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. However, the ethics of the accounting profession allow for instances whereby informing those above your supervisor is expected, an act of internal whistleblowing, and in rare circumstances going outside the organization to report the wrongdoing. Whistleblowing obligations will be discussed in Chapter 3. 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. 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 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

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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 understandable position because of internal pressures that work against voicing one’s concerns and acting on one’s values, 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.

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.

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.”

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.” 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.”

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 abilities and conduct. You would not want to be disrespected or 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.

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Responsibility Josephson points out that our capacity to reason and our freedom to choose make us morally responsible for our actions and decisions. We are accountable for what we do and who we are.40

Chapter 1 Ethical Reasoning: Implications for Accounting 18

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. Responsibility for accounting professionals means to meet one’s ethical and professional obligations when performing services for an employer or client. Professional accountants in business often find themselves at the front line of protecting the integrity of the financial reporting process. Public accountants should approach audit services with an inquiring mind and be skeptical of what the client says and the information provided. As discussed later on, in the final analysis, the ultimate obligation of accounting professionals is to meet their public interest responsibilities. The public (i.e., investors and creditors) relies on the ethics of accountants and auditors and trusts they will act in the name of the public good.

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. 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 and 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.”

Fairness in accounting can be equated with objectivity. Objectivity means the financial and accounting information needs to presented free from bias, that is, consistent with the evidence and not based solely on one’s opinion about the proper accounting treatment. Objectivity helps to ensure that financial statements are reliable and verifiable. The purpose of objectivity is to make financial statements more useful to investors and end users.

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 benevolence enable a person who possesses these qualities to consider the interests of others. Josephson believes that caring is the

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“heart of ethics and ethical decision making.”44

The judgments we make in life reflect whether we have acted responsibly. Eleanor Roosevelt, the former first lady, puts it well: “One’s philosophy is not best expressed in words; it is expressed in the choices one makes...and the choices we make are ultimately our responsibility.”41

Chapter 1 Ethical Reasoning: Implications for Accounting 19

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 circumstances 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.” An important part of good citizenship is to obey the laws, be informed about the issues, volunteer in your community, and vote in elections. During his presidency, Barack Obama called for citizens to engage in some kind of public service to benefit society as a whole. Accounting professionals are part of a community with specific ideals and ethical standards that govern behavior. These include responsibilities to one another to advance the profession and not bring discredit on oneself or others. As citizens of a community, accountants and auditors should strive to enhance the reputation of the accounting profession. 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 a client’s trusting that CPA to perform services competently and maintain the confidentiality of client information (except for certain whistleblowing instances). One builds “reputational capital” through favorable actions informed by ethical behavior.

Expectations of Millennials Universum, the global employer branding and research company, annually surveys college undergraduate and MBA students. In 2014, it surveyed about 60,000 U.S. college students from 311 institutions to find out what they were looking for as they enter the world of work, as well as their views on the attractiveness of specific employers. The results of the survey reflect a desire to join an organization that respects its people, provides a supportive environment, recognizes performance, provides development and leadership opportunities, challenges one intellectually, fosters a work/life

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balance, and serves the public good.46

Chapter 1 Ethical Reasoning: Implications for Accounting 20

Students were asked to identify up to three career goals. The top five goals (with percentages of students who selected them) were:

It also asked students to identify the most important “attractors” an employer could offer. The responses provided by at least 40 percent of students were:

These results are interesting in that Millennials clearly recognize motivating factors other than money in selecting a career. Their values appear in many ways to be consistent with the Six Pillars of Character including respect, responsibility, fairness, and civic virtue. Moreover, they were concerned about a prospective employer’s reputation and image, and 39 percent found ethical standards to be an attractive attribute in a prospective employer, second only to financial strength (40 percent). Other civic virtue issues of importance included corporate social responsibility (21 percent) and environmental sustainability (13 percent). How did the accounting profession fare with respect to the most desirable businesses to work for? Perhaps not surprisingly, Google was the most desirable employer to work for (21 percent), followed by Walt Disney Company (14 percent) and then Apple (13 percent). Of the Big-4 international professional accounting firms, Ernst & Young (EY) was the highest rated (13 percent), followed by Deloitte (11 percent), PricewaterhouseCoopers (PwC) (10 percent), and KPMG (7 percent). We caution students not to make too much of the rank ordering of CPA firms because more prestigious surveys such as the 2015 survey conducted by Fortune Magazine of the top 500 companies to work for has KPMG at the top while another survey conducted by Vault in 2015 ranks PwC the highest. Consulting Magazine’s 2014 survey lists Deloitte Consulting as the best firm to work for followed by EY. These surveys generally are based on quality of life issues and development opportunities.

Reputation 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 a client’s trusting that CPA to perform services competently and maintain the confidentiality 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

Work/life balance (79 percent)1. Job security (50 percent)2. Be a leader or manager of people (43 percent)3. Be competitively or intellectually challenged (43 percent)4. Dedicated to a cause or feel I am serving a greater good (36 percent)5.

Leaders who will support my development (49 percent)1. Respect for its people (46 percent)2. Creative and dynamic work environment (43 percent)3. Recognizing performance (meritocracy) (43 percent)4. Friendly work environment (42 percent)5.

senator and presidential candidate John Edwards shows how quickly one’s reputation can be

Chapter 1 Ethical Reasoning: Implications for Accounting 21

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 presidential 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 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, admitted 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 reputation. 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, promise never to do it again, 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.

Civility, Ethics, and Workplace Behavior Can there be any doubt that incivility in society is on the rise? Not according to one of your authors. Mintz opines in his blog about incivility that daily we witness instances of inconsiderate, “in your face” behavior in communications and other forms of rudeness. There are many causes of incivility, many of which are social media–driven. The sometimes anonymous feel of posts on Twitter and other social media sites makes it relatively easy to use impersonal forms of communication to vent one’s feelings without the immediate consequences of face-to-face discussions. One inappropriate Twitter rant begets another and eventually we see a further erosion of ethics in society.

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Chapter 1 Ethical Reasoning: Implications for Accounting 22

Civility is not peripheral to ethics, dealing merely with manners, proper etiquette, and politeness. It runs much deeper and requires restraint, respect, and responsible action both in one’s personal behavior and professional activities. Remember, ethics deals in broad terms with how we treat others. Two pertinent questions are: Can you be civil and not entirely ethical? Can you be ethical and not terribly civil? The answer to the first is a qualified “yes.” You can be well behaved and gracious to others but still be motivated by non-ethical values such as greed. The problem is you may wind up using others to advance your self-interests. The answer to the second is “no.” Treating others badly and with disrespect means you have not committed to act in accordance with the pillars of character. Taken to its extreme, uncivil behavior could manifest itself in meanness toward others, bullying, and cyberbullying. Such behaviors fly in the face of caring and empathy for others. Fair treatment is replaced by biased behaviors against others who somehow are seen as different, inferior, or just not worthy of respect. Civility should be taught in our schools at the earliest possible age. Benjamin Franklin said that “the purpose of the high school shall be to teach civility, because without civility democracy will fail.” Just as one’s social networking practices in personal matters can influence workplace behavior including critical postings about fellow employees or the company, uncivil behavior in personal affairs might translate into incivility in the workplace. This may be company driven if employees feel mistreated or under extreme pressure to produce results. The result could be a lack of organizational commitment and loyalty issues that lead one to vent frustrations on social media. Of course, one’s propensity to act disrespectfully toward others can translate into workplace incivility including bullying behavior. Incivility in the workplace can lead to tangible costs for a business. In a survey of 800 managers and employees in 17 industries published in Harvard Business Review, Porath and Pearson report that workers who had experienced incivility indicated that they lost work time worrying about the incident (80 percent), their commitment to the organization declined (78 percent), performance declined (66 percent), lost work time avoiding the offender (63 percent), and intentionally decreased their work effort (48 percent).

Civility in accounting manifests itself in the way accounting professionals market and promote their services and in their interactions with clients. The AICPA Code of Professional Conduct prohibits acts that might bring the profession into disrepute or do harm to current or prospective clients. For example, advertising of professional services and solicitation of new clients should not be made in a false, fraudulent, misleading, or deceptive manner. CPAs should not make promises in their communications that may not be kept such as to create unjustified expectations of favorable results. Professionalism and work ethic are important qualities of accounting professionals. Professionalism is generally defined as the strict adherence to courtesy, honesty, and responsibility when dealing with individuals or other companies in business and clients in public accounting. For CPAs, this means to act in accordance with personal and professional values such as trustworthiness, integrity, transparency, and the pursuit of excellence. A strong work ethic includes completing assignments in a timely manner, diligently, and with the highest quality possible. Ethics and professionalism in accounting also means to always place the public interest ahead of one’s self-interests, the interests of an employer, and the client’s interests. The public expects accounting and auditing professionals to be selfless in the pursuit of the public good.

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Chapter 1 Ethical Reasoning: Implications for Accounting 23

Modern Moral Philosophies

LO 1-4 Differentiate between moral philosophies and their effect on ethical reasoning in accounting.

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 decision making occurs in accounting. 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. Moreover, even if we know what the right thing to do is, we still may be unable to act on our beliefs because others in the organization provide reasons and rationalizations to deviate from those beliefs and may establish barriers to ethical action. This occurred in the WorldCom fraud when Scott Sullivan, the CFO, attempted to divert Cynthia Cooper from her goal to reveal the accounting fraud. The noted philosopher James Rest points out that moral philosophies present guidelines for “determining how conflicts in human interests are to be settled for optimizing mutual benefit of people living together in groups.” However, there is no single moral philosophy everyone accepts. Notably, moral philosophies have been used to defend a particular type of economic system and individuals’ behavior within these systems.

Adam Smith’s seminal work, An Inquiry Into the Nature and Causes of the Wealth of Nations (1776), outlined the basis for free-market capitalism. Capitalism laissez-faire philosophies, such as minimizing the role of government intervention and taxation in the free markets, and the idea that an “invisible hand” guides supply and demand are key elements of his political philosophy. These ideas reflect the concept that each person, by looking out for his or her self-interest, inadvertently helps to create the best outcome for all. “It is not from the benevolence of the butcher, the brewer, or the baker, that we can expect our dinner, but from their regard to their own interest,” Smith wrote.

Even before Smith wrote The Wealth of Nations he produced a treatise on moral philosophy. The Theory of Moral Sentiments (1759) makes the case that business should be guided by the morals of good people. Smith sets forth a theory of how we come to be moral, of how morality functions on both individual and societal levels, and of what forces are likely to corrupt our sense of morality, which is derived from our capacity to sympathize directly and indirectly with other people. This occurs by feeling what others actually feel in their circumstances. We are able to achieve this moral perspective because of our consciences, which allow us to envision our own actions just as a disinterested observer might.

Moral norms therefore express the feelings of an impartial spectator. A feeling, whether on the part of a person motivated to take action or on the part of a person who has been acted upon by others, is worthy of moral approval if and only if an impartial observer would sympathize with that feeling. When achieving a morally right feeling is difficult, we call that achievement “virtuous”; otherwise, we describe people as acting or failing to act within the bounds of “propriety.” In the end, moral norms and ideals, and the judgments by which we guide ourselves towards those norms and ideals, arise out of the process by which we try to achieve mutual sympathy.

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Chapter 1 Ethical Reasoning: Implications for Accounting 24

Smith distinguishes two kinds of normative guides to action: rules and virtues. Moral rules bar certain types of egregious behavior, such as murder, theft, and rape. They provide a basis for shared expectations of society and are essential to justice, without which societies could not survive. Virtue, on the other hand, requires more than simply following moral rules. Our emotional tendencies not only affect the sentiments of the impartial observer but we adopt those sentiments so that we identify with and become the impartial spectator to the extent possible. If we are truly virtuous, a submission to certain rules will constrain everything we do, but within that framework we can operate without rules by adopting dispositions such as kindness, empathy, patience, endurance, and courage.

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 applicable 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 resolve ethical issues in business. Instead, we present them to aid in resolving ethical dilemmas in accounting. Exhibit 1.3 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. One word of caution. Even though you may know what the right thing to do is, that does not mean you will act in the same way as your thoughts and feelings. Distractions occur and reasons and rationalizations are provided, making it more difficult to “give voice to your values,” as will be discussed in Chapter 2.

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 realization 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.” 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 egoists 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.

Let’s examine the following example from the perspectives of egoism and enlightened egoism. The date

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is Friday, January 17, 2016, and the time is 5:00 p.m. It is the last day of fieldwork on an audit, and you

Chapter 1 Ethical Reasoning: Implications for Accounting 25

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Chapter 1 Ethical Reasoning: Implications for Accounting 26

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, 2015, and that were not confirmed 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 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 supervisor 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, 2015. 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 judgment to others’ judgment, including that of top management of the firm. 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, and then choose the course of action that provides the greatest benefits after the costs have been taken into account. 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.

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. 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

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example, a rule in accounting such as “don’t subordinate judgment to the client” 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 stakeholders, 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 “never compromise audit independence.” 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 general 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 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.

While utilitarianism is a very popular ethical theory, there are some difficulties in relying 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 liquidity? 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. 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.

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

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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 profession’s rules of conduct to meet their obligations to the users of the financial statements. 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 deontologists argue there are some things we should never do. 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 store owner to gain from his hard work 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. 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.

An important contribution of Kantian philosophy is the so-called categorical imperative: “Act only according to that maxim by which you can at the same time will that it should become universal law.” The “maxim” of our acts can be thought of as the intention 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 universally 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.

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

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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.

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 corresponding moral duties to respect those rights. One of the most widely discussed cases of this kind is taken from William Styron’s novel 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.

Now, we do not face such morally excruciating decisions in accounting (thank goodness). 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 decision 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.

Justice as Fairness John Rawls (1921–2002) developed a conception of justice as fairness using elements of both Kantian and utilitarian philosophy. He described a method for the moral evaluation of social and political institutions this way.

Imagine that you have set for yourself the task of developing a totally new social contract for today’s society. How could you do so fairly? Although you could never actually eliminate all of your personal biases and prejudices, you would need to take steps at least to minimize them. Rawls suggests that you imagine yourself in an original position behind a veil of ignorance. Behind this veil, you know nothing of yourself and your natural abilities, or your position in society. You know nothing of your sex, race, nationality, or individual tastes. Behind such a veil of ignorance all individuals are simply specified as rational, free, and morally equal beings. You do know that in the “real world,” however, there will be a wide variety in the natural distribution of natural assets and

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abilities, and that there will be differences of sex, race, and culture that will distinguish groups of people from each other.

Rawls says that behind the veil of ignorance the only safe principles will be fair principles, for you do not know whether you would suffer or benefit from the structure of any biased institutions. The safest principles will provide for the highest minimum standards of justice in the projected society. Rawls argues that in a similar manner, the rational individual would only choose to establish a society that would at least conform to the following two rules:

(a) reasonably expected to be to everyone’s advantage and

(b) attached to positions and offices open to all.

The first principle—often called the Liberty Principle—is very Kantian in that it provides for basic and universal respect for persons as a minimum standard for all just institutions. But while all persons may be morally equal, we also know that in the “real world” there are significant differences between individuals that under conditions of liberty will lead to social and economic inequalities.

The second principle—called the Difference Principle—permits such inequalities and even suggests that it will be to the advantage of all (similar to the utility principle), but only if they meet the two specific conditions. Thus the principles are not strictly egalitarian, but they are not laissez-faire either. Rawls is locating his vision of justice in between these two extremes. When people differ over what they believe should be given, or when decisions have to be made about how benefits and burdens should be distributed among a group of people, questions of justice or fairness inevitably arise. These are questions of distributive justice.

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, individuals 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. Justice as fairness is the basis of the objectivity principle in the AICPA Code that establishes a standard of providing unbiased financial information. 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 judgments 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, unaffected 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

Each person is to have an equal right to the most extensive basic liberty compatible with similar liberty for others.

1.

Social and economic inequalities are to be arranged so that they are both:2.

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materially misleading.

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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, organizations, or outcomes is not very strong, then procedural justice becomes more important. Consider, for example, a potential whistleblower who feels confident about bringing her concerns to top management 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, such as the Six Pillars of Character. 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 virtues 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. The philosopher Alasdair MacIntyre states that the exercise of virtue requires “a capacity 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 enable 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.

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 acceptable behavior in the accounting profession (its community). MacIntyre relates virtues to the internal rewards of a practice (i.e., the accounting profession). 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., AICPA Code principles) 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.

Mintz points out that the accounting profession is a practice with inherent virtues that enable

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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

Chapter 1 Ethical Reasoning: Implications for Accounting 32

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.

The virtues enable accounting professionals to resolve conflicting duties and loyalties in a morally appropriate way. They provide accountants with the inner strength of character to withstand pressures that might otherwise overwhelm and negatively influence their professional judgment in a relationship of trust. 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 investors and creditors ahead of any perceived loyalty obligation to your immediate supervisor or other members of top management. 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 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 Cynthia Cooper did 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.”

The Public Interest in Accounting

LO 1-5 Explain the concept of 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, professional bodies, and regulatory agencies 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. 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.

In the United States, the state boards of accountancy are charged with protecting the public interest in licensing candidates to become CPAs. The behavior of licensed CPAs and their ability to meet ethical and professional obligations is regulated by the state boards. Regulatory oversight is based on the statutorily defined scope of practice of public accountancy. There are 54 state boards including four U.S. territories. 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. The accounting profession is a community with values and standards of behavior. These are embodied

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in the various codes of conduct in the professional bodies, including the American Institute of Certified Public Accountants (AICPA). The AICPA is a voluntary association of CPAs with more than 400,000 members in 145

Chapter 1 Ethical Reasoning: Implications for Accounting 33

countries, including CPAs in business and industry, public accounting, government, and education; student affiliates; and international associates. CPA state societies also exist in the United States. The Institute of Management Accountants (IMA), with a membership of more than 70,000, is the worldwide association for accountants and financial professionals working in business. We discuss ethics 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 more than 180,000 members. The IIA also has a code of ethics for its professionals. 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 142,000 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 over 175 members and associate members in 130 countries representing approximately 2.5 million accountants. Typically, licensed CPAs work for public accounting firms, and in business, government, and education. It is important to note that state board rules and statutory regulations always supersede rules of professional associations, such as the AICPA, so that when the rules conflict a licensed CPA should follow the state board rules. A good example is when a licensed CPA has possession of client records while performing professional services. Under Rule 501.76 of the Texas State Board of Public Accountancy, a licensee must not withhold client records, including workpapers that constitute client records, once a demand has been made for them regardless of whether fees due to the licensee are outstanding for services already provided. However, under Rule 501 (Section 1.400.200) of the AICPA Code of Professional Conduct (AICPA Code), members of the AICPA can withhold member work product if there are fees due for the specific work product. In this instance, the more restrictive requirement of the Texas State Board must be followed.

Regulation of the Accounting Profession Professions are defined by the knowledge, skills, attitudes, behaviors, and ethics of those in the (accounting) profession. Regulation of a profession is a specific response to the need for certain standards to be met by the members of the profession. The accounting profession provides an important public service through audits and other assurance services and those who choose to join the community pledge to act in the public interest. According to IFAC Policy Position Statement 1, a number of reasons exist why regulation might be necessary to ensure that appropriate quality is provided in the market for professional accounting services. These include compliance with ethics, technical, and professional standards and the need to represent the interests of users of those services (i.e., investors and creditors).

Regulations exist to address the knowledge imbalance between the client and the provider of services, who has professional expertise. Regulation also helps when there are significant benefits or costs from the provision of accountancy services that accrue to third parties, other than those acquiring and producing the services. Effective regulation is predicated on serving the interests of those who are the beneficiaries of professional accounting services. To meet the public interest, regulation must be objectively determined, transparent, and implemented fairly and consistently. The benefits of regulation to the economy and society should outweigh the costs of that regulation. While regulation is important, it is a necessary but insufficient condition to ensure ethical and professional behavior. Regulations should be designed to promote and achieve this behavior. It is the ethical behavior of the professional accountant that is the ultimate guarantee of good service and

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AICPA Code of Conduct

LO 1-6 Discuss the Principles section of the AICPA Code of Professional 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 in most of this book. 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 to apply a framework of professional values along with ethical reasoning to a dilemma faced by management accountants. 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.

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 professional conduct to moral judgment, the AICPA Code recognizes the importance of moral reasoning in meeting professional obligations. 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 commerce.” 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. In discharging their professional responsibilities, CPAs may encounter conflicting pressures from each of these groups. According to the public interest principle, when conflicts arise, the actions taken to resolve them should be based on integrity, guided by the precept that when CPAs fulfill their responsibilities to the public, clients’ and employers’ interests are best served. 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 intellectual honesty and be free of conflicts of interest in meeting professional responsibilities. Objectivity pertains to all CPAs in their performance of all professional services. Independence applies only to CPAs who provide attestation services (i.e., auditing and other assurance services), 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 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 investors and creditors (external users),

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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

Chapter 1 Ethical Reasoning: Implications for Accounting 35

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 and the exercise of due care to protect the public interest.

Independence is required both in fact and in appearance. Because it is difficult to determine independence in fact inasmuch as 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 competency 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 accordance with the public interest, (4) following relevant technical and ethical standards, and (5) properly planning and supervising engagements. A key element of due care is professional skepticism, which means to have a questioning mind and critical assessment of audit evidence. The importance of the due care standard is as follows. 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 quality 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 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 misstatement of the financial statements. 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 philosopher, discusses the moral point of view as being one that emphasizes practical reason and rational choice. 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 core values of integrity, objectivity, and independence; attitudes for exercising professional skepticism; and a framework for ethical reasoning all underlie virtue-based decision making in accounting.

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EXHIBIT 1.4 Virtues and Ethical Obligations of CPAs

cihtEseutriV s’eltotsirA al Standards for CPAs

Trustworthiness, benevolence, altruism Integrity

noitpeced-non ,ssenlufhturTytirgetni ,ytsenoH

Impartiality, open-mindednes ecnednepedni ,ytivitcejbOs

Reliability, dependability, faithfulness Loyalty (confidentiality)

erac euDssenihtrowtsurT (competence and prudence)

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 reasoned judgments to be made, and in accounting, they support integrity—the inner strength of character to withstand pressures that might otherwise overwhelm and negatively influence their professional judgment. A summary of the virtues is listed in Exhibit 1.4.

Application of Ethical Reasoning in Accounting

LO 1-7 Apply the IMA Statement of Ethical and Professional Practice to a case study.

In this section, we discuss the application of ethical reasoning in its entirety to a common 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 material misstatements in financial statements. Many internal accountants, such as controllers and CFOs, are CPAs and members of the IMA. The IMA’s Statement of Ethical Professional Practice is presented in Exhibit 1.5. 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.

DigitPrint Case Study DigitPrint was formed in March 2015 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.

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EXHIBIT 1.5 Institute of Management Accountants Statement of Ethical Professional Practice

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:

II. Confidentiality Each member has a responsibility to:

III. Integrity Each member has a responsibility to:

IV. Credibility Each member has a responsibility to:

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

Maintain an appropriate level of professional expertise by continually developing knowledge and skills.

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Perform professional duties in accordance with relevant laws, regulations, and technical standards.

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Provide decision support information and recommendations that are accurate, clear, concise, and timely.

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Recognize and communicate professional limitations or other constraints that would preclude responsible judgment or successful performance of an activity.

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

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Refrain from using confidential information for unethical or illegal advantage..

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

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

Communicate information fairly and objectively.. Disclose all relevant information that could reasonably be expected to influence an intended user’s understanding of the reports, analyses, or recommendations.

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Disclose delays or deficiencies in information, timeliness, processing, or internal controls in conformance with organization policy and/or applicable law.

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Chapter 1 Ethical Reasoning: Implications for Accounting 38

these policies do not resolve the ethical conflict, you should consider the following courses of action:

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 position 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, and the venture capitalists find out about the material misstatement in the financial

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.

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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.

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

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statements at a later date, then Wonderful would be 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 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, the lower income, and the effect of the unrecorded transactions on working capital; the company 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 statements would not “present fairly” financial position and results of operations. It violates the rights of the venture capitalists to receive accurate and reliable 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 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 president 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.

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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 accountants and auditors to place the public interest ahead of all other interests. Accounting 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. We hope that you will internalize the ethical standards 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 CFOs/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 obligations of accountants and auditors are best understood in the context of ethical and professional responsibilities and organizational ethics. Ethical leadership is a critical component of creating the kind of ethical organization environment that supports ethical decision making. 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 behavioral ethics issues and cognitive development to lay the groundwork for discussions of professional judgment and professional skepticism that form the basis of a sound audit. We 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. A critical component of ethical behavior is to go beyond knowledge of what the right thing to do is and translate such knowledge into action. Cognitive development theories address this issue. We also explain the “Giving Voice to Values” methodology that has become an integral part of values-based decision making. 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. We also address whistleblowing considerations for accounting professionals and the confidentiality requirement. The remainder of this book focuses more directly on accounting ethics. Chapter 4 addresses the AICPA Code and provisions that establish standards of ethical behavior for accounting professionals. In Chapter 5, we address fraud in financial statements, including the Fraud Triangle, and the obligations of auditors to assess the risk of material misstatements in the financial statements. We also address the PCAOB inspection process. Auditors can be the target of lawsuits because of business failures and deficient audit work. In Chapter 6, we look at legal liability issues and regulatory requirements. The techniques used to manipulate earnings and obscure financial statement items are discussed in the context of earnings management in Chapter 7. These “financial shenanigans” threaten the reliability of the financial reports

Chapter 1 Ethical Reasoning: Implications for Accounting 41

and can lead to legal liabilities for accountants and auditors. Finally, in Chapter 8, we look at ethical leadership, the heart and soul of an ethical organization. Leadership in the accounting profession is examined from the perspective of auditor and firm behavior. This chapter ties together much of the discussion in this book and discusses challenges to ethical decision making in the accounting profession going forward.

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. The messages sent by some reality programs is anti-ethics, such as MTV’s “16 and Pregnant.” Then there is the Canadian-based online dating service and social networking service, Ashley Madison. Its tacky Web site aims to facilitate cheating (Slogan: “Life is short. Have an affair.”) 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.” 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. 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.

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Discussion Questions 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 deontological and teleological methods to reason out what you would do and why.

1.

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.

2.

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

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

a.

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.

b.

4. 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?

a.

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.

b.

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 David Petraeus, former U.S. military general and head of the Central Intelligence Agency (CIA). On November 9, 2012, Petraeus resigned from the CIA after it was announced he had an extramarital 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 accepting 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?

5.

One explanation about rights is that there is a difference between what we have the right to do and6.

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what the right thing to do is. Explain what you think is meant by this statement. Do you believe that if someone is rude to you, you have a right to be rude right back? 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 10 percent of the sportscasters voted in 2015 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 (36.8 percent) and Clemens (37.5 percent) in their third year of eligibility (2015) 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. Evaluate whether Bonds and Clemens should be elected to the Hall of Fame from a situational ethics point of view.

7.

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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?

8.

Hofstede’s Cultural Dimensions in Exhibit 1.2 indicate that China has a score of only 20 in Individualism, while the U.S. score is 91. How might the differences in scores manifest itself when the public interest is threatened by harmful actions taken by a member of management who has direct control over an employee’s standing within the organization? Should cultural considerations in this instance influence ethical behavior?

9.

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

b.

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?

11.

Do you think it is ethical for an employer to use social media information as a factor when considering whether to hire an employee? What about monitoring social networking activities of employees while on the job? Use ethical reasoning in answering these questions.

12.

In a 2014 segment of Shark Tank, Trevor Hiltbrand, the founder of nootropic supplement maker Cerebral Success, sought funding from the “Sharks” to introduce a line of nootropic shots to be sold on college campuses in Five Hour Energy-style containers, but encountered some pushback from some of the Sharks who questioned the ethics of marketing to stressed-out, sleep-deprived college students anxious to get good grades. Should it matter if Hiltbrand was trying to capitalize on the need to gain a competitive edge in college by selling something that may not have received FDA approval?

13.

According to Adam Smith’s The Wealth of Nations, when it comes to government oversight in the free market and regulations, the less intervention, the better. Does the government play an important

14.

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role in encouraging businesses to behave in an ethical manner? Explain the basis for your answer. What role do environmental laws have in a capitalistic system? According to the 2011 National Business Ethics Survey conducted by the Ethics Resource Center, Generational Differences in Workplace Ethics, a relatively high percentage of Millennials consider certain behaviors in the workplace ethical when compared with their earlier counterparts. These include:

The report further concludes that younger workers are significantly more willing to ignore the presence of misconduct if they think that behavior will help save jobs.

Use ethical reasoning to support your points of view.

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Use social networking to find out about the company’s competitors (37%), “Friend” a client or customer on a social network (36%), Upload personal photos on a company network (26%), Keep copies of confidential documents (22%), Work less to compensate for cuts in benefits or pay (18%), Buy personal items using a company credit card (15%), Blog or tweet negatively about a company (14%), and Take a copy of work software home for personal use (13%).

Choose one or more behaviors and explain why Millennials might view the behavior as ethical.a. Choose one or more behaviors and explain why you think it is unethical.b.

How should an accounting professional go about determining whether a proposed action is in the public interest?

16.

Distinguish between ethical rights and obligations from the perspective of accountants and auditors.17. Using the concept of justice, evaluate how an auditor would assess the equality of interests in the financial reporting process.

18.

Why is it important for a CPA to promote professional services in an ethical manner? Do you believe it would be ethical for a CPA to advertise professional services using testimonials and endorsements? Why or why not?

19.

Do you think it would be ethical for a CPA to have someone else do for her that which she is prohibited from doing by the AICPA Code of Professional Conduct? Why or why not? Do you think a CPA can justify allowing the unethical behavior of a supervisor by claiming, “It’s not my job to police the behavior of others?”

20.

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.

21.

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

22.

Chapter 1 Ethical Reasoning: Implications for Accounting 45

Endnotes

Practice includes a confidentiality standard that requires members to “keep information 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?

23.

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 manipulation of numbers or records, would you agree to go along with the request? What ethical considerations exist for you in deciding on a course of action?

24.

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.

25.

Assume you are preparing for an interview with the director of personnel and you are considering some of the questions that you might be asked. Craft a response that you would feel comfortable

26.

Describe an experience in the workplace when your attitudes and beliefs were ethically challenged.

What are the most important values that would drive your behavior as a new staff accountant

Describe your ethical expectations of the culture in an accounting firm. What would you do if your position on an accounting issue differs from that of firm management?

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, Available at: www.thefreehreportonpsu.com/REPORT_FINAL_071212.pdf.

1.

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

2.

Eyder Peralta, “Paterno, Others Slammed In Report For Failing To Protect Sandusky’s Victims,” July 12, 2012, Available at: www.npr.org/blogs/thetwo-way/2012/07/12/156654260/was-there- a-coverup-report-on-penn-state-scandal-may-tell-us.

3.

Jeffrey Toobin, “Former Penn State President Graham Spanier Speaks,” the New Yorker online, August 22, 2012, Available at: www.newyorker.com/online/blogs/newsdesk/2012/08/graham- spanier-interview-on-sandusky-scandal.html#ixzz2PQ326lkq.

4.

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).

5.

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

6.

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

7.

Lynne W. Jeter, Disconnected: Deceit and Betrayal at WorldCom (Hoboken, NJ: Wiley, 2003).8.

giving for each one.

Use a personal example if you have not experienced a workplace dilemma.

in a CPA firm?

Chapter 1 Ethical Reasoning: Implications for Accounting 46

Securities Litigation Watch, Betty Vinson Gets 5 Months in Prison, Available at: http://slw.issproxy.com /securities_litigation_blo/2005/08/betty_vinson_ge.html.

9.

Cynthia Cooper, Extraordinary Circumstances (Hoboken, NJ: Wiley, 2008).10. Teaching Values, The Golden Rule in World Religions, Available at: www.teachingvalues.com/11.

William J. Prior, Virtue and Knowledge: An Introduction to Ancient Greek Ethics (London: Routledge, 1991).

12.

William H. Shaw and Vincent Barry, Moral Issues in Business (Belmont, CA: Wadsworth Cengage Learning, 2010), p. 5.

13.

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.

14.

Joseph Fletcher, Situation Ethics: The New Morality (Louisville: KY: Westminster John Knox Press), 1966.15. Josephson Institute of Ethics, 2012 Report Card on the Ethics of American Youth’s Values and Actions, Available at: http://charactercounts.org/programs/reportcard/2012/index.html.

16.

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, Available at: www.sociology.org/content/vol7.4 /lambert_etal.html.

17.

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.

18.

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

19.

Brenda Sheets and Paula Waddill, “E-Cheating Among College Business Students,” Information Technology, Learning, and Performance Journal, Fall 2009, Volume 25, Issue 2, p. 4.

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.

Ethics Resource Center, 2013 National Business Ethics Survey of Social Networkers, Available at: http://www.ethics.org/nbes/key-findings/social-networking/.

27.

Ethics Resource Center, 2013 National Business Ethics Survey of Social Networkers, Available at: http://www.ethics.org/nbes/key-findings/social-networking/, pp. 8–10.

28.

goldenrule.html.

Chapter 1 Ethical Reasoning: Implications for Accounting 47

(London: Sage, 1980). Geert Hofstede, Culture’s Consequences: Comparing Values, Behaviours, Institutions, and Organizations (Thousand Oaks, CA: Sage, 2001), p. 359.

30.

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).

31.

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

32.

Aristotle, Nicomachean Ethics, trans. W. D. Ross (Oxford, UK: Oxford University Press, 1925).33. Michael Josephson, Making Ethical Decisions, rev. ed. (Los Angeles: Josephson Institute of Ethics, 2002).

34.

Alasdair MacIntyre, After Virtue, 2nd ed. (Notre Dame, IN: University of Notre Dame Press, 1984).35. Josephson.36. George Washington, George Washington’s Rules of Civility and Decent Behavior in Company and Conversation (Bedford, ME: Applewood Books, 1994), p. 9.

37.

Washington.38. Cognitive Sciences Laboratory at Princeton University, WordNet, Available at: http://wordnet.princeton.edu.39.

40. Amy Anderson, “Profiles in Greatness - Eleanor Roosevelt,” Success, December 1, 2008, 41.

Josephson.42. Edmund L. Pincoffs, Quandaries and Virtues against Reductivism in Ethics (Lawrence: University Press of Kansas, 1986).

43.

Josephson.44. Josephson.45. Michigan Technological University/Business, Universum Student Survey 2014, University Report/ US Edition, Available at: http://www.mtu.edu/career/employers/partner/2014/presentations/usss 2014 university report - ug - business - michigan technological university.pdf.

46.

Rhonda Schwartz, Brian Ross, and Chris Francescani, “Edwards Admits Sexual Affair; Lied as Presidential Candidate” (Interview with “Nightline”), August 8, 2008.

47.

Christine Porath and Christine Pearson, “The Price of Incivility,” Harvard Business Review, January–February 2013, Available at: https://hbr.org/2013/01/the-price-of-incivility.

48.

James R. Rest, Moral Development: Advances in Research and Theory (NY: Praeger, 1986).49. Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (1776), eds. R. H. Campbell, A. S. Skinner, and W. B. Todd (Oxford: Oxford University Press, 1976).

50.

Adam Smith, The Theory of Moral Sentiments (1759), eds. D. D. Raphael and A. L. Macfie (Oxford: Oxford University Press, 1976).

51.

Samuel Fleischacker, “Adam Smith’s Moral and Political Philosophy,” The Stanford Encyclopedia of Philosophy (Spring 2013 Edition), ed. Edward N. Zalta, Available at: http://plato.stanford.edu/archives /spr2013/entries/smith-moral-political/.

52.

Geert Hofstede, Culture’s Consequences: International Differences in Work-Related Values29.

Josephson.

http://www.success.com/article/profiles-in-greatness-eleanor-roosevelt.

Chapter 1 Ethical Reasoning: Implications for Accounting 48

Ferrell et al., p. 157.54. Ferrell et al., p. 158.55. 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), Available at: www.scu.edu/ethics.

56.

Velasquez et al., 1989.57. Velasquez et al., 1989.58. Velasquez et al., 198959. Velasquez et al., 1989.60. Ferrell et al., pp. 160–161.61. Claire Andre and Manuel Velasquez, “Rights Stuff,” Markkula Center for Applied Ethics’ Issues in Ethics 3, no. 1 (Winter 1990), Available at: www.scu.edu/ethics/publications/iie/v3n1/.

62.

Velasquez et al., 1990.63. Immanuel Kant, Foundations of Metaphysics of Morals, trans. Lewis White Beck (New York: Liberal Arts Press, 1959), p. 39.

64.

Velasquez et al., 1990.65. Velasquez, et al. 1990.66. William Styron, Sophie’s Choice (London: Chelsea House, 2001).67. Manuel Velasquez, Claire Andre, Thomas Shanks, and Michael J. Meyer, “Justice and Fairness,” Issues in Ethics 3, no. 2 (Spring 1990).

68.

Ferrell et al., p. 165.69. MacIntyre, pp. 187–190.70. MacIntyre, pp. 190–192.71. Mintz, 1995.72. Mintz, 1995.73. Martin Stuebs and Brett Wilkinson, “Restoring the Profession’s Public Interest Role,” The CPA Journal 79, no. 11, (2009) pp. 62–66.

74.

James E. Copeland, Jr., “Ethics as an Imperative,” Accounting Horizons 19, no. 1 (2005), pp. 35–43.75. International Federation of Accountants (IFAC), IFAC Policy Position Statement 1, September 2011, Available at: http://www.ifac.org/system/files/publications/files/PPP1-Regulation-of-the- Accountancy-Profession.pdf.

76.

American Institute of Certified Public Accountants, Code of Professional Conduct at June 1, 2012 (New York: AICPA, 2012); Available at: www.aicpa.org/Research/Standards/CodeofConduct/

77.

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

78.

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

79.

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.

53.

Pages/default.aspx.

Chapter 1 Ethical Reasoning: Implications for Accounting 49

Ralph Waldo Emerson, Essays: First and Second Series (New York: Vintage Paperback, 1990).81. See: www.espn.go.com/mlb/story/_/id/8828339/no-players-elected-baseball-hall-fame-writers.82. Ethics Resource Center, Generational Differences in Workplace Ethics: A Supplemental Report of the 2011 National Business Ethics Survey, Available at: http://www.ethics.org/files/u5/2011

83.

IMA—The Association of Accountants and Financial Professionals in Business, IMA Statement of Ethical Professional Practice, Available at: www.imanet.org/pdfs/statement%20of%20Ethics_web.pdf.

80.

GenDiffFinal_0.pdf.

Chapter 1 Ethical Reasoning: Implications for Accounting 50

Chapter 1 Cases

Case 1-1 Harvard Cheating Scandal 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 professor and his teaching assistants. The issue is whether cheating 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. The university said that more than half of the students were forced to withdraw, a penalty that typically lasts from two to four semesters. Many returned by 2015. Of the remaining cases, about half were put on disciplinary probation—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 collaboration. 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 graduate 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 typographical errors in some cases), indicating that they had written them together or plagiarized them. But some students 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 instructions: “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 instructor clarified three exam questions by e-mail 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 teaching assistants sometimes encouraged collaboration, in fact. The teaching assistants—graduate students who 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 behavior in helping students to understand the questions better. An interesting part of the scandal is that, in March 2013, administrators searched e-mail accounts of some junior faculty members, looking for the source of leaks to the news media about the cheating investigation, prompting much of the faculty to protest what it called a breach of trust. Harvard adopted an honor code on May 6, 2014. The goal is to establish a culture of academic integrity at the university.

1

The facts of this case are taken from Richard Perez-Peña,” Students Disciplined in Harvard Scandal,” February 1, 2013, Available at www.nytimes.com/2013/02/02/education/harvard-forced-dozens-to-leave-in-cheating-scandal.html?_r=0. 1

Chapter 1 Ethical Reasoning: Implications for Accounting 51

in an institution such as Harvard University?

Answer the following questions about the Harvard cheating scandal.

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?

1.

Who is at fault for the cheating scandal? Is it the students, the teaching assistants, the professor, or the institution? Use ethical reasoning to support your answer.

2.

Do you think Harvard had a right to search the e-mail accounts of junior faculty, looking for the source of leaks to the news media? Explain.

3.

What is meant by the culture of an organization? Can an honor code establish a culture of academic integrity4.

Case 1-2 Giles and Regas 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 second 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 concerned 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 engagement 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 continued 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

Chapter 1 Ethical Reasoning: Implications for Accounting 52

possible seriousness of their relationship, while reflecting 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 managing 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 discussed why it was taking so long to get the audit recommendations 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 promises to get back to Sax by the end of the week.

Questions

Analyze the behavior of each party from the perspective of the Six Pillars of Character. Assess the personal responsibility of Ed Giles and Susan Regas for the relationship that developed between them. Who do you think is mostly to blame?

1.

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?

2.

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.

3.

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 without 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 camera. 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.”

Chapter 1 Ethical Reasoning: Implications for Accounting 53

In a written account Abbasi gave the Post, he said that the 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 present, 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 individual 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

Do you think the bystander effect was at work in the subway death incident? What role might situational ethics have played in Abbasi's response? How might the bystander effect translate to a situation where members of a work group observe financial improprieties committed by one of their group that threatens the organization? In general, do you think that someone would come forward?

1.

Another explanation for the inaction in the subway incident 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.

2.

What would you have done if you were in Abbasi's place and why?3.

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 District. There have been some problems with audit documentation 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 its 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

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 entertainment expenses?

1.

Using Josephson’s Six Pillars of Character as a guide, evaluate the statements and behavior of the manager.2. 3. 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? a.

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?

b.

Chapter 1 Ethical Reasoning: Implications for Accounting 54

Case 1-5 Reneging on a Promise

Part A Billy Tushoes recently received an offer to join the accounting 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

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

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?

1.

Identify the stakeholders in this case. Evaluate the alternative courses of action for Billy using ethical reasoning. What should Billy do? Why?

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.

Case 1-6 Capitalization versus Expensing 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 expenditures 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 capitalization. However, she is under a great deal of pressure to go along with capitalization to boost earnings and 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 Assume both Hernandez and Harrison hold the CPA and CMA designations.

What are the loyalty obligations of both parties in this case?1. Assume that you were in Gloria Hernandez’s position. What would motivate you to speak up and act or to stay silent? Would it make a difference if Harrison promised this was a one-time request?

2.

What would you do and why?3.

Chapter 1 Ethical Reasoning: Implications for Accounting 55

Case 1-7 Eating Time 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 forehead, took a glass of water, and asked, “Would it be better if I took some of the work home at night and on weekends, completed 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.”

In an effort to deal with the problem, Kevin contacts Joyce, a friend and fellow employee, and asks if she has faced similar problems. Joyce answers “yes” and goes on to explain she handles it by “ghost-ticking.” Kevin asks her to explain. “Ghost-ticking is when we document audit procedures that have not been completed.” Kevin, dumbfounded, wonders, what kind of a firm am I working for?

Questions

Kevin is not a CPA yet. What are his ethical obligations in this case? 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. What about engaging in ghost-ticking?

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?

3.

Case 1-8 Shifty Industries 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 liberally as possible. You are the tax accountant and a CPA working at the company and you report to the tax manager. He reports to the controller. You are concerned about the fact that your supervisor has asked you to go along with an improper

Chapter 1 Ethical Reasoning: Implications for Accounting 56

treatment of section 179 depreciation on the 2015 tax return so you can deduct the $100,000 full cost of eligible equipment against taxable income. The problem as you see it is the 2014 limitation of $500,000, which would have been fine for 2015 had Congress extended it, was rolled back to a maximum of $25,000. Therefore, your supervisor is planning to allow Shifty to deduct $75,000 more than allowed by law. Using a 35 percent tax rate it means the company is “increasing” its cash flow by $26,250. Answer the following questions to prepare for a meeting you will have tomorrow morning with the tax manager.

Questions

What values are most important to you in deciding on a course of action? Why? 1. Who are the stakeholders in this case and how might they be affected by your course of action?2. What would you do and why, assuming your approach will be based on the application of the ethical reasoning methods discussed in the chapter?

3.

Case 1-9 Cleveland Custom Cabinets Cleveland Custom Cabinets is a specialty cabinet manufacturer 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 administrative and sales staff members working for the company. James Leroy owns Cleveland Custom Cabinets. His accounting manager is Marcus Sims, who reports to the director of finance. Sims manages 15 accountants. The staff is responsible for keeping track of manufacturing costs by job and preparing internal and external financial reports. The internal reports are used by management 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 2016, it estimated total overhead to be $4.8 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 company’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, 2016, 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 working capital loan. He knew the bank would be reluctant to grant the loan based on the income numbers in Exhibit 1. Without the money, Cleveland could have problems financing everyday operations.

EXHIBIT 1 Cleveland Custom Cabinets

Net Income for the Quarter Ended March 31, 2016

Sales $6,400,000

Cost of goods sold 4,800,000

Gross margin $1,600,000

000,015,1sesnepxe evitartsinimda dna gnilleS

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, 2015, to 1.4 percent for March 31, 2016. Sims pointed out that the estimated overhead cost had doubled for 2016 compared to the actual cost for 2015. He explained to Leroy that rent had doubled and the cost of

Chapter 1 Ethical Reasoning: Implications for Accounting 57

utilities skyrocketed. In addition, the custom-making machinery was wearing out more rapidly, so the company’s repair and maintenance costs also doubled from 2015. Leroy wouldn’t accept Sims’s explanation. Instead, he told Sims that the quarterly income had to be at least the same percentage of sales as at December 31, 2015. Sims looked confused and reminded Leroy that the external auditors would wrap up their audit on April 30. Leroy told Sims not to worry about the auditors. He would take care of them. Furthermore, “as the sole owner of the company, there is no reason not to 'tweak’ the numbers on a one-time basis. I own the board of directors, so no worries there.” He went on to say, “Do it this one time and I won’t ask you to do it again.” He then reminded Sims of his obligation to remain loyal to the company and its interests. 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 accounting to you.”

Questions 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? What about the external auditors? Should Sims simply accept Leroy’s statement that he would handle them?

1.

2. Assume that Sims is a CPA and holds the CMA. Put yourself in Sims’s position. What are your ethical considerations in deciding whether to tweak the numbers?

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Assume you do a utilitarian analysis to help decide what to do. Evaluate the harms and benefits of alternative courses of action. What would you do? Would your analysis change if you use a rights theory approach?

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Think about how you would actually implement your chosen action. What barriers could you face? How would you overcome them? Is it worth jeopardizing your job in this case? Why or why not?

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Case 1-10 Better Boston Beans 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. Cyndie 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. Cyndie 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 paid for the tuition and books.)

Because Cyndie 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 Levy, who is the assistant shift supervisor. Jeffrey has been with Boston Beans for three years but recently was demoted from shift supervisor. Jeffrey reports to Sarah Hoffman, the new shift supervisor. Sarah reports to David Cohen, the owner of the store.

For the past two weeks, Jeffrey has been leaving before 11 p.m., after most of the stores in the Marketplace close, and he has asked Cyndie to close up by herself. Cyndie feels that this is wrong and it is starting to concern her, but she hasn’t spoken to Jeffrey or anyone else. Basically, she is afraid to lose her job. Her parents have told her that financially she is on her own. They were disappointed that Cyndie did not go to graduate school or interview for a professional position after graduating from college.

Something happened that is stressing Cyndie out and she doesn’t know what to do about it. At 11 p.m. one night, 10 Japanese tourists came into the store for coffee. Cyndie 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

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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 during the workday. Cyndie didn’t want to ignore the man’s comments, so she answered that her coworker had to go home early because he was sick. That seemed to satisfy the tourist. It took Cyndie 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, she reflected on the experience. Cyndie realized that it could get worse before it gets better because Jeffrey was now making it a habit to leave work early. At this point, Cyndie realizes that she either has to approach Jeffrey about her concerns or speak to Sarah. She feels much more comfortable talking to Sarah because, in Cyndie’s own words, “Levy gives me the creeps.”

Questions

Do you think it was right for Cyndie to tell the Japanese tourist that “her coworker had to go home early because he was sick?”

1.

Cyndie decided to speak with Jeffrey. From an ethical perspective, do you think Cyndie made the right decision as opposed to speaking directly with either Sarah Hoffman or David Cohen? Would you have done the same thing? Why or why not?

2.

During their discussion, Jeffrey tells Cyndie that he has an alcohol problem. Lately, it’s gotten to him really bad. That’s why he’s left early—to get a drink and calm his nerves. Jeffrey also explains that this is the real reason he was demoted. He had been warned that if one more incident occurred, David would fire him. He pleaded with Cyndie to work with him through these hard times. How would you react to Jeffrey’s request if you were Cyndie? Would your answer change if Jeffrey was a close personal friend instead of someone who gave you the creeps? Why or why not?

3.

Assume that Cyndie keeps quiet. The following week, another incident occurs. Cyndie gets into a shouting match with a customer who became tired of waiting for his coffee after 10 minutes. Cyndie felt terrible about it, apologized to the customer after serving his coffee, and left work that night wondering if it was time to

4.

apply to graduate school. The customer was so irate that he contacted David and expressed his displeasure about both the service and Cyndie’s attitude. David asks to meet with Jeffrey, Sarah, and Cyndie the next day. What are Cyndie’s ethical responsibilities at this point?

Chapter 1 Ethical Reasoning: Implications for Accounting 59

Learning Objectives

After studying Chapter 2, you should be able to:

LO 2-1 Describe Kohlberg’s stages of moral development. LO 2-2 Explain the components of Rest’s model and how it influences ethical

decision making. LO 2-3 Describe the link between moral intensity and ethical decision making. LO 2-4 Explain how moral reasoning and virtue influence ethical decision

making. LO 2-5 Apply the steps in the Integrated Ethical Decision-Making Model to a

case study. LO 2-6 Analyze the thought process involved in making decisions and taking

ethical action. LO 2-7 Describe the “Giving Voice to Values” technique and apply it to a case

study.

2 Cognitive Processes and Ethical Decision Making in Accounting

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Ethics Reflection

Arthur Andersen and Enron One event more than any other that demonstrates the failure 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. 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. 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 largest account and the largest client in the Houston office. Andersen’s judgment was compromised by this relationship 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. When Enron declared bankruptcy, there was $13.1 billion in debt on the company’s books, $18.1 billion on its nonconsolidated subsidiaries’ books, and an estimated $20 billion more off the balance sheets. Barbara Toffler pinpoints Andersen's failures in Final Accounting, her book about the rise and fall of Andersen, noting that The Powers Report denounced Andersen for failing to fulfill its professional and ethical obligations in connection with its auditing of Enron’s financial statements, as well as to bring to the attention of Enron’s board of directors concerns about Enron’s internal controls over these related-party transactions.

The possibility of an accounting fraud at Enron was first raised in an article by two Fortune magazine reporters, Bethany McLean and Peter Elkind, who in 2004 wrote a book that became the basis for a movie of the same name, titled The Smartest Guys in the Room, in which they criticized Andersen for failing to use the professional skepticism that requires that an auditor approach the audit with a questioning mind and a critical assessment of audit evidence.

Andersen’s ethics were 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 investigators 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 earnings were artificially low due to several hundred million dollars of nonrecurring expenses and write-offs. The proposed adjustments were not material, Berardino testified, because they represented less than 8 percent of “normalized” earnings.

The Enron-Andersen relationship illustrates how a CPA firm can lose sight of its professional obligations. While examining Enron’s financial statements, the auditors at Andersen knew that diligent application of strict auditing standards required one decision, but that the consequences for the firm were harmful to its own business interests. It placed the client's interests ahead of its own and the public interest.

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 violating Section 10(b) of the Securities

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In this chapter, we explore the process of ethical decision 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. That may be more difficult than it sounds because the accountant may encounter resistance from those who have a vested interest in the outcome and provide reasons and rationalizations for deviating from sound ethical decisions in a particular instance. In such cases, the decision maker needs to finnd a way to give “voice” to values -- express one’s beliefs and act on them. Think about the following questions as you read this chapter: (1) What are the cognitive processes that guide ethical decision making? (2) What would you do if your attitudes and beliefs conflict with your intended behavior? (3) If you encounter resistance to ethical action, ask yourself: Who can I speak to, what can I say, and what actions can I take to act in accordance with my values?

As we practice resolving dilemmas we find ethics to be less a goal than a pathway, less a destination than a trip, less an inoculation than a process.

Ethicist Rushworth Kidder (1944–2012)

Kidder believed that self-reflection was the key to resolving ethical dilemmas, and a conscious sense of vision and deep core of ethical values provide the courage to stand up to the tough choices.

Kohlberg and the Cognitive Development Approach

LO 2-1 Describe Kohlberg’s stages of moral development.

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 philosophical theories of justice and rights. Kohlberg’s views on ethical development are helpful 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.

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

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Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting 63

him to make: It cost $200 for the radium, and he 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 to 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. 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.

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

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.

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 intentions (i.e., the ends justify the means). In Response C (Postconventional), a societywide perspective is used in decision making. Law is the key in making moral decisions (for example, rule utilitarianism; justice orientation). The examples in Table 2.2 demonstrate the application of Kohlberg’s model of cognitive development to possible decision making in business.

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Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting 64

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.

(Continued)

Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting 65

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 (bribery) 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.

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.” 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 1.3 (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 (GAAP, in this instance) 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 principle 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. This creates an objective standard for determining the right decision. The auditor reasons that the orderly functioning of markets and a level

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Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting 66

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 application of virtues such as objectivity and integrity enables her to carry out the ethical action and act in a responsible manner. 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 values and ethical behavior. In the context of business, an individual’s moral development can be influenced by corporate culture, especially ethics training. 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. 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.

The Ethical Domain in Accounting and Auditing Professions, such as accounting, are characterized by their unique expertise gained through education and training, a commitment to lifelong learning, service to society, a code of ethics, and an agreement to abide by the profession’s code, and participation in the self-governance and monitoring of the profession. A commitment to serve the public interest is the bedrock of the accounting profession. Snoeyenbos, Almeder, and Humber have described this as a “social contract,” in which the professional discharges her obligation by operating with high standards of expertise and integrity. When the profession does not maintain these standards, the social contract is broken, and society may decide to limit the role or the autonomy of the profession. This occurred in the aftermath of the accounting scandals when Congress passed the Sarbanes-Oxley Act (SOX) and established the Public Company Accounting Oversight Board (PCAOB) to oversee the auditing, ethics, and independence practices of CPA firms that audit companies with stock listed on the New York Stock Exchange (NYSE) and NASDAQ. For nonpublicly-owned companies, the standards of the AICPA still apply.

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 collective interests of the firm’s management; (3) the accounting profession, including various regulatory bodies such as the Securities and Exchange Commission (SEC) and the PCAOB; and (4) the general public, who rely on the attestations and representations of the practitioner and the firm. 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 beneficiary of the independent auditing services, so the public interest may conflict with client interests. These conflicts might influence the cognitive development of auditors, thereby influencing their ethical reasoning.

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The accounting profession’s codes of conduct (i.e., the AICPA Code and IMA Ethical Standards) 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. If an auditor reasons at the postconventional 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 accountants and auditors in practice. Findings show that ethical reasoning may be an important determinant of professional judgment, such as the disclosure of sensitive information and auditor independence. 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. 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.

The role of an accountant is to tell a story—to make an account—of a series of business activities. This story can be told from a variety of perspectives (i.e., employer or client) and can therefore result in many accounts. It is the role of the accountant to determine the perspective that will fairly present the information in accordance with laws and accounting standards, but they contain options and ambiguities. A higher level of understanding is required to deal with these different perspectives, the options and ambiguities that exist within the standards, and the uncertainties of business life. This higher level of understanding is encapsulated in the postconventional level of reasoning.

Moral Reasoning and Moral Behavior

Within the cognitive-developmental paradigm the most distinguishing characteristic of morality is the human capacity to reason. Moral judgment has long been regarded as the single most influential factor—and the only truly moral determinant—of a person’s moral behavior. By definition, morality requires that a person’s actions be rational, motivated by purpose or intent, and carried out with autonomous free will. Kohlberg maintained that it is as a result of development in moral reasoning that one becomes truly a moral person, in both mind and deed.

Kohlberg’s work is not without its critics. Some philosophers complain it draws too heavily from Rawls’s Theory of Justice and makes deontological ethics superior to other ethical perspectives. They note that the theory applies more to societal issues than to individual ethical decisions. A number of psychologists have challenged the notion that people go through “rigid” stages of moral reasoning, arguing instead that they can engage in many ways of thinking about a problem, regardless of their age.

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Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting 68

Although he later admitted to having underestimated the complexity of the relation between moral stage and action and revised his thinking to include two intervening cognitive functions to explain it—a prescriptive judgment of the moral right and a personal judgment of responsibility to act accordingly —Kohlberg still contended that it is the logic of a person’s reasoning that most strongly influences her moral behavior. Thus, reason constitutes the essential core and strength of character of a person’s moral maturity in Kohlberg’s theory.

Kohlberg’s commitment to reason has been challenged by some who claim he disregarded other factors also associated with moral functioning, such as emotion and traits of character. Others have criticized Kohlberg’s emphasis on reason without considering its interaction with other components of morality, and its link to moral behavior in particular. Still others claim the over-reliance on dilemmas, such as Heinz and the Drug, to evaluate moral reasoning shortchanges the role of virtue ethics and its focus on the character of individuals and their overall approach to life.

Noted moral psychologist James Rest attempted to address some of the problems that are recognized in Kohlberg’s work, and in doing so has moved from the six-stage model to one with three levels of understanding: personal interest, maintaining norms, and postconventional. Rest focuses on the maintaining norms (similar to the conventional level) and postconventional schemas. By maintaining norms, Rest means recognizing the need for societywide norms; a duty orientation; the need for cooperation; uniform and categorical application of norms, laws, and rules; and that individuals will obey the norms and laws and expect others to do the same even though it may not benefit all affected parties equally.

Rest’s conception has particular appeal for accountants who at this level of moral development recognize the importance of various laws and standards, comply with them, understand that sometimes compliance would benefit them and sometimes not, but recognize that obeying these norms is important for society. Rest recognized that, while operating at this level would be ideal for an accountant, it does not ensure that the accountant can make good decisions when there are options and ambiguities within accounting and auditing standards, nor does it ensure that he will have the ability to make good decisions when business circumstances arise that are outside the current laws, norms, or standards.

A higher level of understanding is needed to deal with these different perspectives. The postconventional schema integrates such issues by recognizing that accountants do not have to follow the norms but should seek the moral criteria behind the norms for guidance in action. In accounting this means the fair presentation of financial information in a way that benefits society—that is, the public interest.

Rest’s Four-Component Model of Ethical Decision Making

LO 2-2 Explain the components of Rest’s model and how it influences ethical decision making.

Cognitive-developmental researchers have attempted to understand the process of ethical decision making. In particular, 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 decision making; that is, it depicts how an individual first identifies an ethical dilemma and then continues through to his intention and finally finds courage to behave ethically. Each

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Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting 69

Rest built his four-component model by working backward. He started with the end product—moral action—and then determined the steps that produce such behavior. He concluded that ethical action is the result of four psychological processes: (1) moral sensitivity (recognition), moral judgment, (3) moral focus (motivation), and (4) moral character.

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. A good example of failing to spot the ethical issues is Dennis Kozlowski, the former CEO of Tyco International. On June 17, 2005, Kozlowski was convicted of crimes related to his receipt of $81 million in purportedly unauthorized bonuses, the purchase of art for his Manhattan apartment of $14.725 million, and the payment by Tyco of a $20 million investment banking fee to Frank Walsh, a former Tyco director. He also had Tyco pay the $30 million for his apartment, which included $6,000 shower curtains and $15,000 “dog umbrella stands,” not to mention charging the company one-half of the $2 million, 40th birthday party for his wife held on the Italian island of Sardinia under the guise of having a board of directors meeting. On September 19, 2005, Kozlowski was sentenced to serve from eight years and four months to twenty-five years in prison for his role in the scandal. On January 17, 2014, he was granted conditional release. Kozlowski, commenting on his trial in a March 2007 interview with Morley Safer for “60 Minutes,” said, “I am absolutely not guilty of the charges. There was no criminal intent here. Nothing was hidden. There were no shredded documents. All the information the prosecutors got was directly off the books and records of the company.” He also claimed to have done nothing different from his predecessors. He invoked "ethical legalism" in his defense -- if it is legal, it is ethical. Kozlowski was blinded by his ambition and never remotely thought about the ethics of his actions. He was not sensitive to these issues because of a desire to keep up with “The Masters of the Universe,” by which he meant other CEOs who, at the time, were raking in hundreds of millions of dollars in executive compensation. Our ability to identify an ethical situation enables us to focus on how alternative courses of action might affect ourselves and others. Kozlowski acted without reflecting on the ethics of the situation. He failed even the most basic test of ethical behavior, which is 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. 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 measured by his level of moral development. Once a person is aware of possible lines of action and how people would be affected by the alternatives, a process aided by the philosophical reasoning methods, a judgment must be made about which course of action is more morally justifiable (which alternative is just or right). Moral judgment relates to developing moral reasoning abilities over time. Kohlberg argued that individuals progress through a series of moral stages just as they do physical stages. Each stage is more advanced than the one before. People engage in more complex reasoning as they progress up the stages

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and become less self-centered and develop broader definitions of morality. Rest added that developing moral judgment is a social and cognitive construct that progressed from a self-focused view of moral issues, through a group-based moral perspective, to a reliance on postconventional moral principles, and a primary factor in the understanding of moral actions and emotions. Making moral judgments is crucial for moral behavior. Carpendale suggests that moral reasoning is viewed as a process of coordinating all perspectives involved in a moral dilemma. He contends that Kohlberg’s stages entail a view of moral reasoning as the application of a moral principle or rule to a dilemma in order to generate a solution. Once an individual has internalized a moral principle or rule she would then be expected to apply it to all moral conflicts encountered. If reasoning consists of understanding and coordinating conflicting perspectives in a moral dilemma, consistency in reasoning across different situations should not be expected.

Moral Motivation After concluding what course of action is best, decision makers must be focused on taking the moral action and follow through with ethical decision making. Moral values may conflict with other values. 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. Sometimes individuals want to do the right thing but are overwhelmed by countervailing pressures that may overpower their ethical intentions because of perceived personal costs. The loss of a job or a client can be motivating factors that compromise integrity and block ethical action. What would you do if the primary revenue-producing client in your tax practice threatens to fire you and take his bookkeeping work elsewhere unless you ignore a 1099 form showing a significant amount of income that is reportable to the IRS? We can imagine some tax accountants rationalizing not reporting income especially if the client makes a convincing, albeit unethical case to go along just this one time. Emotions also play a part in moral motivation. Organizations should create ethically rewarding environments to increase moral motivation. To reduce the costs of behaving morally, policies and procedures should be instituted that make it easier to report unethical behavior, prevent retaliation, and create an ethical culture in the organization. Leaders have to inspire employees and build confidence that their ethical intentions are supported by organizational systems.

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. 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 (i.e., have courage and maintain integrity to do otherwise). 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. Executing a plan of action takes character. Moral agents have to overcome indifference and opposition, resist distractions, cope with fatigue, and develop tactics and strategies for reaching their goals. Johnson points out that this helps to explain why there is only a moderate correlation between moral judgment and moral behavior. Many times deciding does not lead to doing.

The character traits and virtues discussed in this chapter contribute to ethical follow-through. Courage

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helps leaders implement their plans despite the risks and costs of doing so while prudence helps them

Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting 71

choose the best course of action. Integrity encourages leaders to be true to themselves and their choices. Compassion and justice focus the attention of leaders on the needs of others rather than on personal priorities. Selflessness is the underlying virtue that, in accounting, enables an accounting professional to place the public interest ahead of those of one’s employer or client. 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 one component may not necessarily be adequate in another, and moral failure can occur when there is a deficiency in any one component. 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).

Moral Intensity

LO 2-3 Describe the link between moral intensity and ethical decision making.

The lack of research on the characteristics of a moral issue prompted Thomas Jones to develop the moral intensity model. He argued that the characteristics of the moral issue—what he collectively termed moral intensity—influence ethical decision making. Jones’s model links moral intensity to Rest’s Four-Component Model. The six dimensions are briefly explained below.

Magnitude of Consequences refers to the degree to which an individual may be harmed or benefited by the decision maker’s action. A greater degree of harm or benefit results in an increase in moral intensity.

Temporal Immediacy refers to the length of time between the action and its consequences. An action with immediate negative consequences will cause a greater increase in moral intensity than an action for which the consequences are delayed.

Social Consensus refers to the degree of agreement among a social group that an action is good or bad. This social group could be society as a whole (e.g., a fraudulent financial statement is not morally accepted by society because accounting rules and SEC laws prohibit it). A strong Social Consensus that an act is morally wrong increases moral intensity.

Proximity refers to the nearness of the decision maker to the individuals potentially affected by the consequences. An increase in proximity results in an increase of moral intensity. An auditor who becomes too close to a client and is dealing with fraudulent financial statements is likely to feel more pressure from the client because of their close relationship.

Probability of Effect refers to the likelihood that the predicted consequences and the expected level of harm/benefit will occur. Moral intensity increases with an action that has a high probability of occurrence and high likelihood of causing predicted harm. Pressures increase on auditors when harm to the public interest intensifies with the likelihood of fraudulent financial statements.

Concentration of Effect refers to the relationship between the number of people affected and the magnitude of harm. Moral intensity increases if the Concentration of Effect is great. Fraudulent financial statements issued by a publicly owned company that is also using the statements for a significant loan creates additional pressures on auditors to make the most ethical decision possible.

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Our contention is there is an important link between moral intensity and ethical decision making. As individuals face morally intense situations, their awareness of the moral dilemma, their judgments about choices and consequences, and their intention to act are significantly affected by specific characteristics of the moral situation. One study found that Social Consensus is significantly associated with moral awareness, judgment, and intention. As subjects in the study recognized a moral issue, formed a judgment, and decided on their intention to act, they were strongly affected by what they believed others within their social group considered morally right or wrong.

The link between Social Consensus and ethical decision making makes sense in accounting because it is a community with shared values and beliefs and expectations for ethical actions. On the other hand, if the CPA firm has a culture of placing the client’s interests ahead of the public interest, then intensity increases and moral action may not occur.

Aligning Ethical Behavior and Ethical Intent: Virtue-Based Decision Making

LO 2-4 Explain how moral reasoning and virtue influence ethical decision making.

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. The authors point out that audit failures at companies such as Enron and WorldCom demonstrate that the rules in accounting cannot replace auditors’ professional 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. 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. 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. 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. 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 decision maker’s propensity to exercise sound ethical judgment. Thorne believes that virtue 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,

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both perspectives acknowledge the critical role of cognition in individuals’ ethical decision making. Exhibit 2.1 presents Thorne’s integrated model of the ethical decision-making process.

EXHIBIT 2.1 Thorne’s Integrated Model of Ethical Decision Making

Exhibit 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 reasoning, 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.

Even though virtue is a critical component of ethical behavior, other factors may get in the way of taking ethical action including situational pressures, business norms, and the moral intensity of the issue itself that influences ethical decision making. Also, one’s strength of character deepens with experience, and reflection on ethical dilemmas can bolster one’s resolve.

Ethical Decision-Making Models

LO 2-5 Apply the steps in the Integrated Ethical Decision-Making Model to a case study.

Dealing with moral issues can be perplexing. How, exactly, should we think through an ethical issue? What questions should we ask? What factors should we consider? The philosophical methods of moral reasoning suggest that once we have ascertained the facts, we should ask ourselves five questions when trying to resolve a moral issue:

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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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What benefits and what harms will each course of action produce, and which alternative will lead to the best overall consequences?

Ethical Intention

Ethical Behavior

Sensitivity

Prescriptive Reasoning

Ethical Motivation

Ethical Character

Perception

Moral Virtue

Understanding

Instrumental Virtue

Identification of Dilemma

Ethical Judgment

Moral Development

Virtue

Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting 74

In commenting on the method, Velasquez points out that it does not provide an automatic solution to moral problems. It is not meant to. The method is merely meant to help identify most of the important ethical considerations. In the end, we must deliberate on moral issues for ourselves, keeping a careful eye on both the facts and on the ethical considerations involved.

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 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. Decision-making guidelines can help us make better ethical choices. Johnson points out that taking a systematic approach encourages teams and individuals to carefully define the problem, gather information, apply ethical standards and values, identify and evaluate alternative courses of action, and follow through on their choices. They are also better equipped to defend their decisions.

Kidder’s Ethical Checkpoints Ethicist Rushworth Kidder acknowledges that ethical issues can be “disorderly and sometimes downright confusing.” They can arise suddenly, create complex issues, and have unexpected consequences. However, Kidder argues that there is an underlying structure to the ethical decision- making process. Kidder suggests that nine steps or checkpoints can help bring order to otherwise confusing ethical issues. What follows is a brief summary of the major points.

What moral rights do the affected parties have, and which course of action best respects those rights? Which course of action treats everyone the same, except where there is a morally justifiable reason not to, and does not show favoritism or discrimination? Which course of action advances the common good? Which course of action develops moral virtues?

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Recognize that there is a moral issue. Similar to Rest’s notion of ethical sensitivity, we must acknowledge that an issue deserves our attention and moral questions exist.

1.

Determine the actor. Kidder distinguishes between involvement and responsibility. Because we are members of larger communities, we are involved in any ethical issue that arises in the group. Yet we are only responsible for dealing with problems that we can do something about. For example, I may be concerned that clients threaten to fire their auditors if they plan to give a negative opinion on the financial statements. However, there is little I can do about it unless it happens in my firm.

2.

Gather the relevant facts. Adequate, accurate, and current information is important for making effective decisions of all kinds, including ethical ones. Consider the motives of affected parties, patterns of behavior, likely consequences if the problem persists, and likely outcome of one course of action or another.

3.

Test for right-versus-wrong issues. Kidder suggests using four determinations including a legal test. If lawbreaking is involved (i.e., fraudulent financial statements), then the problem becomes a legal matter, not a moral one. The smell test relies on intuition. If you have an uneasy feeling about the decision or course of action, chances are it involves right-versus-wrong issues. The front-page test asks how you would feel if your decision made it to the front page of the local newspaper. If you feel uncomfortable about it, then you should consider choosing another alternative. The mom test

4.

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Johnson evaluates Kidder’s approach to ethical decision making by pointing out it seems to cover all the bases, beginning with defining the issue all the way through to learning from the situation in the aftermath of the decision. He recognizes that some decisions involve deciding between two “goods” and leaves the door open for creative solutions. Making a choice is an act of courage, as Kidder points out, and we can apply lessons learned in one dilemma to future problems.

On the flip side, Johnson points out that it is not easy to determine who has responsibility for solving a problem, the facts may not be available, or a time constraint prevents gathering all the relevant information, and decisions do not always lead to action. The model seems to equate deciding with doing and, as we saw in our earlier discussion of moral action, we can decide on a course of action but not follow through. Johnson concludes that Kidder is right to say that making ethical choices takes courage. However, it takes even more courage to put the choice into effect. We believe that a decision-making process in accounting helps to organize one’s thoughts about the ethical issues that accounting professionals face and can serve as a basis for analysis in many of the cases in this book. The integrated model explained below draws on Rest’s Model and Kidder’s Checkpoints to provide a basis for ethical decision making when accounting issues create ethical dilemmas. Consideration is given to moral intensity and how intellectual instrumental virtues enable ethical action to occur.

asks how you would feel if your mother or some other important role model became aware of your choice. If you have a queasy feeling, then it is best to reconsider your choice. Test for right-versus-right paradigms. If an issue does not involve wrong behavior, then it likely pits two important positive values against each other. Kidder identified four such models: truth-telling versus loyalty to others and institutions; personal needs versus needs of the community; short-term benefits versus long-term negative consequences; and justice versus mercy. When an ethical dilemma pits two core values against each other, a determination should be made whether they are in conflict with one another in this situation.

5.

Apply the ethical standards and perspectives. Consider which ethical principle is most relevant and useful to this specific issue. Is it utilitarianism? Kant’s categorical imperative? Justice as fairness? Or, is it a combination of perspectives?

6.

Look for a third way. Compromise is one way to reveal a new alternative that will resolve the problem or to develop a creative solution. A third way can also be the product of moral imagination. One’s conception of the moral and ethical issues can change when considering different perspectives from a moral point of view. We may discover a better, economically viable, and morally justifiable solution.

7.

Make the decision. At some point we have to make the decision. However, we may be mentally exhausted from wrestling with the problem, get caught up in analysis paralysis, or lack the necessary courage to come to a decision.

8.

Revisit and reflect on the decision. Return to the decision later, after the issue has been resolved, to debrief. Reflect on the lessons to be learned. How can you apply them to future decisions? What ethical issues did it raise?

9.

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Reflection would follow after the decision has been made. What was the outcome? How should it affect my approach to ethical decision making? How can I do better in the future?

Application of the Integrated Ethical Decision-Making Model: Ace Manufacturing In order to illustrate the use of the model, a short case appears in Exhibit 2.2. The facts of the case and ethical issues are analyzed below using the Integrated Model. It is not our intention to cover all points; instead, it is to illustrate the application of the model and consideration of Rest’s framework, moral intensity, and the virtues previously discussed and identified in Thorne’s study.

Ace Manufacturing: Integrated Ethical Decision-Making Process 1. Identify the ethical and professional issues (ethical sensitivity).

GAAP

Identify the ethical and professional issues (ethical sensitivity).1.

What are the ethical and professional issues in this case (i.e., GAAP and GAAS)?

Who are the stakeholders (i.e., investors, creditors, employees, management, the organization)?

Which ethical/professional standards apply (i.e., AICPA Code Principles, IMA Ethical Standards, and IFAC standards)?

Identify and evaluate alternative courses of action (ethical judgment).2.

What legal issues exist?

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)?

Reflect on the moral intensity of the situation and virtues that enable ethical action to occur (ethical intent).

3.

Evaluate the magnitude of the consequences if specific actions are taken; likelihood of those consequences; ability to effect ethical responses by one’s actions; consensus view within the profession about the appropriateness of the intended actions.

Consider whether anyone's rights are at stake and how they manifest in the decision-making process

Consider how virtue (i.e., intellectual virtues) motivates ethical actions.

Take action (ethical behavior).4. Decide on a course of action consistent with one’s professional obligations.

How can virtue (i.e., instrumental virtue) support turning ethical intent into ethical action?

What steps can I take to strengthen my position and argument?

How can I counter reasons and rationalizations that mitigate against taking ethical action? Who can I go to for support?

Appears there may be fraud in the financial statements. Expense accounts were charged for personal withdrawals.

Integrated Ethical Decision-Making Process

The integrated model links to Rest’s framework as follows:

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Stakeholders

Ethical/professional standards

2. Identify and evaluate alternative courses of action (ethical judgment).

Legal issues

Alternatives/ethical analysis

Prevailing ethical theories: Rule utilitarianism dictates that certain rules should never be violated regardless of any utilitarian benefits. Owners have a right to know about Paul’s ethical lapse.

3. Reflect on the moral intensity of the situation and virtues that enable ethical action to occur (ethical intent).

Financial statements do not fairly present financial position and results of operations due to improper expensing of personal expenditures. Taxable income may be similarly misstated.

Owners including Jack Jones Paul Jones (son) Larry Davis (new accountant/CPA) IRS Banks that may be approached about the loan

Objectivity: Davis should not permit bias or influence, because of his relationship with Paul, to interfere with making the right choice. Integrity: Don’t subordinate judgment to Paul even though he is your boss. Due care: Professional skepticism has been exercised; carry through diligently and insist on supporting evidence for the recorded expenditures.

GAAP appears to be violated; financial statements are fraudulent. Legal liabilities may exist. Tax payments will be understated assuming the improper accounting carries over to taxable income.

Do nothing: Moral blindness is not a defense to unethical action; violates the rights of the owners of the business; Davis will have violated his ethical responsibilities under the AICPA Code. Confront Paul and insist on an explanation: (a) allow him to repay the amount if he agrees to do so, or (b) bring the matter to the attention of the owners regardless of what Paul says. Report the matter to Jack Jones—let Paul’s dad deal with it: He may pay back the amounts for his son, which sweeps the ethical problem under the rug; he may read the riot act to his son. Report the matter to all of the owners: Davis may be fired; the other owners may be grateful and negate any negative action against Davis by Paul or his dad.

Do I want to be responsible for getting Paul in trouble with his dad, possibly fired? Paul may be prosecuted for his actions. The consequences for Ace are severe so I need to be sure of my decision.

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4. Take action (ethical behavior).

Once I decide what to do and why, I need to assess how best to express myself and be true to my values. This entails considering how others may react to my decision. This is where a "Giving Voice to Values" framework comes in handy, as discussed below. Traditional philosophical reasoning methods have limitations. We have already pointed out the need for a link between moral judgment, moral intent, and moral behavior. Beyond that, even if a decision maker has followed a sound ethical analysis, knows what to do, and has made the ethical choice, it still does not mean that her voice will be heard within the organization and it may require a different approach to make a real difference. In the Ace Manufacturing case, Larry Davis needs to prepare for what might happen when he meets with Paul. As explained later on, scripting responses is a sound way of ensuring that one’s voice is heard in the resolution of the matter. This is where tools that are provided through behavioral ethics come into play.

EXHIBIT 2.2 Ace Manufacturing

Ace Manufacturing is a privately held company in Anytown, USA. There are three stockholders of the company—Joe Smith, Sue Williams, and Jack Jones. Jones manages the business including the responsibility for the financial statements. Smith and Williams are in charge of sales and marketing. Each owner has a one-third stake in the business.

Jones recently hired his son, Paul, to manage the office. Paul has limited managerial experience, but his father hopes Paul will take over in a few years when he retires, and this is a good opportunity for Paul to learn the business.

Paul is given complete control over payroll, and he 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 company, and Jack Jones needed someone he could trust to be in charge of these sensitive operations. He did ask his son to hire someone as soon as possible to help with these and other accounting functions. Paul hired Larry Davis shortly thereafter based on a friend’s recommendation. While Davis is relatively inexperienced, he did graduate with honors in Accounting from Anytown University and recently passed all parts of the CPA Exam.

On March 21, one year after hiring Davis, Paul discovered that he needed surgery. Even though the procedure was fairly common and the risks were minimal, Paul planned to take three weeks off after the surgery because of other medical conditions that might complicate the recovery. He told Davis to approve vouchers for payment and present them to his father during the four-week period for payment. Paul had previously discussed this plan with his father, and they both agreed that Davis was ready to assume the additional responsibilities. They did not, however, discuss the matter with either Smith or Williams.

I want to do the right thing but will my actions do irreparable harm to others? Should I be concerned about “caring about others” given the profession’s standards? Can I ever trust Paul again? What he did is wrong and I shouldn't become a party to a cover-up. I am accountable for my actions; I need to maintain my integrity and not subordinate judgment to Paul.

Insist that steps be taken to correct the accounting; have the courage to stand up for my beliefs. I should give Paul an opportunity to explain why he did what he did, out of fairness, but be prepared to approach the other owners if his explanation and intended actions are not satisfactory.

(Continued)

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The bank statement for March arrived on April 4. Paul did not tell Davis to reconcile the bank statement. In fact, he specifically told Davis to just put it aside until he returned. But Davis looked at the March statement while trying to trace a payment to a vendor who had billed the company for an invoice that Davis thought had already been paid. In the course of examining the bank statement, Davis noticed five separate payments to Paul, each for $2,000, during March. He became suspicious because Paul’s salary was $3,950 per month. What’s more, a check for that amount appeared on the statement.

Curiosity got the better of Davis and he decided to trace the checks paid to Paul to the cash disbursements journal. He looked for supporting documentation but couldn’t find any. He noticed that the five checks were coded to different accounts including supplies, travel and entertainment, office expense, and two miscellaneous expenses. He then reviewed the banks statements for January and February and found five separate check payments each month to Paul each for $2,000.

Davis didn’t know what to do at this point. He was quite certain there was no business justification for the $30,000 payments to Paul for the first three months of the year and he was concerned that if the same pattern continued unabated for the next three months, the total of $60,000 payments to Paul might threaten the ability of the company to secure a $100,000 loan for working capital.

What would you do if you were in the position of Larry Davis? Use the Integrated Ethical Decision-Making Model to craft your responses.

Behavioral Ethics

LO 2-6 Analyze the thought process involved in making decisions and taking ethical action.

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. Daniel Kahneman, the Nobel Prize–winning behavioral economist, points out that System 1 thinking is our intuitive system of processing 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. For example, System 1 thinking is detecting that one object is more distant than another, while an example of System 2 thinking is parking in a narrow space.

Kahneman’s fundamental proposition is that we identify with System 2, “the conscious, reasoning self that has beliefs, makes choices and decides what to think about and what to do.” But the one that is really in charge is System 1 as it “effortlessly originates impressions and feelings that are the main sources of the explicit beliefs and deliberate choices of System 2.”

What follows is an example of using System 1 thinking instead of the more deliberate approach of System 2, and drawing 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

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make it more difficult to resolve an ethical dilemma in a morally appropriate way. It may occur because

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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. 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. One limitation of the philosophical reasoning approaches incorporated into decision-making models is that how we think we should behave is different 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 our behavior creates the need to resolve contradictory or conflicting beliefs, values, and perceptions. 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).

Cognitive dissonance suggests that we have an inner drive to hold all our attitudes and beliefs in harmony and avoid disharmony. When there is inconsistency between attitudes or behaviors (dissonance), something must change to eliminate the dissonance. Festinger posits that dissonance can be reduced in one of three ways: (1) change one or more of the attitudes, behavior, or beliefs so as to make the relationship between the two elements a consonant one; (2) acquire new information that outweighs the dissonant beliefs; or (3) reduce the importance of the cognitions (beliefs, attitudes). The Betty Vinson situation at WorldCom, discussed in Chapter 1, is a case in point about the dangers of reducing dissonance by changing one’s attitudes and behaviors. 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. In a sense she reduced the importance of her own intuitions about the appropriateness of what she was asked to do. Bazerman and Gino ask: What makes even good people cross ethical boundaries? Wittmer asks: Do individuals in organizations always act and behave consistently with what they know or believe to be the right thing to do? The behavioral approach to ethics leads to understanding and explaining moral and immoral behavior in systematic ways. In reality, whether behaviors are viewed legally or ethically, we hold individuals accountable for their behaviors and choices, at least in part because they should have known better. Even if we agree on what someone should ethically do in a given situation, our judgment is often clouded by other factors that cause us to act against our intuition of what good sense dictates. Why did CEO Richard Scrushy certify HealthSouth Corporation’s financial statements when he knew or was reckless in not knowing they were materially false and misleading? What influenced him to behave unethically? Once we start asking these questions, we shift our attention from inquiring about what the right thing to do is, or what a good person should do. Rather, we are attempting to understand why such an individual acted the way he did, trying to identify the factors that influenced or caused the behaviors. We have moved from a prescriptive framework, such as with the philosophical reasoning methods, to a more descriptive mode of analysis. Such a perspective is important in leading

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Behavioral ethics looks at how human beings actually behave in moral contexts and describes the actual behavior of people, how situational and social forces influence it, and ways in which decisions can be nudged in a more ethical direction through simple interventions. This approach to ethics requires understanding and explaining moral and immoral behavior in systematic ways. It requires understanding the antecedents and consequences of both ethical and unethical actions. Finally, it requires identifying levers at both the individual and the institutional level to change ethically questionable behaviors when individuals are acting in unethical ways that they would not endorse with greater reflection.

Giving Voice to Values

LO 2-7 Describe the “Giving Voice to Values” technique and apply it to a case study.

“Giving Voice to Values (GVV)” is a behavioral ethics approach that shifts the focus away from traditional philosophical reasoning to an emphasis on developing the capacity to effectively express one’s values in a way that positively influences others by finding the levers to effectively voice and enact one’s values. The methodology asks the protagonist to think about the arguments others might make that create barriers to expressing one’s values in the workplace and how best to counteract these “reasons and rationalizations.”

GVV links to ethical intent and ethical action in Rest’s Model. An ethical decision maker should start by committing to expressing her values in the workplace. The intent is there, but it may fall short of the mark of taking ethical action unless a pathway can be found to express one’s values in the workplace. It is the pathway that GVV addresses. GVV is used post–decision making; that is, you have already decided what to do and have chosen to voice your values. In the Ace Manufacturing case, elaborated on below, Davis knows he must act and we assume he has decided to give Paul a chance to explain about the “personal” expenditures. Other decisions might be made by students, but we use the alternative of giving Paul a chance to explain his actions as the basis for the following discussion. Davis wants to do what he thinks is right, but he needs to be prepared for the eventuality that Paul will pressure him to stay silent. Davis needs to find a way to communicate his values powerfully and persuasively in the face of strong countervailing organizational or individuals norms, reasons, and rationalizations. In other words, how can Davis find a way to effectively articulate his point of view so that others can be convinced of its rightness? According to Mary Gentile who developed the GVV methodology, “It shifts the focus away from awareness and analysis to action by addressing a series of questions for protagonists after identifying the right thing to do,” including: How can you get it done effectively and efficiently? What do you need to say, to whom, and in what sequence? What will the objections or pushback be and, then, what will you say next? What data and examples do you need to support your point of view?

Kohlberg argued that higher moral development requires role-taking ability. Role-taking ability involves understanding the cognitive and affective (i.e., relating to moods, emotions, and attitudes) aspects of another person’s point of view. Davis needs to consider how Paul might react; what he might say; and how Davis might counter those statements when he meets with Paul. The underlying theme of GVV is that we can effectively voice values in the workplace if we have the

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proper tools to do so. GVV relies on developing arguments and action plans, and rehearsing how to

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voice/enact not just any values, but moral values specifically. For our purposes, the pillars of character and virtues discussed in this and the previous chapter are our target behaviors.

Reasons and Rationalizations An important part of the GVV methodology is to develop ways to confront barriers we may encounter when value conflicts exist in the workplace. These barriers often appear in the form of “reasons and rationalizations” that can confound our best attempts to fulfill our sense of organizational and personal purpose. These are the objections one might hear from colleagues when attempting to point out an ethical problem in the way things are being done, as Cynthia Cooper experienced in the WorldCom case. Or, sometimes you do not hear them because they are the unspoken assumptions of the organization.

GVV provides a framework to deal with the opposing points of view based on the following series of questions.

Gentile identifies the most frequent categories of argument or rationalization that we face when we speak out against unethical practice. Some of the most common arguments include:

Expected or Standard Practice: “Everyone does this, so it’s really standard practice. It’s even expected.”

Materiality: “The impact of this action is not material. It doesn’t really hurt anyone.”

Locus of Responsibility: “This is not my responsibility; I’m just following orders here.”

Locus of Loyalty: “I know this isn’t quite fair to the customer, but I don’t want to hurt my reports/team /boss/company.” An additional argument we include is:

Isolated Incident: “This is a one-time request; you won’t be asked to do it again.”

Basic Exercise in GVV GVV Brief Exercise: Doing Good by Being Good Matt and Becca volunteered to head up the Accounting Club efforts to organize volunteers for a clean-up effort and raise donations to help the students, faculty, and staff at the college affected by Hurricane Debits. Over 1,200 had been displaced from their homes, apartments, and dorm rooms due to the severe weather. Over the next month the 25 students of the club helped clean up debris left by the storm and donated over 2,000 hours of time. Matt set up a GoFundMe Web page and posted pictures of the devastation on Instagram. Donations from the community totaled $20,367. The relief agencies in town suggested the club purchase $100 Visa and MasterCard gift cards to be distributed to the affected community members. Matt purchased 200 such cards and Becca delivered them.

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What are the main arguments you are trying to counter? That is, what are the reasons and rationalizations you need to address?

What is at stake for the key parties, including those who disagree with you?

What levers can you use to influence those who disagree with you?

What is your most powerful and persuasive response to the reasons and rationalizations you need to address? To whom should the argument be made? When and in what context?

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GoFundMe program and 200 locals received a $100 gift card each. Becca, who was the club treasurer, quickly realized there was $367 unaccounted for. Matt tried to explain there were fees for processing the transactions. Becca asked Matt: “Why didn’t you go to the stores that agreed to waive the fees for the disaster relief recovery?”

“Becca, they waived most of the fees but the remaining fees totaled $400. I donated $33 to cover the balance.” “Do you have receipts for the balance?” “Becca, don’t you trust me?” “Matt, do you recall what our Auditing professor said yesterday? Trust but verify? I need the receipt for the gift cards.” “Ok, Becca. I’ll find it and get it to you soon.” Shortly after the meeting ended, Becca hears Matt telling another member about a trip he planned to see his girlfriend. “Matt, last week you told me you had no money to go. How did you get it?” “It’s not such an expensive trip. It should cost about $400,” Matt told David.

David was surprised to hear the amount was the same as the credit card fees but said nothing. Becca happened to overhear the conversation and immediately realized that 4 more victims could have been helped. She was suspicious of Matt’s explanation, to say the least. Becca knew she had to do something but wasn’t sure of the approach she should take. She also knows Matt is a former president of the club, is graduating this year, and has a position with a Big Four accounting firm. Answer the following questions to develop a script for Becca assuming she has decided to approach Matt about the $400.

Discussion Questions (brief talking points are provided for Becca). 1. What are the main arguments you are trying to counter? That is, what are the reasons and rationalizations you need to address?

2. What’s at stake for the key parties, including those with whom you disagree?

Matt created a trust and loyalty defense (Locus of Loyalty).

Matt is graduating and doesn’t want anything to affect his position with the firm.

Matt may say the $400 is a small amount and not worth arguing over (Materiality).

Matt may say it was a one-time event and won’t happen again (Isolated Incident).

Matt’s reputation is on the line.

Becca may be concerned other club members would not support her and suggest she should let it

go, given Matt’s situation. (They might approach the dilemma from an egoistic point of view;

Becca needs to emphasize enlightened egoism/Rights).

Becca needs to consider what would happen if the club faculty advisor found out or members of the community become aware of the situation (Kidder’s front page test).

Later that afternoon at the Accounting Club meeting, Matt announced that $20,000 was raised for the

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3. What levers can you use to influence those with whom you disagree?

4. What is your most powerful and persuasive response to the reasons and rationalizations you need to address?

Students should think about other points they might make if faced with a similar ethical dilemma.

Ace Manufacturing: GVV Analysis Building on the Ace Manufacturing case discussed earlier on, once Davis has decided what to do, which is to give Paul a chance to explain, he needs to consider how best to express his point of view; act on his beliefs; and convince Paul to take corrective action. He needs to anticipate the reasons and rationalizations Paul may provide and how to counter them. Using the GVV framework, what follows is a brief explanation of how such a meeting with Paul might go. What are the main arguments you are trying to counter? That is, what are the reasons and rationalizations you need to address?

These could be addressed from the perspective of Paul trying to convince Davis to remain silent about the apparent misappropriation of company cash and/or offering to pay back the money.

Becca could speak to David who also attended the meeting and develop a plan to approach Matt.

Becca could tell Matt that she will go to the faculty advisor if he doesn’t repay the $367.

Becca could emphasize to Matt he is jeopardizing the respect that others have for him.

Becca could explain to Matt he is cheating the victims out of money that is rightly theirs. She could

emphasize the lack of ethical standards in his action.

Becca could explain to Matt if he had acted similarly while working for the Big Four firm, he would

have violated the profession’s ethical standards including due care and integrity.

Becca could explain that her loyalty obligation is to the club and victims of the disaster.

Becca could emphasize to Matt that he doesn’t want to implicate David in any cover-up and needs to

do the right thing.

Davis was told to put bank statements aside and not to do reconciliations. Paul may explain that, because the company is privately owned, no one gets hurt by what he did. He may try to convince Davis that the use of company cash for personal purposes is a common practice in the company because it’s not publicly owned. (Expected or Standard Practice) Paul may play the sympathy card and explain that he needed the money to pay for hospitalization costs. He may argue that the amount of money involved is not significant. (Materiality) He may rationalize that the reason for withdrawing cash is the low monthly salary for someone in his position; he’s not being compensated adequately. He may explain it was a one-time event and won’t happen again. (Isolated Incident)

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What is at stake for the key parties, including those who disagree with you? (Moral intensity issues exist here.)

What levers can you use to influence those who disagree with you?

What is your most powerful and persuasive response to the reasons and rationalizations you need to address? To whom should the argument be made? When and in what context?

Paul may pressure Davis into staying silent by implying his dad knows about it and has approved the withdrawals. He may promise to pay the money back as soon as he gets out of the hospital (no harm, no foul).

Paul’s reputation is on the line because he committed a fraud on the company. Jack Jones will feel embarrassed for himself and his son if Davis discloses what Paul has done to the other owners. The other owners have a right to know what has happened. Davis may lose his job if he confronts Paul even if he drops the matter later on. The ability of the company to secure the $100,000 loan is at stake. Davis’ reputation for integrity is at stake.

Davis can ask Paul for supporting documentation to back up the coding of expenses to different accounts; he can share with Paul his analysis of the bank statements. When faced with the evidence, Paul may agree to repay the amount and not do it again. Davis can try to convince Paul that his actions are harmful to the company and potentially very embarrassing for his dad; he needs to come forward sooner rather than later and correct the “mistake.” He can try to convince Paul that he needs to look at the long-term effects of taking money from the company that has not been properly authorized, rather than focus on short-term gain. Davis can use the leverage of threatening to go to all the owners if Paul doesn’t admit the mistake and take corrective action; his loyalty obligation is to the three owners, not Paul. They are the ones with the most at stake. Davis has an ethical responsibility to inform the owners; Smith and Williams might serve as supporters to help counteract the reasons and rationalizations provided by Paul for his actions. Davis’ reputation is at stake. As a CPA, he cannot violate the ethics of the profession; the accounting is wrong and needs to be corrected; he needs to explain about his integrity obligation.

Davis should explain to Paul that he was acting diligently when he looked at the bank statements because he didn’t want to pay the same vendor twice and needed to see whether the first check had cleared the bank statement. He should explain that using company cash for personal purposes is never acceptable unless Paul can demonstrate that the other owners knew about it and approved it. He should stress to Paul that taking company funds without approval is wrong regardless of the amount involved; it violates ethical norms; there are no good reasons for doing so.

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Responses to Reasons and Rationalizations: Ace Manufacturing Case Assume that Larry Davis calls Paul Jones and they set a 2:00 p.m. meeting at Paul’s home where he is convalescing. The meeting goes like this:

“Paul, how are you feeling?”

“OK, Larry. What’s happening at work?” “That’s why I wanted to see you.” “Yeah, why’s that?” “I noticed $10,000 payments to you each month for the first three months of the year. I can’t find any supporting documentation for these amounts.” Paul immediately becomes indignant. “I told you not to look at the bank statements. You ignored my orders and disrespected my position. Your job is on the line here.” Davis is taken aback. He hesitates at first but explains about the vendor billing and tells Paul he saved the company $40,000 by detecting the duplicate billing. Paul starts to get tired and stressed out so they agree to meet in Paul’s office the following week when he returns to work. Paul’s final comment is, “Tell no one about this meeting!” Davis returns to the office and starts to reflect on the meeting. He is not sure what to do at this point. He is thinking about his options, including not waiting for the meeting with Paul before acting.

Based on the meeting between Paul and Davis and earlier considerations, what are the most powerful and persuasive responses to the reasons and rationalizations given by Paul in his defense that Davis needs to address? Davis might seek out some advice at this point. Perhaps he has a trusted friend or adviser who can bring a fresh perspective to the situation? Davis has to be be true to his values, have the courage to act on his beliefs, and meet his ethical and professional obligations. What would you do at this point if you were in Larry’s position?

Concluding Thoughts

In this chapter we have progressed from describing Kohlberg’s model of moral development to Rest’s model of ethical decision making and considered issues of moral intensity and virtue in developing an Integrated Ethical Decision-Making Model. We intend the model to be used as a framework to guide

Davis should challenge Paul’s statement that his dad knows about it and approved it by suggesting they both go to Jack Jones and discuss the matter; he is calling Paul’s bluff. Paul may back off at this point, which confirms the asset misappropriation. He should explain to Paul that it is not enough to simply pay the money back. Davis doesn’t want to get caught up in a cover-up. He should ask himself: What if Paul persists in his actions even after repaying the $30,000? If he doesn’t inform the owners now, he could be accused of being part of the problem, dismissed from his job, and the oversight authorities in the accounting profession may be contacted. While this may seem remote at the time, Davis should be skeptical of anything Paul tells him.

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ethical analysis by students and frame the debate in the classroom when ethical dilemmas are discussed. It is not necessary to consider every element of the model in every case. Instead, it should serve as a reminder to students of some of the most important points to consider when making ethical decisions. Ethical decisions are not made in a vacuum. Pressures exist in the real world of business and accounting; cultures may support or work against ethical behavior; and individuals react differently to the reasons and rationalizations given for not taking the ethical path. Therefore, it is important to understand how best to make your case when faced with an ethical dilemma. As we have learned, knowing what to do is not the same as doing it. We need a way to overcome obstacles and deal with those who would distract us from our goal to be the best person we can be; to make the ethical choice; and to follow through with ethical action. This is where the GVV framework is most valuable. The tendency when a book on ethics is written is to focus on negative behaviors whether by a CEO, CFO, or accounting professional who does not live up to her values. But we should not loose sight of the many heroes we have in accounting, some of which were named in our concluding thoughts to Chapter 1. There are many such people who on a daily basis stand up to their supervisors and clients who pressure them to go along with financial wrongdoing; clients want to tell their own story about the company’s success rather than a truthful one. New whistleblowing laws and protections in SOX and the Dodd-Frank Financial Reform Act that will be discussed in Chapter 3 provide a mechanism for accounting professionals to speak out after they have made a good faith effort to change things albeit to no avail. However, application of the GVV methodology in the real world may serve to negate the need for whistleblowing. The protagonist may be successful in voicing her values in an effective manner and changing the ethical landscape. The field of behavioral ethics holds great promise for helping students to better understand their motivations for action and learn how to speak up when wrongdoing exists. Speaking up when things go wrong and voicing one’s beliefs is something that takes practice, which is why we discussed the GVV methodology in this chapter. We follow through with additional discussions in the rest of the book. You will face dilemmas in the workplace; all of us do. You may make some mistakes, but in truth the only mistake is not trying to correct wrongdoing. Perhaps the least likely person to choose for our final inspirational quote in this chapter is Kristi Loucks, a cake designer and pastry chef who also writes books. Loucks famously said, “The road to success is littered with failures, but the lessons learned are crucial in plotting your course to success!”

Discussion Questions Sometimes in life things happen that seem to defy logic, yet that may be a sign of the times we are living in today. 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 Heene, claimed that he had floated away in a homemade helium balloon that was shaped to resemble a silver flying saucer. Some in the media referred to the incident as “Balloon Boy.” The authorities 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 pleaded to protect his wife, Mayumi, a Japanese citizen, whom he believed may have been deported if Richard was convicted of a more serious crime. Richard also agreed to pay $36,000 in restitution.

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Identify the stakeholders and how they were affected by Heene’s actions using ethical reasoning. 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?

1.

In an example of art imitating life, 16-year-old playwright Billy Reece was inspired by the Balloon Boy incident to write a play that was first performed at the Thespian Festival at the University of Nebraska–Lincoln in 2014. Balloon Boy: The Musical was presented in the 2015 New York Musical Theater Festival Developmental Reading Series. It has been said that, “Art has the power to evoke the same emotions, thoughts, moral and ethical controversies, and conflicts that we experience in life.” Plato was certain that art was nothing but a dangerous and shallow imitation of life that served only to draw humans far away from the Truth. Discuss these thoughts from your own perspective of emotions, thoughts, moral considerations, and what “truth” means to you.

2.

In the debate over why good people do bad things, Tenbrunsel suggests that people are often blind to the ethical dimensions of a situation, a concept he refers to as “bounded ethicality.” Craig Johnson addresses moral disengagement by saying: When others try to encourage you to bad behavior (“the dark side”) realize that you are an independent agent, and that you have a personal responsibility to behave morally. Discuss what this means to you.

3.

One reason otherwise good people may do bad things is what psychologists call scripts. This term refers to the procedures that experience tells us to use in specific situations. Unlike other forms of experience, scripts are stored in memory in a mechanical or rote fashion. Explain why a System 1 approach to decision making might create a script that leads us to make a questionable or unethical decision.

4.

How do you assess at what stage of moral development in Kohlberg’s model you reason at in making decisions? Do you believe your level of reasoning is consistent with what is expected of an accounting professional? How does the stage you indicate relate to the findings of research studies discussed in this chapter about moral reasoning in accounting?

5.

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.

6.

In his research into the components of ethical decision making, Rest raised the following issue: Assuming someone possesses sound moral reasoning skills, “Why would they ever chose the moral alternative, especially if it involves sacrificing some personal value or suffering some hardship? What motivates the selection of moral values over other values?” How does Rest’s model deal with such a question? How would you answer it from the point of view of an accounting professional?

7.

In the text, we point out that Rest’s model is not linear in nature. An individual who demonstrates adequacy in one component may not necessarily be adequate in another, and moral failure 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.

8.

In teaching about moral development, instructors often point out the threefold nature of morality: It depends on emotional development (in the form of the 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?

9.

Do you believe that our beliefs trigger our actions, or do we act and then justify our actions by changing our beliefs? Explain.

10.

Do you believe that a person’s stage of moral development and personal moral philosophy play a11. role in how values and actions are shaped in the workplace? Explain.

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Explain why moral problems may be of greater intensity than nonmoral problems.12. Michael just graduated with a degree in Accounting from State University. He worked hard in school but could only achieve a 2.95 GPA because he worked 40 hours a week to pay his own way through college. Unfortunately, Michael was unable to get a job because the recruiters all had a 3.0 GPA cut-off point. Michael stayed with his college job for another year but is anxious to start his public accounting career. One day he reads about a job opening with a local CPA firm. The entry-level position pays little but it’s a way for Michael to get his foot in the door. However, he knows there will be candidates for the position with a higher GPA than his so he is thinking about using his overall GPA, which was 3.25 including two years of community college studies, rather than his major GPA and the GPA at State, even though the advertisement asks for these two GPAs. Michael asks for your opinion before sending in the resume. What would you say to Michael and why?

13.

In this chapter, we discuss the study by Libby and Thorne of the association between auditors’ virtue and professional judgment, done 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. Explain how these virtues relate to an auditor’s intention to make ethical decisions.

14.

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?

15.

According to a survey reported by the Daily Mail in the United Kingdom, one in eight women has bought expensive clothes, worn them on a night out, and then returned them the next day. Nearly half of those who did confess said they were motivated by money because they couldn’t afford to keep the clothes given their current economic condition. But 18 percent said they did it because they enjoyed the “buzz.” Those most likely to do it were 18- to 24-year-olds, 16 percent of whom admitted to returning worn clothes (http://www.dailymail.co.uk/femail/article-2157430 /How-women-wear-expensive-new-frock-shop.html#ixzz3ea5m2mo).

Assume you are best friends with one such woman. She asks you to go shopping with her for a dress for the Senior Prom. She says the dress will be returned after the prom. You know what she does is wrong, but she is your best friend and don’t want her to get in trouble. What would you do and why? How might you counter the likely reasons and rationalizations she will give for her actions?

16.

Sharon is an intern with a local CPA firm. Prior to returning to school, her supervisor goes on sick leave and asks her to do some complicated reconciliation work for him. She is given what seems to her to be an unrealistic deadline. Sharon looks at the workpapers and supporting documentation and realizes she doesn’t have the skills to complete the work without help. She contacts her supervisor who tells her to talk to Holly, a good friend of Sharon and former intern at the firm, for help. Holly returned to school one semester ago. What ethical considerations do you have in this matter? What would you do and why?

17.

Identify the ethical issues in each of the following situations and what your ethical obligations are, assuming you are faced with the dilemma.

18.

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A consultant for a CPA firm is ordered by her superior to downgrade the ratings of one company's software package being considered for a client and increase the ratings for another company, which is run by the superior's wife. What would you do and why?

a.

A tax accountant is told by his superior to take a position on a tax matter that is not supportable by the facts in order to make the client happy. This is a common practice in the firm and the likelihood of the IRS questioning it is remote. Would you go along with your supervisor?

b.

An auditor for a governmental agency concluded a contractor’s accounting system was inadequate; her supervisor changed the opinion to adequate in order to minimize the audit hours on the job and make the process seem more efficient. Would you go above your supervisor in this matter and bring your concerns to high-ups in the agency?

c.

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 nonaccounting 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. Do you think that taking an Accounting Ethics course would affect your level of moral development and ability to reason through ethical issues? Why or why not?

19.

66

Explain why the process of ethical decision making depends on a number of moral, social, psychological, and organizational factors.

20.

Emotional self-awareness refers to understanding your own feelings, what causes them, and how they impact your thoughts and actions. It is widely known that ethical dilemmas involving other employees/managers are inherently emotional. Researchers have found that such strong negative emotions as sadness and anger influenced individuals to make less ethical decisions, and that emotional intelligent individuals were able to make ethical decisions against the biasing influence of those negative emotions. Explain how moods could influence the thought process and ethical decision making. Have you made a decision you later regretted based on your emotional response?

21.

Windsor and Kavanagh propose in a research study that client management economic pressure is a situation of high moral intensity that sensitizes auditors’ emotions and thus motivates their moral reasoning to make deliberative decisions either to resist or accede to client management wishes. Explain how you think such a process might work.

22.

The nature of accountants’ work puts them in a special position of trust in relation to their clients, employers, and the general public, who rely on their professional judgment and guidance in making decisions. Explain the link between professional judgment and ethical decision making in accounting.

23.

Explain what you think each of the following statements means in the context of moral development.

24.

How far are you willing to go to do the right thing?a. How much are you willing to give up to do what you believe is right?b. We may say that we would do the right thing, but when it requires sacrifice, how much are we willing to give up?

c.

25. 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:

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Endnotes

“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.”

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).

1.

Wendy Zellner, “The Fall of Enron,” BusinessWeek, December 17, 2001, p. 30.2. Barbara Ley Toffler with Jennifer Reingold, Final Accounting: Ambition, Greed, and the Fall of Arthur Andersen (New York: Broadway Books, 2003), p. 217.

3.

Bethany McLean and Peter Elkind, The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron (New York: Penguin Group, 2003).

4.

Paul M. Clikeman, Called to Account: Fourteen Financial Frauds That Shaped the American Accounting Profession (New York: Routledge, 2009).

5.

Daniel Edelman and Ashley Nicholson, “Arthur Andersen Auditors and Enron: What Happened to Their Texas CPA Licenses?” Journal of Finance and Accountancy, http://www.aabri.com /manuscripts/11899.pdf.

6.

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.

7.

Carol Gilligan, In a Different Voice: Psychological Theory and Womens Development (Cambridge, MA: Harvard University Press, 1982).

8.

James R. Rest and Darcia Narvaez, eds., Moral Development in the Professions: Psychology and Applied Ethics (New York: Psychology Press, 1994), p. 4.

9.

Rest and Narvaez.10. Rest and Narvaez.11. Muriel J. Bebeau and S. J. Thoma, “Intermediate Concepts and the Connection to Moral Education,” Educational Psychology Review 11, no. 4 (1999), p. 345.

12.

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.

13.

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.

14.

William Crain, Theories of Development: Concepts and Applications, 6th ed. (Upper Saddle River,15. NJ, 2010).

Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting 92

Kay Plummer, “Improving Ethical Judgment through Deep Learning,” in Ethics and Auditing, eds. Tom Campbell and Keith Houghton (Canberra, Australia: ANU-E Press, 2010).

16.

Milton Snoeyenbos, Robert F. Almeder, and James M. Humber, Business Ethics, Corporate Values and Society (Buffalo, NY: Prometheus Books, 1983), pp. 239–264.

17.

Lawrence A. Ponemon and David R. L. Gabhart, “Ethical Reasoning Research in the Accounting and Auditing Professions,” in Moral Development in the Professions: Psychology and Applied Ethics, eds. James R. Rest and Darcia Narvaez (New York: Psychology Press, 1994), pp. 101–120.

18.

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.

19.

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.

20.

Larry Ponemon and David Gabhart, “Auditor Independence Judgments: A Cognitive Developmental Model and Experimental Evidence,” Contemporary Accounting Research (1990), pp. 227–251.

21.

Larry Ponemon, “Auditor Underreporting of Time and Moral Reasoning: An Experimental-Lab Study,” Contemporary Accounting Research (1993), pp. 1–29.

22.

Ponemon and Gabhart, 1994, p. 108.23. Plummer, p. 244.24. Lawrence Kohlberg, Essays on Moral Development: Vol. II: The Psychology of Moral Development: The Nature and Validity of Moral Stages (San Francisco: Harper & Row, 1984).

25.

Mary Louise Arnold, “Stage, Sequence, and Sequels: Changing Conceptions of Morality, Post-Kohlberg,” Educational Psychology Review, Vol. 12, No. 4, 2000, pp. 365–383.

26.

James R. Rest, Darcia Narvaez, Muriel J. Bebeau, and Stephen J. Thoma, Postconventional Moral Thinking: A Neo-Kohlbergian Approach (Mahwah, NJ: Lawrence Erlbaum, 1999).

27.

M. L. Arnold, pp. 367–368.28. John C. Gibbs, “Toward an Integration of Kohlberg’s and Hoffman’s Moral Development Theories,” Human Development 34, 1991, pp. 88–104.

29.

Richard S. Peters, Moral Development and Moral Education (London: George Allen & Unwin, 1982).

30.

Augusto Blasi, “Bridging Moral Cognition and Moral Action: A Critical Review of the Literature,” Psychological Bulletin, Vol. 88, No. 1, 1980, pp. 1–45.

31.

William Damon and Anne Colby, “Education and Moral Commitment,” Journal of Moral Education, Vol. 25, No. 1, 1996, pp. 31–37.

32.

Craig E. Johnson, Organizational Ethics: A Practical Approach, 3rd ed. (NY: Sage Publications, Inc., 2015).

33.

Plummer, pp. 242–244.34. James R. Rest, “Morality,” in Handbook of Child Psychology: Cognitive Development, Vol. 3,35. series ed. P. H. Mussen and vol. ed. J. Flavell (New York: Wiley, 1983), pp. 556–629.

Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting 93

Lawrence Kohlberg, The Meaning and Measurement of Moral Development (Worcester, MA: Clark University Press, 1979).

36.

Rest and Narvaez, p. 24.37. Jeremy I. M. Carpendale, “Kohlberg and Piaget on Stages and Moral Reasoning,” Developmental Review, Vol. 20, Issue 2, 2000, pp. 181–205.

38.

Craig E. Johnson, Meeting the Ethical Challenges of Leadership (New York: Sage Publications, 2011).

39.

Steven Dellaportas, Beverly 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.

40.

Thomas Jones, “Ethical Decision Making by Individuals in Organizations: An Issue-Contingent Model,” Academy of Management Review 16, pp. 366–395.

41.

Jones, p. 379.42. Sarah Hope Lincoln and Elizabeth K. Holmes, “Ethical Decision Making: A Process Influenced by Moral Intensity,” Journal of Healthcare, Science and the Humanities, Vol. 1, No. 1, 2011, pp. 55–69.

43.

Johnson.44. Theresa Libby and Linda Thorne, “Virtuous Auditors: While Virtue Is Back in Fashion, How Do You Define It and Measure Its Importance to an Auditor’s Role?” CA Magazine, November 2003, Available at: www.camagazine.com/archives/print-edition/2003/nov/regulars/camagazine24374.aspx.

45.

Libby and Thorne.46. 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.

47.

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.

48.

Manuel Velasquez, Claire Andre, Thomas Shanks, and Michael J. Meyer, “Thinking Ethically: A Framework for Moral Decision Making,” Available at: http://www.scu.edu/ethics/practicing /decision/thinking.html#sthash.zMGI3C7i.dpuf.

49.

Rushworth M. Kidder, How Good People Make Tough Choices (NY: Simon & Schuster, 1995).50. Johnson, 2011, pp. 249–250.51. Richard F. West and Keith Stanovich, “Individual Differences in Reasoning: Implications for the Rationality Debate,” Behavioral & Brain Sciences (2000), 23, pp. 645–665.

52.

Daniel Kahneman, “A Perspective on Judgment and Choice: Mapping Bounded Rationality,” American Psychologist (2003), 58, pp. 697–720.

53.

Leon Festinger, A Theory of Cognitive Dissonance (Evanston, IL: Row & Peterson, 1957).54. Penny Tompkins and James Lawley, “Cognitive Dissonance and Creative Tension—The Same or Different?” from presentation at The Developing Group, October 3, 2009, Available at: http://www.cleanlanguage.co.uk/articles/articles/262/0/Cognitive-Dissonance-and-Creative-Tension/

55.

Page0.html.

Festinger.56.

Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting 94

Max H. Bazerman and Francesca Gino, “Behavioral Ethics: Toward a Deeper Understanding of Moral Judgment and Dishonesty,” Annual Review of Law and Social Science 8 (December 2012), pp. 85–104.

57.

Dennis P. Wittmer, “Behavioral Ethics in Business Organizations: What the Research Teaches Us,” in Encyclopedia of Business Ethics and Society, ed. Robert W. Kolb (NY: Sage Publications, 2008).

58.

Wittmer, p. 62.59. Bazerman and Gino.60. The University of Texas uses a program, “Ethics Unwrapped,” to teach GVV to its students. Videos are available on the following Web site: http://ethicsunwrapped.utexas.edu/

61.

Materials to teach GVV and cases are available on the GVV Web site: http://www.babson.edu /Academics/teaching-research/gvv/Pages/curriculum.aspx

62.

M.C. Gentile, Giving Voice to Values: How to Speak Your Mind When You Know What’s Right. (New Haven, CT: Yale University Press, 2010).

63.

Gentile.64. Gentile.65. 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.

66.

Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting 95

Chapter 2 Cases

Case 2-1 A Team Player? (a GVV case) Barbara is working on the audit of a client with a group of five other staff-level employees. During the audit, Diane, a member of the group, points out that she identified a deficiency in the client’s inventory system that she did not discover during the physical observation of the client’s inventory. The deficiency was relatively minor, and perhaps that is why it was not detected at the time. Barbara suggests to Diane that they bring the matter to Jessica, the senior in charge of the engagement. Diane does not want to do it because she is the one who identified the deficiency and she is the one who should have detected it at the time of the observation. Three of the other four staff members agree with Diane. Haley is the only one, along with Barbara, who wants to inform Jessica. After an extended discussion of the matter, the group votes and decides not to inform Jessica. Still, Barbara does not feel right about it. She wonders: What if Jessica finds out another way? What if the deficiency is more serious than Diane has said? What if it portends other problems with the client? She decides to raise all these issues but is rebuked by the others who remind her that the team is already behind on its work and any additional audit procedures would increase the time spent on the audit and make them all look incompetent. They remind Barbara that Jessica is a stickler for keeping to the budget and any overages cannot be billed to the client.

Questions

Discuss these issues from the perspective of Kohlberg’s model of moral development. How does this relate to the established norms of the work group as you see it?

1.

Assume you are in Barbara’s position. What would you do and why? Consider the following in answering the question:

2.

How can you best express your point of view effectively?

What do you need to say, to whom, and in what sequence?

What do you expect the objections or pushback will be and, then, what would you say next?

Case 2-2 FDA Liability Concerns (a GVV case) Gregory and Alex started a small business based on a secret-recipe salad dressing that got rave reviews. Gregory runs the business end and makes all final operational decisions. Alex runs the creative side of the business. Alex’s salad dressing was a jalapeno vinaigrette that went great with barbeque or burgers. He got so many requests for the recipe and a local restaurant asked to use it as the house special, that Alex decided to bottle and market the dressing to the big box stores. Whole Foods and Trader Joe’s carried the dressing; sales were increasing every month. As the business grew, Gregory and Alex hired Michael, a college friend and CPA, to be the CFO of the company. Michael’s first suggestion was to do a five-year strategic plan with expanding product lines and taking the company public or selling it within five to seven years. Gregory and Alex weren’t sure about wanting to go public and losing control, but expanding the product lines was appealing. Michael also wanted to contain costs and increase profit margins.

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At Alex’s insistence, they called a meeting with Michael to discuss his plans. “Michael, we hired you to take care of the accounting and the financial details,” Alex said. “We don’t understand profit margins. On containing costs, the best ingredients must be used to ensure the quality of the dressing. We must meet all FDA requirements for food safety and containment of food borne bacteria, such as listeria or e coli, as you develop cost systems.” “Of course,” Michael responded. “I will put processes in place to meet the FDA requirements.” At the next quarterly meeting of the officers, Alex wanted an update on the FDA processes and the latest inspection. He was concerned whether Michael understood the importance of full compliance. “Michael,” Alex said, “the FDA inspector and I had a discussion while he was here. He wanted to make sure I understood the processes and the liabilities of the company if foodborne bacteria are traced to our products. Are we doing everything by the book and reserving some liabilities for any future recalls?” Michael assured Alex and Gregory that everything was being done by the book and the accounting was following standard practices. Over the next 18 months, the FDA inspectors came and Michael reported everything was fine. After the next inspection, there was some listeria found in the product. The FDA insisted on a recall of batch 57839. Alex wanted to recall all the product to make sure that all batches were safe. “A total recall is too expensive and would mean that the product could be off the shelves for three to four weeks. It would be hard to regain our shelf advantage and we would lose market share,” Michael explained. Alex seemed irritated and turned to Gregory for support, but he was silent. He then walked over to where Michael was sitting and said, “Michael, nothing is more important than our reputation. Our promise and mission is to provide great-tasting dressing made with the freshest, best, organic products. A total recall will show that we stand by our mission and promise. I know we would have some losses, but don’t we have a liability reserve for recall, like a warranty reserve?” “The reserve will not cover the entire expense of a recall,” Michael said. “It will be too expensive to do a total recall and will cause a huge loss for the quarter. In the next six months, we will need to renew a bank loan; a loss will hurt our renewal loan rate and terms. You know I have been working to get the company primed to go public as well.” Alex offered that he didn’t care about going public. He didn’t start the business to be profitable. Gregory, on the other hand, indicated he thought going public was a great idea and would provide needed funds on a continuous basis. Alex told Michael that he needed to see all the FDA inspection reports. He asked, “What is the FDA requiring to be done to address the issue of listeria?” “I’m handling it, Alex,” Michael said. “Don’t worry about it. Just keep making new salad dressings so that we can stay competitive.” “Well, Michael, just answer what the FDA is asking for.” “Just to sterilize some of our equipment, but it shouldn’t be too bad.”

“Michael, it’s more than that,” Alex responded. “The FDA contacted me directly and asked me to meet with them in three days to discuss our plans to meet the FDA requirements and standards. We will be fined for not addressing issues found in prior inspections. I want to see the past inspection reports so I can better understand the scope of the problem.” “Listen, Alex,” Michael said. “I just completed a cost–benefit analysis of fixing all the problems identified by the FDA and found the costs outweighed the benefits. We’re better off paying whatever fines they impose and move on.”

“Michael, I don’t care about cost–benefit analysis. I care about my reputation and that of the company. Bring me all the inspection reports tomorrow.” The three of them met the following day. As Alex reviewed the past inspection reports, he realized that he had relied on Michael too much and his assurances that all was well with the FDA. In fact, the FDA had repeatedly noted that more sterilization of the equipment was needed and that storage of the products and ingredients needed additional care. Alex began to wonder whether Michael should stay on with the company. He also was concerned

Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting 97

about the fact that Gregory had been largely silent during the discussions. He wondered whether Gregory was putting profits ahead of safety and the reputation of the company.

Questions Alex knows what the right thing to do is. As Alex prepares for a meeting on the inspection reports the next day, he focuses on influencing the positions of Michael and Gregory, both of whom will be involved in the meeting. Put yourself in Alex’s position and answer the following questions.

What are the main arguments you are trying to counter? That is, what are the reasons and rationalizations you need to address?

1.

What is at stake for the key parties, including those who disagree with you?2. What levers can you use to influence those who disagree with you?3. What is your most powerful and persuasive response to the reasons and rationalizations you need to address? To whom should the argument be made? When and in what context?

4.

Case 2-3 The Tax Return (a GVV case) Brenda Sells sent the tax return that she prepared for the president 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, 2016. Sells was not sure 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 cannot 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.” “You’re missing the basic point that the deduction for losses is only available if you itemize deductions,” Vincent said. “Kohn is not doing that. He’s using the standard deduction.” Brenda realized she had blown it by not knowing that.

Brenda didn’t know what to say. Vincent seemed to be telling her the lottery amounts shouldn’t be reported. But that was against the law. She 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 flexible in such situations. And, I'll tell you, other staff in the same situation have been loyal to the firm. Let’s meet again in my office tomorrow at 9 a.m.”

Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting 98

Questions

Analyze the alternatives available to Brenda using Kohlberg’s six stages of moral development. Assume that Brenda has no reason to doubt Vincent’s veracity 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?

1.

Assume you have decided what your position will be in the meeting with Vincent but are not quite sure how to respond to the reasons and rationalizations provided by him to ignore the lottery losses. How might you counter those arguments? What would be your most powerful and persuasive responses?

2.

Assume that Brenda decides to go along with Vincent and omits the lottery losses and gains. Next year a similar situation arises with winnings from a local poker tournament. Kohn now trusts Brenda and shared with her that he won $4,950 from that event. He tells you to not report it because it was below the $5,000 threshold for the payer to issue a form W-2G. 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 and why?

3.

Case 2-4 A Faulty Budget (a GVV Case) Jackson Daniels graduated from Lynchberg State College two years ago. Since graduating from college, he has worked in the accounting department of Lynchberg Manufacturing. Daniels was recently asked to prepare a sales budget for the year 2016. He conducted a thorough analysis and came out with projected sales of 250,000 units of product. That represents a 25 percent increase over 2015. 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 manufacture 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.” Walker asked Daniels what he planned to do about it. “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, Jack. 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?” “Jon, I owe it to Pete to be honest. He hired me.” “You know Pete is always pressuring us to ‘make the numbers.’ Also, Pete has a zero tolerance for employees who make mistakes. That’s why it’s standard practice around here to sweep things under the rug. Besides, it’s a one-time event—right?” “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?” “Well, you can tell Pete about it at that time. Why raise a red flag now when there may be no need?” 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.”

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Jimmy (Pete) Beam is the vice president of production. Jackson Daniels had referred to him in his conversation with Jonathan Walker. After several days of reflection on his friend’s comments, Daniels decided to approach Pete and tell him about the mistake. He knew there might be consequences, but his sense of right and wrong ruled the day. What transpired next surprised Daniels.

“Come in, Jack” Pete said. “Thanks, Pete. I asked to see you on a sensitive matter.” “I’m listening.” “There is no easy way to say this so I’ll just tell you the truth. I made a mistake in my sales budget. The projected increase of 25 percent was wrong. I checked my numbers and it should have been 12.5 percent. I’m deeply sorry; want to correct the error; and promise never to do it again.” Pete’s face became beet red. He said, “Jack, you know I hired 20 new people based on your budget.” “Yes, I know.” “That means ten have to be laid off or fired. They won’t be happy and once word filters through the company, other employees may wonder if they are next.” “I hadn’t thought about it that way.” “Well, you should have.” Here’s what we are going to do…and this is between you and me. Don’t tell anyone about this conversation.” “You mean not even tell my boss?” “No, Pete said.” Cwervo can’t know about it because he’s all about correcting errors and moving on. Look, Jack, it’s my reputation at stake here as well.”

Daniels hesitated but reluctantly agreed not to tell the controller, Jose Cwervo, his boss. The meeting ended with Daniels feeling sick to his stomach and guilty for not taking any action.

Questions

What are Daniels’s options in this situation? Use ethical reasoning to identify the best alternative. What would you do if you were in Daniels’ position?

1.

Given that you have decided to take some action even though you had agreed not to do so, who would you approach to express your point of view and why?

2.

What is at stake for the key parties?3. What are the main arguments you are likely to encounter in making the strongest case possible?4. What is your most powerful and persuasive response to the reasons and rationalizations you may need to address? To whom should the argument be made? When and in what context?

5.

Case 2-5 Gateway Hospital (a GVV case) Troy just returned from a business trip for health-care administrators in Orlando. Kristen, a relatively new employee who reports to him, also attended the conference. They both work for Gateway Hospital, a for-profit hospital in the St. Louis area. The Orlando conference included training in the newest reporting requirements in the health-care industry, networking with other hospital administrators, reports on upcoming legislation in health care, and the current status of regulations related to the Affordable Care Act. The conference was in late March and coincided with Troy’s kids’ spring break, so the entire family traveled to Orlando to check out Walt Disney World and SeaWorld.

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The hospital’s expense reimbursement policy is very clear on the need for receipts for all reimbursements. Meals are covered for those not provided as part of the conference registration fee, but only within a preset range. Troy has never had a problem following 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 their 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 reading or careful examination. He realizes the amount involved is not material and probably won’t be detected. Kristen is approached by Joyce, the head of the accounting department, about Troy’s expenses, which seem high and not quite right. Kristen 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 administrators, 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 you, as Kristen, have decided the best approach, at least in the short run, is to put off responding to Joyce so that you can discuss the matter with Troy. Answer the following questions.

Questions

What are the main arguments you feel Troy will make and reasons and rationalizations you need to address?1. What is at stake for the key parties in this situation?2. What levers can you use to influence how Troy reacts to your position in this matter?3. What is your most powerful and persuasive response to the reasons and rationalizations you need to address? To whom should the argument be made? When and in what context?

4.

Case 2-6 LinkedIn and Shut Out The facts of this case are fictional. Any resemblance to real persons, living or dead, is purely coincidental. Kenny is always looking to make contacts in the business world and enhance his networking experiences. He knows how important it is to drive customers to his sports memorabilia business. He’s just a small seller in the Mall of America in Bloomington, Minnesota. Kenny decided to go on LinkedIn. Within the first few weeks, he received a number of requests that said, “I’d like to add you to my professional network.” At first almost all of such requests came from friends and associates he knew quite well. After a while, however, he started to receive similar requests from people he didn’t know. He would click on the “view profile” button, but that didn’t provide much useful information so he no longer looked at profiles for every request. He simply clicked the “accept” button and the “You are now connected” message appeared. One day Kenny received the following message with a request to “connect”: “I plan to come to your sports memorabilia store in the future so I thought I’d introduce myself first. I am a financial planner and have helped small business owners like yourself to develop financial plans that provide returns on their investments three times the average rate received for conventional investments. I’m confident I can do the same for you. As a qualified professional, you can trust my services.” Kenny didn’t think much about it. It certainly sounded legitimate. Besides, he would meet the financial planner soon and could judge the type of person he was. So, Kenny linked with the planner.

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A week later, the financial planner dropped by Kenny’s store and provided lots of data to show that he had successfully increased returns for dozens of people. He even had testimonials with him. Kenny agreed to meet with him in his St. Paul office later that week to discuss financial planning. The meeting took place and Kenny gave the financial planner a check for $30,000, which was most of Kenny’s liquid assets. At first the returns looked amazing. Each of the first two quarterly statements he received from the planner indicated that he had already earned $5,000; a total of $10,000 in six months. Three months later Kenny did not receive a statement. He called the planner and the phone had been disconnected. He sent e-mails but they were returned as not valid. No luck with text messages. Kenny started to worry whether he ever would see his money—at least the $30,000. He was at a loss what to do. A friend suggested he contact LinkedIn and see if it could help. His online contact led to the following response in an e-mail:

As per our agreement with you, we are not liable to you or others for any indirect, incidental, special, consequential, or punitive damages, or any loss of data, opportunities, reputation, profits or revenues, related to the services of LinkedIn. In no event shall the liability of LinkedIn exceed, in the aggregate for all claims against us, an amount that is the lesser of (a) five times the most recent monthly or yearly fee that you paid for a premium service, if any, or (b) $1,000. This limitation of liability is part of the basis of the bargain between you and LinkedIn and shall apply to all claims of liability (e.g., warranty, tort, negligence, contract, law) and even if LinkedIn has been told of the possibility of any such damage, and even if these remedies fail their essential purpose. If disputes arise relating to this Agreement and/or the Services, both parties agree that all of these claims can only be litigated in the federal or state courts of Santa Clara County, California, USA, and we each agree to personal jurisdiction in those courts.

To say Kenny was distraught is an understatement. He felt like he had been shut out. While he did he not understand all the legalese, he knew enough that he would have to hire an attorney if he wanted to pursue the matter.

Questions

How would you characterize Kenny’s thought process in the way he responded to requests to connect on LinkedIn?

1.

Who is to blame for what happened to Kenny and why?2. What would you do at this point if you were in Kenny’s position and why?3.

Case 2-7 Milton Manufacturing Company Milton Manufacturing Company produces a variety of textiles for distribution to wholesale manufacturers of clothing products. 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 2005, and it grew in revenue from $500,000 to $5 million in 10 years. However, the revenues declined to $4.5 million in 2015. 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 2016. Irv Milton met with Ann Plotkin, the chief accounting officer (CAO), on January 15, 2016, to discuss a proposal by Plotkin to control cash outflows. He was not overly concerned about the recent decline in net cash flows from operating activities because these amounts were expected to increase in 2016 as a result of projected higher levels of revenue and cash collections. However, that was not Plotkin’s view. Plotkin knew that if overall negative capital expenditures continued to increase at the rate of 40 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 2016 for

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investing activities would be limited to the level of those capital expenditures in 2013, the last year of an overall positive cash flow. Operating activity cash flows had no such restrictions. 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 headquarters in Long Island City. He was informed of the new capital expenditure policy by Ira Sugofsky, the vice president for operations. Markowicz told Sugofsky that the new policy could negatively affect plant operations because certain machinery and equipment, essential to the production process, had been breaking down more frequently during the past two years. The problem was

EXHIBIT 1 Milton Manufacturing Company

Summary of Cash Flows For the Years Ended December 31, 2015 and 2014 (000 omitted)

December 31, 2015 December 31, 2014

Cash Flows from Operating Activities

245 $273 $emocni teN Adjustments to reconcile net income to net cash provided by operating activities (2,350) (2,383)

Net cash provided by operating activities $ (1,978) $ ( 1,841)

Cash Flows from Investing Activities

Capital expenditures $ (1,420) $ (1,918)

Other investing inflows (outflows) 176 84

Net cash used in investing activities $ (1,244) $ (1,834)

Cash Flows from Financing Activities

Net cash provided (used in) financing activities $ 168 $ 1,476

Increase (decrease) in cash and cash equivalents $ (3,054) $ (2,199)

Cash and cash equivalents—beginning of the year $ 3,191 $ 5,390

Cash and cash equivalents—end of the year $ 147 $ 3,191

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 2016. 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 2016. Net cash inflows from operating activities exceeded outflows by $1,250,000 during this time period. It was the first time in two years that there was a positive cash flow from operating activities. Production operations accelerated during the third quarter as a result of increased demand for Milton’s textiles. An aggressive advertising campaign initiated in late 2015 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

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supplier. That supplier’s price was lower, and the quality of the motors would significantly 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 managers. Sugofsky seemed indifferent but reminded Markowicz of the capital expenditure restrictions in place and that the Long Island City plant was committed to keeping expenditures at the same level as it had in 2014. 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, “You and I may not agree with it, but a policy is a policy.” Markowicz reflected on his obligations 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 supplier, Markowicz knew he could save the company $1,500, or 50 percent of cost, on each motor purchased from the overseas supplier. After carefully considering the implications of his intended action, Markowicz contacted the other plant managers 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 at the beginning of the fourth quarter of 2016 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 resulting from increased revenues 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 continued to operate. The acquisitions by Markowicz and the other plant managers enabled the company to keep up with the growing demand for textiles, and the company finished the year with record high levels of profit and net cash inflows from all activities. 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 borrowed was received on October 3, 2016. During the course of an internal audit of the 2016 financial statements, 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 determined 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 situation, Milton called in Sugofsky. When Wald told him about her findings, Sugofsky’s face turned beet red. He told Wald that he had instructed Markowicz not to make the purchase. He also inquired about the accounting since Wald had said it was wrong. Wald explained to Sugofsky that the $1 million should be 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 nodded their heads 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 discussed in the chapter to help you assess the following:

Identify the ethical and professional issues of concern to Beverly Wald as the chief internal auditor and a CPA.1. Who are the stakeholders in this case and what are their interests?2.

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Identify alternative courses of action for Wald, Plotkin, and Sugofsky to present in their meeting with Milton. How might these alternatives affect the stakeholder interests?

3.

If you were in Milton’s place, which of the alternatives would you choose and why?4.

Case 2-8 Juggyfroot “I’m sorry, Lucy. That’s the way it is,” Ricardo said. The client wants it that way. “I just don’t know if I can go along with it, Ricardo,” Lucy replied. “I know. I agree with you. But, 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,” Ricardo explained. “Have you spoken to Fred and Ethel about this?” Lucy asked. “Are you kidding? They’re the ones who made the decision to go along with Juggyfroot,” Ricardo responded. “I don’t care, Ricardo. I expect more from you. I didn’t join this firm to compromise my values.”

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 partner of the office. Fred and Ethel are the engagement review partners that make final judgments on difficult accounting issues, especially when there is a difference of opinion with the client. All four are CPAs. Ricardo Rikey is preparing for a meeting with Norman Baitz, the CEO of Juggyfroot. Ricardo 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 2015 by 8 percent. Ricardo knows that without the change, the earnings would have declined by 2 percent and the company’s stock price would have taken a hit. However, he is also very aware of his ethical and professional responsibilities. In the meeting, Ricardo decides to overlook the recommendation by Fred and Ethel. Ricardo points out to Baitz that the investment in question was marketable, and in the past, the company had sold similar investments in less than one year. Ricardo adds there is no justification under generally accepted accounting principles (GAAP) to change the classification from trading to available-for-sale. What happened next shocked Ricardo back to reality. The conversation between Baitz and Ricardo went this way.

“I hate to bring it up, Ricardo, but do you recall what happened last year at about the same time?” “What do you mean?” “You agreed that we could record $1 million as revenue for 2014 based on a sale of our product that we held at an off-site distribution warehouse until the client asked for delivery, which occurred in 2015.” Ricardo remembered all too well. It almost cost the firm the Juggyfroot account. “Are you going to throw that in my face?” “No, Ricardo. Just a gentle reminder that you had agreed to go along with what we had asked at that time. We expect you to be loyal to our interests here as well.”

The meeting broke up when Baitz received a confidential phone call. They agreed to continue it first thing in the morning.

Questions

Should Ricardo let what happened last year affect how he approaches the issue of the improper recording of marketable securities when he resumes his discussion with Baitz in the morning? Why or why not?

1.

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How would you handle the issue if you were in Ricardo’s position? Develop an action plan to get your point of view across. What would you say? What do you expect the objections or pushback will be? How would you convince Baitz of the rightness of your position?

2.

Case 2-9 Phar-Mor

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.

Background 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, 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. He brought Monus the bad news that, following a number of years of eroding profits, the company 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.

1

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. Also, he thought of himself as a team player. Finn prepared the reports, and Monus changed the numbers for four months before turning the task over to Finn. These reports with the false numbers were faxed to Shapira and given to Phar-Mor’s board. Basically, the company was lying to its owners.

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The fraud occurred by dumping the losses into a “bucket account” and then reallocating the sums to one of the company’s hundreds of stores in the form of increases in inventory amounts. Phar-Mor issued fake invoices for merchandise purchases and made phony journal entries to increase inventory 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 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. Cherelstein and Anderson discussed what to do about the fraud. Cherelstein asked Anderson why he hadn’t done something about it. Anderson asked how could he? He was the new kid on the block. Besides, Pat (Finn) seemed to be disinterested in confronting Monus. Cherelstein was not happy about the situation and felt like he had a higher responsibility. He 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 beginning, 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 example 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 defrauding 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 additional effort to solve the inventory and billing problems. However, the losses just kept on coming.

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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 knew about it now and felt compelled to do something. Cherelstein thought about the persistent complaints by vendors that they were not being paid and their threats to cut off shipments to Phar-Mor. Cherelstein knew that, without any product in Phar-Mor stores, the company could not last much longer.

Questions

Evaluate the role of each of the stakeholders in this case from an ethical perspective. How do you assess blame for the Phar-Mor fraud?

1.

Assume you are in Stan Cherelstein’s position. Evaluate the moral intensity issues in the case. How do these issues relate to Rest’s Four-Component Model of Ethical Decision Making? What are the challenges for Cherelstein in that regard?

2.

Assume you decide to confront Monus. How would you counter the likely reasons and rationalizations you will hear from Monus? What levers do you have to influence Monus’s behavior?

3.

What is the ethical message of Phar-Mor? That is, explain what you think the moral of this story is.4.

Case 2-10 WorldCom The WorldCom fraud was the largest in U.S. history, surpassing 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:

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 capacity.” That name was designed to mask the true nature of the costs and treat them as capitalizable costs rather than as operating 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 reactions I was getting from some of the finance executives.”

Booking “line costs” for interconnectivity with other telecommunications companies as capital expenditures rather than operating expenses.

1.

Inflating revenues with bogus accounting entries from “corporate unallocated revenue accounts.”2.

1

David K. Katz and Julia Homer, “WorldCom Whistle-blower Cynthia Cooper,” CFO Magazine, February 1, 2008. Available at: www.cfo.com/article.cfm/10590507. 1

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When asked whether there was anything about the culture 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 strategy 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. It was clear she felt uneasy with the accounting at WorldCom. Vinson said that she took her concerns to Sullivan, who told her that Ebbers did not want to lower Wall Street expectations. Asked how she chose which accounts to alter, Vinson testified, “I just really pulled some out of the air. I used some spreadsheets.” Her lawyer 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.

2

Questions

Identify the stakeholders in the WorldCom case and how their interests were affected by the financial fraud.1. Do you think Betty Vinson was a victim of “motivated blindness”? Are there steps should could have taken to stand up for what she believed? Explain.

2.

In a presentation at James Madison University in November 2013, Cynthia Cooper said, “You don’t have to be a bad person to make bad decisions.” Discuss what you think Cooper meant and how it relates to our discussion of ethical and moral development in the chapter.

3.

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 integrity throughout, even as Sullivan was trying to bully her into dropping the investigation.

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: www.people.tamu.edu/˜jstrawser/acct229h/Current%20 Readings/E.%20WSJ.com%20-%20A%20Staffer%20 Ordered%20to%20Commit%20Fraud,%20Balked.pdf.

2

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Learning Objectives

After studying Chapter 3, you should be able to:

LO 3-1 Describe the link between organizational climate and ethical leadership. LO 3-2 Explain the link between organizational ethics, individual ethics, and

corporate culture. LO 3-3 Analyze why and how organizational culture is formed. LO 3-4 Discuss the views of employees about ethics in their organizations. LO 3-5 Describe the causes of fraud, detection methods, and preventative

controls. LO 3-6 Explain the components of corporate governance and their relationship

to corporate culture. LO 3-7 Analyze the moral basis for whistleblowing and accountants’ obligations

to whistle blow.

3 Organizational Ethics and Corporate Governance

Chapter

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Ethics Reflection

Satyam: India’s Enron Corporate governance failures marked the business and accounting frauds of the early 2000s. The United States was not alone. Enron and WorldCom had their counterparts in the global arena. Italy had a massive fraud at Parmalat, and Satyam, sometimes referred to India’s Enron, was a $1.4 billion fraud that triggered a reduction in share price of almost 99 percent.

Satyam Computer Services was the fourth-largest software exporter in India until January 2009, when the CEO and cofounder, Ramalinga Raju, confessed to inflating the company’s profits and cash reserves over an eight-year period. The accounting fraud at Satyam involved dual accounting books, more than 7,000 forged invoices, and dozens of fake bank statements. The total amount of losses was 50 billion Rs (rupees) (equal to about $1.40 billion). This represented about 94 percent of the company’s cash and cash equivalents. Raju stepped down in early January 2009. In April 2015, he was convicted of forging documents and falsifying accounts. He is currently serving a seven-year prison term.

The Satyam incident was investigated by India’s “Serious Frauds” (seems a redundancy) O�ce that coordinated the investigations and the diversion of funds by promoters within and outside India and corporate governance failings.

Corporate Governance Failings The legal complaints alleged that members of the audit committee of the Satyam board of directors—who were responsible for overseeing the integrity of the company’s financial statements, the performance and compensation of the outside auditors from PricewaterhouseCoopers (PwC) India firms, and the adequacy and e�ectiveness of internal accounting and financial controls—were responsible for the publication of false and misleading public statements due to their extreme recklessness in discharging their duties and their resulting failure to discover and prevent the massive accounting fraud.

E�ective corporate governance was missing at Satyam at all levels including:

A unique aspect of the corporate governance system in India is the ownership of shares by outside promoters, multinational blockholder companies, and the state. Unlike in the United States where public ownership is high and transparency is key, the more closed system in India leads to a relative lack of full and fair disclosure.

Lack of independent members of the board of directors; those not beholden to management.

Audit committee failings to properly oversee financial reporting and internal controls.

Questionable “ethical” tone at the top that worked against promoting ethical and competent behavior throughout the organization.

External audits that were heavily influenced by conflicts of interest between PwC and management.

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Audit Failures by PwC and Resulting Legal Actions

The complaint asserted claims against PwC and its Indian partners and affiliates. Satyam’s outside auditors from the PwC India firms allegedly were aware of the fraud but still certified the company’s financial statements as accurate. The company’s financial statements were signed off on by PwC on March 31, 2008.

PwC and its Indian affiliates initially hid behind “client confidentiality” and stated that it was “examining the contents of the statement.” Realizing that this was not enough, PwC came up with a second statement claiming that “the audits were conducted in accordance with applicable auditing standards and were supported by appropriate audit evidence.” This is somewhat troublesome because an audit in accordance with generally accepted auditing standards (GAAS) calls for examining the contents of the financial statements. Given that the firm did not identify the financial wrongdoing at Satyam, it would appear that the firm, at the very least, was guilty of professional negligence. At a minimum, the firm missed or failed to do the following:

One ironic note about the Satyam fraud is in September 2008 the World Council for Corporate Governance honored the company with a “Golden Peacock Award” for global excellence in corporate governance. Once news of the fraud broke, the council rescinded the award, stating that the company failed to disclose material information.

As you read this chapter, reflect on the following questions: (1) What systems are necessary to ensure that a company runs efficiently and ethically? (2) What role does corporate culture and ethical leadership play in creating an ethical organization? (3) What are the components of an ethical control environment from an accounting and auditing perspective? (4) How do whistleblowing obligations of accounting professionals influence ethical behavior?

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: 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.

Fictitious invoices with customers were recorded as genuine.

Raju recorded a fictional interest credit as income.

The auditors didn’t ask for a statement of confirmation of balance from banks (for cash balances) and debtors (for receivables), a basic procedure in an audit.

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Organizational Ethics and Leadership

LO 3-1 Describe the link between organizational climate and ethical leadership.

Organizational ethics can be thought of as the generally accepted principles and standards that guide behavior in business and other organizational contexts. High ethical standards require both organizations and individuals to conform to sound moral principles. In organizations, a critical component of creating an ethical organization environment is the culture that includes shared values, beliefs, goals, norms, and problem solving mechanisms. The ethical climate of an organization plays an important role in organizational culture. Whereas an organization’s overall culture establishes ideals that guide a wide variety of member behaviors, the ethical climate focuses specifically on issues of right and wrong. Organizational ethical climate refers to the moral atmosphere of the work environment and the level of ethics practiced within a company. Leaders determine organizational climate and establish character and define norms. Character plays an important role in leadership. Leaders of good character have integrity, courage, and compassion. They are careful and prudent. Their decisions and actions inspire employees to think and act in a way that enhances the well-being of the organization, its people, and society in general. Ralph Waldo Emerson, the American essayist, poet, and philosopher, said, “Our chief want is someone who will inspire us to be what we know we could be.” Johnson points out that virtues are woven into the inner lives of leaders, shape the way they see and behave, operate independent of the situation, and help leaders to live more fulfilling lives. He identifies courage, temperance, wisdom, justice, optimism, integrity, humility, reverence, and compassion as underlying traits of character of effective leaders. Ethical leaders recognize that moral action is risky but continue to model ethical behavior despite the danger. They refuse to set their values aside to go along with the group, to keep silent when customers may be hurt, or to lie to investors. They strive to create ethical environments even when faced with opposition from their superiors and subordinates. Ethical leaders serve as role models for those within the organization and stakeholders that rely on it.

There is no one size fits all for ethical climates. Johnson believes that an organization must first identify principles and practices that characterize positive ethical climates and then adapt them to a particular organization setting. He identifies key markers of highly ethical organizations including humility, zero tolerance for individual and collective destructive behaviors, justice, integrity, trust, a focus on process, structural reinforcement, and social responsibility. We add that an ethical climate is enhanced through a values-driven organization that encourages openness and transparency, and provides a supportive environment to voice matters of concern without fear of retribution or retaliation.

Is there a difference between ethical decision making in general, as we discussed in Chapter 2, and ethical decision making in an organizational setting? We believe there are important differences that incorporate both individual and organizational factors into the process. Ferrell et al. describes a process that is depicted in Exhibit 3.1. What follows is a brief explanation of the components of the framework.

Ethical Issue Intensity Recall our previous discussion of Rest’s Model and the first step of recognizing that an ethical issue exists. Ethical awareness requires that an individual or work group choose among several actions that various stakeholders inside or outside the firm will ultimately evaluate as right or wrong. The relative importance of the issue to the individual, work group and/or organization (intensity) is based on the values, beliefs, and norms involved and situational pressures in the workplace.

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EXHIBIT 3.1 Framework for Understanding Ethical Decision Making in Business

Source: O.C. Ferrell, John Fraedrich, and Linda Ferrell, Business Ethics: Ethical Decision Making and Cases (Stamford, CT: Cengage Learning, 2015).

Individual Factors Values of individuals can be derived from moral philosophies, such as those discussed in Chapter 1. These provide principles or rules people use to decide what is right or wrong from a moral and personal perspective. Although an individual’s intention to engage in ethical behavior relates to individual values, organizational and social forces also play an important role by shaping behavioral intentions and decision making.

Organizational Factors Research has established that in the workplace, the organization’s values often have a greater influence on decisions than a person’s own values. Ethical decisions in the workplace are made jointly, in work groups or other organizational settings. The strength of personal values, the opportunities to behave unethically, and the exposure to others who behave ethically or unethically influence decision making. An alignment between an individual’s own values and the values of the organization help create positive work environments and organizational outcomes.

Opportunity Ferrell points out that opportunity describes the conditions in an organization that limit or permit ethical or unethical behavior. Opportunity results from conditions that either provide internal or external rewards, or fail to erect barriers against unethical behavior. The opportunities that employees have for unethical behavior in an organization can be reduced or eliminated with aggressive enforcement of rules and codes of ethics.

Business Ethics Evaluations and Intentions Ethical dilemmas involve problem-solving situations when the rules governing decisions are often vague or in conflict. The results of an ethical decision are often uncertain: It is not always immediately clear whether or not we made the right decision. Moreover, the decision we make may not always

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Opportunity

Organizational Factors

Individual Factors

Business Ethics Evaluations and Intentions

Ethical or Unethical Behavior

Ethical Issue Intensity

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comport with the one we intended to make because of pressures within the organization. As discussed in Chapter 2, this is where giving voice to one’s values becomes a critical component of taking ethical action.

Ethical or Unethical Behavior The resulting ethical or unethical behavior is greatly influenced by the decision maker’s ability to express one’s values; be supported by the norms, standards, and rules of conduct in the organization; and find a way to be true to these guidelines even in the face of opposing points of view. An organizational ethical culture is shaped by effective leadership. Without top management support for ethical behavior, the opportunity for employees to engage in their own personal approaches to decision making will evolve.

Organizational Influences on Ethical Decision Making

LO 3-2 Explain the link between organizational ethics, individuals ethics, and corporate culture.

Organizational factors can impede ethical decision making. Smith and Carroll presented a detailed argument that organizational factors such as socialization processes, environmental influences, and hierarchical relationships collectively constitute a “stacked deck,” which impedes moral behavior. Organizational factors are likely to play a role in moral decision making and behavior at two points: establishing moral intent and engaging in moral behavior. Explicit organizational behaviors may cause unethical (or ethical) behavior to result despite good (or bad) intention. Thomas Jones developed an explanatory model that merged Rest’s four-step moral reasoning model with Fiske and Taylor’s work on social cognition to illustrate the ethical 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 recognizing moral issues. 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). 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. 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. The Jones-Hiltebeitel model looks at the role of one’s personal code of conduct in ethical behavior within an organization. When an employee was 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. The implications for ethical behavior within the organization are significant because an unethical individual might act dishonestly in one case, while a virtuous person would act in a truthful, trustworthy manner.

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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 attention to the examination of ethical person-organization fit upon the person-organization exchange, within each of the four potential fit options. Burchard presents what she calls the Ethical Dissonance Cycle 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. 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. 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).

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 constructive 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.

High Organizational Ethics, High Individual Ethics (High-High) 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. These three factors relate to the culture of the organization and may have implications for actions such as whistleblowing, as discussed later on. Koh

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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) 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. contends that “dysfunctional leader behaviors and susceptible 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.’ ”

High Organizational Ethics, Low Individual Ethics (High-Low) According to Hamilton and Kelman, 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. Those assimilated 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 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 individual. 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. 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 individual’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. 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.

Seven Signs of Ethical Collapse In her book The Seven Signs of Ethical Collapse, Marianne Jennings analyzes the indicators of possible ethical collapse in companies and provides advice how to avoid impending 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 financial reporting standards and accounting rules as one

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area where this might occur. She points out that “not all companies that have drifted ethically have violated any laws.” 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.” A good example is Dennis Kozlowski at Tyco International who misappropriated company resources for personal purposes without the approval of the board of directors and rationalized that he was just doing what those before him had done. Thus, he invoked one of the reasons and rationalizations that we discussed in giving voice to values—Expected or Standard Practice. Jennings links the rationalizations and legalisms to a culture that leads to behavior based on the notion “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.

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. We briefly address four of the seven signs.

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 earnings. 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, the dominant, larger-then-life CEO of Tyco, 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

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cars and 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 CEOs are unethical (e.g., Steve Jobs and Warren Buffett).

Weak Board of Directors A weak board of directors characterizes virtually all the companies with major accounting 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:

Stakeholder Orientation In a business context, investors and shareholders, creditors, employees, customers, suppliers, governmental agencies, communities, and many others who have a “stake” or a claim in some aspect of a company’s products, operations, markets, industry, and outcome are known as stakeholders. Business influences these groups, but these groups also have the ability to influence business; therefore, the relationship between companies and their stakeholders is a two-way street. 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. 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.

Ferrell states that the degree to which an organization understands and addresses stakeholder demands can be referred to as a stakeholder orientation. This orientation comprises three sets of activities: (1) the organization-wide generation of data about stakeholder 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.

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

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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.

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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 illustrates 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 stakeholders 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 automobile, 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 apparently 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 monetary 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 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. A summary of the Ford analysis follows.

Ford’s Risk-Benefit Analysis Benefits of Fixing the Pintos

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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 × ($200,000) + 180 × ($67,000) + 2,100 × ($700) = $49.5 million

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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’s risk–benefit analysis relied only on act-utilitarian reasoning, 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.

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 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 unconsciously overlook key features of the Pinto case . . . mainly because they did not fit an existing script.” While personal morality was very important to Gioia, he admits that the framing narrative of his workplace “did not include ethical dimension.” The moral mistake was that there were other, better choices that he could have made—albeit ones outside the purview of Gioia’s framing narrative.

Lessons Learned? Has the automobile industry learned a lesson from Ford’s experience with the Pinto? Some observers thought not when, in February 1993, an Atlanta jury held the General Motors Corporation responsible for the death of a Georgia teenager in the fiery crash of one of its pickup trucks. At the trial, General Motors contended in its defense that when a drunk driver struck seventeen-year-old Shannon Moseley’s truck in the side, it was the impact of the high-speed crash that killed Moseley. However, the jury was persuaded that Moseley survived the collision only to be consumed by a fire caused by his truck’s defective fuel-tank design. Finding that the company had known that its “side-saddle” gas tanks which are mounted outside the rails of the truck’s frame, are dangerously prone to rupture, the jury awarded $4.2 million in actual damages and $101 million in punitive damages to Moseley’s parents.

Unit cost: $11 per car, $11 per light truck Total cost: 11,000,000 × ($11) + 1,500,000 × ($11) = $137 million

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Sales: 11 million cars, 1.5 million light trucks

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it still stood behind the safety of its trucks and contended “that a full examination by the National Highway Traffic Safety Administration of the technical issues in this matter will bear out our contention that the 1973–1987 full-size pickup trucks do not have a safety-related defect.” Of course, that wasn’t to be. A stakeholder orientation adds to a corporation’s reputation for being trustworthy. Many parties rely on the considerate, fair-minded, and ethical treatment of stakeholders. Gone are the days when only shareholder interests mattered. Too many groups rely on a corporation today for too many things for an ethical company to ignore those interests.

Establishing an Ethical Culture

LO 3-3 Analyze why and how organizational culture is formed.

Corporate culture is the shared beliefs of top managers in a company about how they should manage themselves and other employees, and how they should conduct their business(es). Southwest Airlines promotes a culture of a: (1) warrior spirit; (2) servant’s heart; and (3) (fun-loving attitude). Most people who fly on Southwest see it as caring about the customer.

An important element of ethical culture is the tone at the top. Tone at the top refers to the ethical environment that is created in the workplace by the organization’s leadership. An ethical tone creates the basis for standards of behavior that become part of the code of ethics. The tone set by managers influences how employees respond to ethical challenges and is enhanced by ethical leadership. When leaders are perceived as trustworthy, employee trust increases; leaders are seen as ethical and as honoring a higher level of duties. Employees identify with the organization’s values and the likely outcome is high individual ethics; high organization ethics; and a lack of dissonance.

If the tone set by management upholds ethics and integrity, employees will be more inclined to uphold those same values. However, if top management appears unconcerned about ethics and focuses solely on the bottom line, employees will be more prone to commit fraud, whether occupational (i.e., job-related), or participation in fraudulent financial reporting as occurred with Betty Vinson. The culture at Tyco can be characterized as laissez-faire because Dennis Kozlowski was too preoccupied with his personal affairs to pay much attention to the company. Consequently, there was an absence of directions, standards, and expectations. With an absence of effective leadership, each department, in fact, each individual did whatever they wanted. Corporate culture starts with an explicit statement of values, beliefs, and customs from top

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What undoubtedly swayed the jury was the testimony of former GM safety engineer Ronald E. Elwell. Although Elwell had testified in more than 15 previous cases that the pickups were safe, this time he switched sides and told the jury that the company had known for years that the side-saddle design was defective but had intentionally hidden its knowledge and had not attempted to correct the problem. At the trial, company officials attempted to paint Elwell as a disgruntled employee, but his testimony was supported by videotapes of General Motors’ own crash tests. After the verdict, General Motors said that

management. A code of ethics serves as a guide to support ethical decision making. It clarifies an organization’s mission, values, and principles, linking them with standards of professional conduct.

123Chapter 3 Organizational Ethics and Corporate Governance

Trust in Business Trust in business is the cornerstone of relationships with customers, suppliers, employees, and others who have dealings with an organization. Trust means to be reliable and 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.” 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. 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.

Johnson & Johnson: Trust Gained In addition to a statements 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 3.2.

EXHIBIT 3.2 Johnson & Johnson Credo

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

(Continued)

124 Chapter 3 Organizational Ethics and Corporate Governance

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.

Source: Johnson & Johnson Credo, http://www.jnj.com/sites/default/files /pdf/jnj_ourcredo_english_us_8.5x11_cmyk.pdf.

The Johnson & Johnson credo clearly sets a positive tone. Notice how it emphasizes 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 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 vacuous position, however. By Kaplan’s own admission, “Johnson & Johnson’s top management put customer safety first, before they worried about their company’s profit and other financial concerns.” 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 capsules 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 Johnson & Johnson did, 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.

Johnson & Johnson: Trust Deficit Johnson & Johnson learned the hard way that trust gained can easily be lost simply with one or two bad acts. The company learned that losing sight of one’s values can cost. Johnson & Johnson announced in January 2012 that it recorded pretax charges and special items totaling $3.3 billion for the fourth quarter

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125Chapter 3 Organizational Ethics and Corporate Governance

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 November 4, 2013, Johnson & Johnson agreed to pay more than $2.2 billion in criminal and civil fines to settle accusations that it improperly promoted the antipsychotic drug Risperdal to older adults, children and people with developmental disabilities. The agreement is the third-largest pharmaceutical settlement in U.S. history and the largest in a string of recent cases involving the marketing of antipsychotic and anti-seizure drugs to older dementia patients. It is part of a decade-long effort by the federal government to hold the health care giant — and other pharmaceutical companies — accountable for illegally marketing the drugs as a way to control patients with dementia in nursing homes and children with certain behavioral disabilities, despite the health risks of the drugs.

In another setback for the company, on February 24, 2015, a Philadelphia jury decided J&J must pay $2.5 million in damages for failing to warn that its Risperdal antipsychotic could cause gynecomastia, which is abnormal development of breasts in males. The lawsuit was brought by the family of an autistic boy who took the drug in 2002 and later developed size 46 DD breasts, according to a lawyer for the family. The case has drawn attention for a few reasons. For one, this was the first lawsuit claiming J&J hid the risks of gynecomastia to go to trial after a handful of cases were settled in recent years. The trial also served as a reminder that J&J had already paid $2.2 billion two years prior to resolve criminal and civil allegations of illegally marketing Risperdal to children and the elderly.

Unfortunately, the problems for Johnson & Johnson go further back. Exhibit 3.3 provides a brief summary of the investigations against the company:

EXHIBIT 3.3 Johnson & Johnson’s Product Liabilities

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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. 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. 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 a�ected by the recalled hip implants. In November 2013, it was announced that Johnson & Johnson agreed to a settlement that could reach up to $4 billion to resolve thousands of lawsuits filed by patients injured by a flawed all-metal replacement hip. Women who have su�ered 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

(Continued)

February 2009, and in July 2011.

126 Chapter 3 Organizational Ethics and Corporate Governance

Ethics in the Workplace

LO 3-4 Discuss the views of employees about ethics in their organizations.

When we think about workplace ethics, the first thing that comes to mind is a code of conduct that influences the development of an ethical culture in the workplace. A code 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. Employees who sense that top managers act unethically quickly lose trust in those managers. The result can be to become disillusioned with the goals of the organization and question whether the corporate culture is one that is consistent with individual, personal values and beliefs. An ethical organization is one in which top managers establish a tone at the top that promotes ethical behavior including to raise questions when questionable behavior occurs. Here is a list of measures that should be taken to establish an ethical culture:

In March 2015, The Lawsuit Settlement Funding Company announced that Johnson & Johnson's Ethicon subsidiary reached a settlement in their transvaginal mesh devices. The settlement came just one day after a $5.7 million verdict was reached against Johnson & Johnson’s Ethicon by a California jury over their Gynecare TVT Abbrevo vaginal mesh device. Details of the latest settlement have not been disclosed.

Some might say that Johnson & Johnson made withdrawals from its “trust” bank in recent years. The company reacted slowly to a variety of crises, at first failing to admit any culpability 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 dramatically 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.

Establish clear policies on ethical conduct including a code of ethics.1. Develop an ethics training program that instills a commitment to act ethically and explains code provisions.

2.

Assign a top-level officer (i.e., Chief Ethics and Compliance Officer) to oversee compliance with ethics policies.

3.

Use the internal auditors to investigate whether ethics policies have been followed in practice.4. Establish strong internal controls to prevent and detect unethical behaviors, such as fraud.5. Establish whistleblowing policies including reporting outlets.6. Establish an ethics hotline where employees can discuss questionable behavior on an anonymous basis.

7.

Have employees sign a statement that they have complied with ethics policies.8. Enforce ethics policies fairly and take immediate action against those who violate the policies.9. Reward ethical behavior by including it in the performance evaluation system.10.

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Character and Leadership in the Workplace “Character Counts” is the mantra of the Josephson Institute of Ethics whose Six Pillars of Character were discussed in Chapter 1. Characteristics of ethical behavior in leaders include: compassion, courage, diligence, fairness, honesty, inclusiveness, initiative, integrity, optimism, respect, responsibility, and trustworthiness. Good leaders have strong character and have a moral imperative underwrite their actions. Management guru, Warren Bennis, is quoted as saying, “Managers are people who do things right, and leaders are people who do the right thing.” Good character can be developed through experience and learning. Each situation we encounter presents a different experience and opportunity to learn and deepen character. Character becomes critical when managing a crisis, such as an ethical dilemma where stakeholder interests conflict. Managers can set the right tone at the top and foster ethical leadership, both of which are necessary for ethical decision making, by following four simple rules:

Integrity: The Basis for Trust in the Workplace Albert Camus, the French Nobel Prize winning author, journalist, and philosopher, said, “Integrity has no need of rules.” People of integrity are self-driven to do the right thing. Leaders of integrity act on the knowledge that their actions are ethical and provide the basis for others in the workplace to follow their lead.

KPMG’s Integrity Survey 2013 provides an inside look at organizational misconduct based upon responses from more than 3,500 U.S. working adults. Key findings from the report include:

Consider how your actions affect others. How will the stakeholders be affected by my intended actions? Here, a utilitarian analysis might help.

1.

Do no harm. Your actions and decisions should not harm others. One exception is whistleblowing because of the need to emphasize “the greater good,” which means the public interest in accounting.

2.

Make decisions that are universal. Consistent with the categorical imperative, ask yourself whether you would want others to resolve the conflict by taking the same or similar action you are about to take. Universal decisions are those that respect the rights of others.

3.

Reflect before deciding. As a final step, think about how you would feel if your actions and decisions appear on the front pages of the local newspaper. Would you be proud to defend them and comfortable explaining them?

4.

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Nearly three out of four employees reported that they had observed misconduct within their organizations in the previous 12 months. More than half of employees reported that what they observed could potentially cause a significant loss of public trust if discovered. Some of the driving forces behind fraud and misconduct in the corporate environment include pressure to do “whatever it takes” to meet targets, not taking the code of conduct seriously, believing employees will be rewarded based upon results and not the means used to achieve them, and fear of losing one’s job for not meeting performance targets. Nearly half of employees were uncertain that they would be protected from retaliation if they reported concerns to management. And more than half suggested a lack of confidence that they would be satisfied with the outcome.

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Employees were asked what they would do if they observed a violation of their organization’s standards of conduct. The results were: 78 percent would notify their supervisor or another manager; 54 percent would try resolving the matter directly; 53 percent would call the ethics or compliance hotline; 26 percent would notify someone outside the organization; and 23 percent would look the other way or do nothing. It’s encouraging to learn that over three-fourths would inform their supervisor, in part because it is the generally recognized initial step in considering whether to blow the whistle. It is somewhat troubling that almost one-quarter of the workers would look the other way or do nothing. Perhaps they have not been given an opportunity to voice their values or have not discovered an effective means to do so. The tone at the top set by top management is a determining factor in creating organizational commitment to high ethics and integrity. Employees were asked whether the chief executive officer and other senior executives exhibited characteristics attributable to personal integrity and ethical leadership. Approximately two-thirds of the employees agreed that their leaders set the right tone regarding the importance of ethics and integrity and served as positive role models for their organization, leaving one-third unsure or in disagreement. Perhaps not surprisingly, a large percentage (64 percent) indicated that the root cause of misconduct was pressure to do “whatever it takes” to meet business objectives, while 59 percent said they believed they would be rewarded for results, not the means used to achieve them. In such instances, the corporate culture does not foster integrity or ethical behavior; instead, expedience and self-interest drive workplace behavior.

Employees Perceptions of Ethics in the Workplace Going beyond the Integrity Survey, it is important to understand how employees view the ethics of the organizations they work for, in part to better understand corporate governance systems and whistleblowing. The 2013 National Business Ethics Survey (NBES) conducted by the Ethics Resource Center provides interesting data about ethics in the workplace. The report is the eighth in a series. The 2013 survey provides information on the views of 6,579 respondents that represent a broad array of employees in the for-profit sector. Exhibit 3.4 summarizes observed misconduct. It is encouraging that all such instances have declined between 2011 and 2013.

EXHIBIT 3.4 2013 NBES Survey of Reporting of Observed Misconduct

11023102tcudnocsiM fo epyT

Stealing or theft 64% 69%

%16%94dekrow sruoh ro stroper emit gniyfislaF

%66%84stroper esnepxe gniyfislaF

Falsifying and/or manipulating fi %26%54noitamrofni gnitroper laicnan

A/N%04sdrocer ro/dna ,skoob ,seciovni gniyfislaF

%25%63srodnev ro sreilppus morf skcabkcik ro stfig etairporppani gnitpeccA

Ethics and compliance programs continue to have a favorable impact on employee perceptions and behaviors.

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129Chapter 3 Organizational Ethics and Corporate Governance

The results of the NBES survey depicted in Exhibit 3.5, indicate a lessening of observed misconduct, virtually no change in reporting it, and a decline in pressure to compromise ethical standards from 2011 to 2013, which may reflect an improving corporate culture. This seems to be the case since the “weak- leaning” culture response went down by 6 points in the same time period. The results also show an increase in ethics training programs and the use of ethical conduct as a performance measure in employee evaluations.

EXHIBIT 3.5 Views of Employees on Ethics in the Workplace from the 2011 National Business Ethics Survey

Item 2013 2011 2009

%8 %31%9 sdradnats lacihte esimorpmoc ot erusserP

%53%04%43erutluc lacihte gninael-kaew/kaeW

%55%54%14tcudnocsim devresbO

%36%56%36tcudnocsim devresbo detropeR

Experienced retaliation after report %51%22%12)gniwolbeltsihw ,.e.i( gni

The percentage of employees experiencing retaliation is up, indicating it still remains a problem in corporate America. Perhaps the new protections under SOX and Dodd-Frank will help to stem the rising tide. One concern is that, while misconduct is down overall, a relatively high percentage of misconduct is committed by managers—the very people who should be establishing an ethical culture and providing ethical leadership. Workers reported that 60 percent of misconduct involved someone with managerial authority from the supervisory level up to top management. Nearly a quarter (24 percent) of observed misdeeds involved senior managers. Also, workers said that 26 percent of misconduct is ongoing within their organizations and about 12 percent of wrongdoing was reported to take place company-wide. Perhaps not surprising, the results indicate that occupational fraud and financial statement fraud are of greatest concern because of their effects on the accuracy and reliability of the financial statements.

Fraud in Organizations

LO 3-5 Describe the causes of fraud, detection methods, and preventative controls.

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 introduce the concept of fraudulent financial statements in this chapter and discuss it more fully in Chapter 5. In this chapter, we will look at the results of the 2014 Global Fraud Survey: Report to the Nations on Occupational Fraud and Abuse, conducted by the Association of Certified Fraud Examiners (ACFE).

Occupational Fraud The 2014 ACFE survey is a follow-up to its 2012 Global Fraud Study. The 2014 survey reports on 1,483 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.44

130 Chapter 3 Organizational Ethics and Corporate Governance

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.” A summary of the findings follows:

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 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. A surprising result is that a “tip” was the most common way of detecting fraud, at 42.2 percent in 2014. 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 (30 percent), and the external audit, at only 3 percent, does not seem to be a reliable method to detect fraud.

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Survey participants estimated that the typical organization loses 5 percent of its revenues to fraud each year. If applied to the 2013 estimated Gross World Product, this translates into a potential projected global fraud loss of nearly $3.7 trillion. The median loss caused by the occupational fraud cases studied was $145,000. Additionally, 22 percent of the cases involved losses of at least $1 million. The frauds reported lasted a median of 18 months before being detected. Asset misappropriation schemes were the most common type of occupational fraud, comprising 85 percent of the reported cases. Financial statement fraud schemes made up just 9 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—more than twice the rate of any other detection method. Employees accounted for nearly half of all the tips that led to the discovery of fraud. Organizations with hotlines were much more likely to catch fraud by a tip. These organizations also experienced frauds that were 41 percent less costly, and they detected frauds 50 percent more quickly. 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. Owners/executives only accounted for 19 percent of all cases, but they caused a median loss of $500,000. Employees, conversely, committed 42 percent of occupational frauds but only caused a median loss of $75,000. Managers ranked in the middle, committing 36 percent of frauds with a median loss of $130,000.

131Chapter 3 Organizational Ethics and Corporate Governance

EXHIBIT 3.6 Initial Detection of Occupational Frauds from the ACFE 2014 Global Survey: Report to the Nations on Occupational Fraud and Abuse

ssoL naideMdetropeR egatnecrePdohteM noitceteD

000,941$%2.24piT

000,521$%0.61weiveR tnemeganaM

000,001$%1.41tiduA lanretnI

000,523$%8.6 tnediccA yB

000,57$ %6.6 noitailicnoceR tnuoccA

000,022$%2.4 noitanimaxE tnemucoD

000,063$%0.3 tiduA lanretxE

000,94$ %6.2 gnirotinoM/ecnallievruS

Notifi 000,052,1$%2.2 tnemecrofnE waL yb de

000,07$ %1.1 slortnoC TI

000,022$%8.0 noissefnoC

A/N%5.0 rehtO

Frequency of Anti-Fraud Controls The survey concludes that proactive fraud prevention and detection controls are a vital part in managing the risk of fraud. Respondents indicated that external audits were the most common control enacted by the victim organization, as they were present in 80 percent of the reported cases. It seems counterintuitive that only 3 percent of the frauds are detected by external audits. The answer lies in that an audit is not designed to detect fraud per se; instead it is to identify and detect risks of material misstatement of the financial statements due to error and fraud. With more than 42 percent of frauds being detected by tips, hotlines should play an essential role in organizations’ anti-fraud programs. However, only 54 percent had a hotline mechanism in place, and less than 11 percent provided rewards for whistleblowers. Exhibit 3.7 summarizes the frequency of anti-fraud controls.

EXHIBIT 3.7 Frequency of Anti-Fraud Controls: 2014 ACFE Global Fraud Survey

detropeR egatnecrePlortnoC duarF-itnA

%4.18stnemetatS laicnaniF fo tiduA lanretxE

Code of Conduct 77.4%

%8.07tnemtrapeD tiduA lanretnI

Management Certifi %0.07stnemetatS laicnaniF fo noitac

External Audit of Internal Controls %2.56gnitropeR laicnaniF revo

Management Review 62.6%

%0.26eettimmoC tiduA tnednepednI

Hotline 54.1%

%4.25smargorP troppuS eeyolpmE

(Continued)

132 Chapter 3 Organizational Ethics and Corporate Governance

Fraud Training for Managers/Executives %8.74

%7.74seeyolpmE rof gniniarT duarF

Anti-Fraud Policy 45.4%

%6.83maeT ro ,noitcnuF ,tnemtrapeD duarF detacideD

%8.43sisylanA/gnirotinoM ataD evitcaorP

%5.33stnemssessA ksiR duarF lamroF

Surprise Audits 33.2%

Job Rotation/Mandato %9.91snoitacaV yr

%5.01srewolbeltsihW rof sdraweR

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. Overall, at least one red flag was identified in 92 percent of cases, and, in 64 percent of cases, the fraudster displayed two or more behavioral red flags. Approximately 44 percent of fraud perpetrators were living beyond their means while the fraud was ongoing, and 33 percent were experiencing known financial difficulties. These warning signs should alert internal auditors that trouble may lie ahead with respect to actual fraud. Exhibit 3.8 shows the fraud indicators identified in the study.

EXHIBIT 3.8 Behavioral Red Flags Displayed by Perpetrators: ACFE 2014 Global Survey: Report to the Nations on Occupational Fraud and Abuse

Behavioral Indicators of detropeR egatnecrePduarF

Living Beyond Means 43.8%

Financial Difficulties 33.0%

%8.12remotsuC/rodneV htiw noitaicossA esolC yllausunU

Control Issues, Unwillingn %1.12seituD erahS ot sse

%4.81edutittA ”relaeD-releehW“

%8.61 smelborP ylimaF/ecroviD

Instability, Suspiciousne %0.51ssenevisnefeD ro ,ss

Addiction Problems 11.8%

%4.9 yaP etauqedanI tuoba denialpmoC

%9.8 smelborP detaleR-tnemyolpmE tsaP

%8.8 snoitacaV ekaT ot lasufeR

Excessive Pressure wi %4.8 noitazinagrO niht

Social Isolation 7.4%

%5.6 ytirohtuA fo kcaL tuoba denialpmoC

%0.6 sseccuS rof erusserP reeP/ylimaF evissecxE

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%9.5ecnatsmucriC efiL ni ytilibatsnI

Past Legal Problems 5.8%

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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 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.

Internal Control Weaknesses According to the Center for Audit Quality, 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. For example, a bank reconciliation should be prepared regularly and by a person(s) with no responsibility for cash record keeping for the handling of cash. The bank reconciliation should be reviewed by an independent person and, in the case of a small business, by the owner. The ACFE survey found that cash-related fraud schemes accounted for almost 40 percent of all types of occupational fraud including skimming (14.1 percent)—the illegal practice of taking money from cash receipts for personal use; check tampering (13.7 percent); and cash larceny (10.7 percent)—the theft of cash after it has been recorded on the books. An effective system of internal controls is critical to establish an ethical corporate culture that should be supported by the tone at the top. By examining Exhibit 3.7 we can see the importance of certain control mechanisms, including the external audit of financial statements (81.4 percent) and the external audit of the internal controls over financial reporting (65.2 percent). Also, the ACFE survey indicates that 32.2 percent of the internal control weaknesses are due to a lack of internal controls. While remaining at a high level, the 2014 results are 3.5 percent below the 2012 findings and 5.6 percent below 2010 findings. This may reflect a commitment by management to improve controls in view of the requirements in the Sarbanes-Oxley Act (SOX) of 2002. As directed by Section 404 of SOX, the Securities Exchange Act of 1934 adopted a regulation that public companies have to include in their annual reports a report of management on the company’s internal control over financial reporting. The internal control report must include a statement of management’s responsibility for establishing and maintaining adequate internal control over financial reporting for the company; management’s assessment of the effectiveness of the company’s internal control over financial reporting as of the end of the company’s most recent fiscal year; a statement

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identifying the framework used by management to evaluate the effectiveness of the company’s internal control over financial reporting; and a statement that the registered public accounting firm that audited the company’s financial statements included in the annual report has issued an attestation report on management’s assessment of the company’s internal control over financial reporting. 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. The likelihood of achievement is affected by a variety of factors including: judgments in decision making can be faulty; breakdowns can occur due to simple mistakes and errors in the application of controls; and controls can be circumvented by the collusion of two or more people. Management override of internal controls may be a problem as well similar to what happened at Enron and WorldCom. Indeed, 18.9 percent of respondents in the ACFE survey indicated that override of existing controls had occurred at victim organizations.

Example of Occupational Fraud What follows is a description of a payroll fraud scheme. Payroll schemes accounted for 11.8 percent of of fraud techniques in the ACFE survey.

The head of a department distributed paychecks to her employees on a weekly basis. Typically, the department head received the payroll checks each week from a payroll processing company and then distributed them to employees. One day another employee noticed the department head had locked his door after the checks were received and wondered about it. He became suspicious and reported it to his manager. A payroll audit discovered that several former employees were still receiving paychecks. It was discovered that the department head had the ability to access and edit electronic time keeping records for hourly employees and knew the passwords to the payroll system for their supervisors. He used this access to falsify hours, and thus paychecks, for previous employees. He then took the paychecks to check cashing companies to redeem them. The department head ultimately confessed to over 100 instances of payroll fraud over a 10-month period totaling almost $100,000.

In this case a lack of proper internal controls contributed to the fraud. The company lacked a proper separation of duties, did not regularly monitor payroll records for “ghost employees,” did not require that employees regularly change their passwords, and allowed the department head who distributed the checks to also accept them from the payroll service. Perhaps a fraud hotline for employees to report suspicious behavior would have led to earlier reporting of the fraud.

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 organization’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, provides examples of common methods to overstate revenue, understate expenses, and make improper asset valuations. Revenue overstatements include the following:

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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.

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Common methods of understating expenses include the following:

Examples of improper asset valuations include the following:

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 3.9 summarizes this fraud.

EXHIBIT 3.9 Miniscribe Fraud

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.

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.

Following its change in management, Quentin T. Wiles became the chair of the board and CEO. 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 CPAs. Patrick 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 (now PwC) 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.

Recording sales of products that are out on consignment.

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.

Manipulating reserves. Changing the useful lives of assets. Failing to take a write-down when needed. Manipulating estimates of fair market value.

(Continued)

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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. Schleibaum directed his subordinates to conceal the remainder of the inventory hole through improper means so that Miniscribe could continue to “make the numbers.” This occurred by falsely inflating the inventory count. To hide the false count from the auditors, division managers 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 Securities and Exchange Commission) 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 and procured 10 exclusive-use trailers. They then purchased 26,000 bricks. 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, (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.

(Continued)

At this point, Wiles was unaware of the inventory hole. Schleibaum properly decided to charge a

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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.

Source: 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.

Of particular note in the Miniscribe fraud 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. It serves as an example of top management fraud, and an override of internal controls existed as well. 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. To say the auditors were deficient in their procedures is an understatement. It is quite rare, to say the least, that auditors fail to adequately secure their working papers at the end of the day. These files should never be left at the client’s office. Just imagine if electronic records were not password protected or flash drives were left on the premises.

Why Does Financial Statement Fraud Occur? Why does financial statement fraud occur? This question has been examined since the 1980s when well-publicized financial statement frauds occurred at companies including ZZZZ Best, Miniscribe, Phar-Mor, Cendant, and Waste Management. Theoretically, there are three factors that appear to be present in every case of financial statement fraud that are addressed in auditing standards. These are explored in detail in Chapter 5. We briefly summarize them here.

Situational pressure. Situational pressures may prompt an otherwise honest person to commit fraud. It typically occurs as a result of immediate pressure within either her internal or external environment. For example, financial analysts project earnings and companies feel the pressure to meet or exceed these amounts. An accountant may come to believe she has no option other than to go along with the fraud. The Betty Vinson situation at WorldCom is a case in point. She did not know how to effectively voice her values or where she could turn to for help.

Perceived opportunity. The opportunity to commit fraud and conceal it must exist. People do not normally commit fraud believing they will get caught. They do it because they believe they can get away with it (i.e., have access to the underlying financial information or override internal controls). The opportunity to commit fraud and conceal it often involves the absence of, or improper oversight by, the board of directors or audit committee, weak or nonexistent internal controls, unusual or complex transactions, accounting estimates that require sufficient subjective judgment by management, and ineffective internal audit staff.

Rationalization. People who commit financial statement fraud are able to rationalize the act. Being able to justify the act makes it possible. The individual must first convince herself that the behavior is temporary or is acceptable. She may believe it is in the best interest of the company to commit the fraud, perhaps because a needed loan will not be secured without financial statements to back it up. There is often the belief that everything will return to normal after the trigger event has passed. Financial statement fraud does not occur in a vacuum. It is enabled by the absence of an ethical culture. Oftentimes, a culture is created and a tone at the top established that presents the image of a company willing to do whatever it takes to paint a rosy picture about financial results. Effective oversight and strong internal controls give way to greed, moral blindness, and inattentiveness to the important details that help to prevent and detect fraud. As with most situations in business, the desire to succeed crowds

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out ethical behavior. Those in the way are pressured to be team players; go along just this one time; and, in the end, compromise their values. We end this section with a quote from Sophocles, the ancient Greek tragedian. He said, “I would prefer even to fail with honor than win by cheating.” In other words, it is better to fail with one’s morals and dignity intact than win by being dishonest.

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 organizational values guide decision making and that ethical standards are being followed. The four pillars of corporate governance are accountability, fairness, transparency, and independence. Accountability means to ensure that management is accountable to the board and the board is accountable to the shareholders. Fairness means to protect shareholders rights, treat them equitably, and provide effective redress for violations. Transparency requires timely, accurate, disclosure on all material matters, including the financial situation, performance, ownership, and corporate governance. Independence means to have the procedures and structures in place to minimize, or avoid completely conflict of interest and to ensure that independent directors are free from the influence of others.

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 corporations. 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.” 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.

The first corporate governance report, Sir Adrian Cadbury’s Report on the Financial Aspects of Corporate Governance (1992), took a broader view in defining it as “the system by which companies are directed and controlled,” and further explained that boards of directors are responsible for the governance of their companies, while the shareholders’ role in governance is to appoint the directors and auditors, and to satisfy themselves that an appropriate governance structure is in place.

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 executive actions of management, and with satisfying legitimate expectations of accountability and regulation by interests beyond the corporate boundaries. 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. 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 including the audit committee, executive compensation policies, and internal controls, and external measures, 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.

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Views of Corporate Governance Differences exist about the role of corporate governance in business. Some organizations take the view that as 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 precepts, 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 (managers) are separate. Managers act as the agents of the investors (principals), who expect those decisions to increase the value of the stock they own. 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 et al. 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.” Because of these potential differences, corporate governance mechanisms are needed to align investor and management interests. A fundamental challenge underlying all corporate governance affairs dates back to the days of Adam Smith. In The Wealth of Nations, Smith said that “the directors of companies, being managers of other people’s money, cannot be expected to watch over it with the same vigilance with which they watch over their own.” 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.

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).

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 is stewardship theory. In this theory, managers are viewed as stewards

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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

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identified as the best interests of “the company,” over self-interests, regardless of personal motivations or incentives.

Under stewardship theory, directors have a fiduciary duty to act as stewards of the shareholders’ interest. Inherent in the concept of the company is the belief that directors can be trusted. Contrary to agency theory, stewardship theory believes that directors do not inevitably act in a way that maximizes their own personal interests: They can and do act responsibly with independence and integrity. Even though some will fail, it does not invalidate the theory.

Stewardship advocates recognize that directors need to consider a broader range of interests, including employees, customers, suppliers, and other legitimate stakeholders, but under the law their first responsibility is to the shareholders. They argue that conflicts of interest between stakeholder groups and the company should be met by competitive pressures in free markets, backed by legislation and legal controls to protect various stakeholder interests (i.e., environmental law; health and safety law; employment discrimination law). Other theories of management exist, including “resource dependency” and “managerial and class hegemony.” 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.

Corporate Governance Regulation Each state in the United States has its own companies law to regulate corporate activity within its boundaries. Federal laws are embodied in the SEC regulations. Over the years the SEC developed an extensive corporate governance regime for companies listed on stock exchanges, including the New York Stock Exchange (NYSE) and NASDAQ. The NYSE has issued extensive regulations as well. Corporate governance regulation in the United States has been ratcheted up in the aftermath of passage of the Sarbanes-Oxley Act. SOX requires management certification of the internal controls over financial reporting (Section 302); that auditors attest to and report on management’s assessment on the effectiveness of the internal control structure and procedures for financial reporting (Section 404); protections for whistleblowers (Section 806); and independent audit committees that oversee financial reporting. One goal of SOX is to reduce the number of restatements of corporate financial reports, especially those that result from materially misleading financial statements. Have the corporate governance requirements of SOX made a differences in the level of financial statement restatements? After all, if this is not the case, then we must question the effectiveness of the act. According to a study by Audit Analytics, the proportion of corporate financial restatements that had no impact on the bottom line was 59 percent in 2014. That brought the increase over the past four years to 22 percentage points, which suggests that the SOX corporate-governance law has succeeded in bolstering companies’ internal controls over financial reporting. Among companies listed on major stock exchanges, there were 460 restatements in 2014 that had no effect on income statements, up slightly from a year earlier.

KBR Inc. made the largest downward earnings restatement, with the engineering and construction company reducing its 2013 net income by $156 million. That was the smallest high for a downward adjustment since 2002; the largest during the period came in 2004, when Fannie Mae wiped $6.3 billion off its prior profits. The 2014 average downward net-income restatement was about $4.4 million, down from $6.6 million a year earlier. These results are encouraging, although we are not convinced they will be sustained. The reason is,

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regardless of regulatory requirements under Section 404, the underlying consideration is good

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old-fashioned ethical behavior. Will egoistic CEOs and CFOs revert to self-interest–driven behavior, as occurred in the scandals of the early 2000s, or have they “seen the light”? If past history is used as a guide, we may be due for another round of corporate financial reporting scandals as seemingly have occurred every 10–15 years. The takeaway from the results reported by Audit Analytics is it appears SOX is encouraging more ethical behavior on the part of top corporate executives, but the jury is still out whether it will have a long-lasting effect. Another concern is that, in accounting, it is only “material” restatements that are considered and the results of the study point to 59 percent as having “no impact” on the bottom line. What does that mean with respect to the size of the restatements and how was the materiality determined?

Executive Compensation One of the most common approaches to the agency problem is to link managerial compensation 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 packages 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.

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 of 2008–2009, 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 government campaign to reshape pay practices across corporate America. The initiative reflected public uproar over executive compensation at companies such as American International Group (AIG), which received a $180 billion bailout from the government and decided to pay $165 million in bonuses to executives. A 2014 study at the Harvard Business School found that Americans believe CEOs make roughly 30 times what the average worker makes in the United States, when in actuality they are making more than 340 times the average worker. On a global basis, this compares with a ratio of 148:1 in Switzerland, the nearest country, 84:1 in the United Kingdom, and 67:1 in Japan. A troubling situation occurs when executives receive huge severance packages after leaving their organizations. The former CEO of CVS received a severance package worth $185 million when he left in early 2011, even though the company’s net earnings had declined in the prior year. In 2014, the former chief operating officer of Yahoo, who was fired earlier in the year, received about $96 million in compensation for his 15 months on the job, including about $58 million in severance packages. 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 2013, the average CEO compensation was $15.2 million as compared with the average worker being paid about $52,100. From an ethical perspective, fairness issues do exist. Thomas Dunfee, a Wharton professor of legal studies and business ethics, puts it this way: Do executive compensation figures reflect an efficient market, or a

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failed one? Are pay levels adequately disclosed? Should shareholders have more say? Are there issues of fairness and justice?

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 disgorgement (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 The Dodd-Frank Wall Street Reform and Consumer Protection Act (H.R. 4173) 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. Two areas where Dodd-Frank relates to corporate governance are in executive compensation and in whistleblowing procedures, which will be discussed later on. 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. 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. Now, about 90 percent have such 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. On July 1, 2015, the SEC proposed rules directing U.S. stock exchanges to create listing standards requiring listed companies to implement policies to recover or “claw back” incentive-based compensation received by executive officers as a result of materially incorrect financial statements. These proposed rules are mandated by Section 954 of Dodd-Frank. Companies may need to comply with the proposed rules as early as the end of 2016, though this timing will depend on when the SEC’s proposed rules are finalized, and will likely be in early 2017. According to a PwC study, many companies have modified their clawback policies since enactment of SOX and Dodd-Frank, and others have indicated that their policies will likely change once the SEC issues its clawback rules. Of the 100 companies in the study, 90 percent have policies to recover compensation if there is a restatement of financial results. However, of those that claw back upon restatement, 73 percent require evidence that the employee caused or contributed to false or incorrect

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financial reporting, while 27 percent require repayment in the event of a restatement even without any personal accountability. In many cases, the clawback amount is only the excess of the amount paid over the payment determined based on the financial results after applying the restatement. We believe that, when designed properly, a policy allowing for clawback of pay from high-level executives is a significant mechanism for corporate accountability.

Say on Pay Dodd-Frank includes “say-on-pay” provisions (Section 951) that require SEC-registered issuers to provide shareholders at least once every three calendar years 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 its compensation policies and decisions have taken into account the results of the shareholder-say-on-pay vote and, if so, how. The idea is for the vote 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. On April 29, 2015, the SEC proposed new rules requiring public companies to make it easier for investors to judge whether top executives’ compensation is in step with the company’s financial performance. The proposal aims to give investors greater clarity about the link between what corporate executives are paid each year and total shareholder return—the annual change in stock price plus reinvested dividends. If finalized, companies would have to include a new table in their annual proxy filings disclosing top executives’ “actual pay.” The new figure is based on the total compensation public companies already calculate for their five highest-paid executives, though it would exclude certain components of pay that officers do not actually take home, such as share grants that have yet to vest. Questions raised by shareholders and others about the size of executive compensation 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. Without transparency, it is difficult to have accountability. 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 analyzed 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 compensation. Instead, the act focuses on the process by which public company executive compensation is set, thereby enforcing the primacy of the business judgment rule in determining executive compensation.65

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Corporate Governance Structures and Relationships

LO 3-6 Explain the components of corporate governance and their relationship to corporate culture.

In his book Corporate Governance and Ethics, Zabihollah Rezaee points out that corporate 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; management; 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 outsiders (shareholders and other stakeholders). Examples of external mechanisms include the financial markets, state and federal statutes, court decisions, and shareholder proposals. Three noteworthy points are: (1) independent directors enhance governance accountability; (2) separation of the duties of the CEO and board chair; and (3) separate meetings between the audit committee and external auditors strengthen control mechanisms.

Ethical and Legal Responsibilities of Officers and Directors

Duty of Care—Managers and Directors Directors and officers are deemed fiduciaries of the corporation because their relationship with the corporation and its shareholders is one of trust and confidence. As fiduciaries, directors and officers owe ethical—and legal—duties to the corporation and to the shareholders. These fiduciary duties include the duty of care and the duty of loyalty.

The standard of due care provides that a director or officer act in good faith, exercise the care that an ordinarily prudent person would exercise in similar circumstances, and act in the way that she considers to be in the best interests of the corporation. Directors and officers who have not exercised the required duty of care can be held liable for the harms suffered by the corporation as a result of their negligence. The duty of due care specifies the manner in which directors must discharge their legal responsibilities, not the substance of director decisions. Directors, due to their statutory responsibilities to direct the business and affairs of a corporation, also have a duty to monitor and oversee the business affairs of a corporation properly. Failure to do so may constitute a breach of the duty of care.

Duty of Loyalty The duty of loyalty requires directors to act in the best interests of the corporation. Loyalty can be defined as faithfulness to one’s obligations and duties. In the corporate context, the duty of loyalty requires directors and officers to subordinate their personal interests to the welfare of the organization. For example, directors must not use corporate funds or confidential corporate information for personal advantage. They must also refrain from self-dealing, such as when a director opposes a stock tender offer that is in the corporation’s best interest simply because its acceptance may cost the director her position.

Duty of Good Faith The obligation of good faith requires an honesty of purpose that leads to caring for the well-being of the constituents of the fiduciary. Vice Chancellor Leo Strine of the Delaware Chancery Court linked good

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faith to fiduciary analysis in the Enron fraud by suggesting that the Enron case might influence courts to look more carefully at whether directors have made a good faith effort to accomplish their duties. He connected good faith with directors’ “state of mind.” Strine identified certain kinds of director conduct that may call good faith into question. These include “a failure to monitor if [the directors’] laxity in oversight was so persistent and substantial that it evidences bad faith.” It can also arise in situations where “committee members knew that their inadequate knowledge disabled them from discharging their responsibilities with fidelity.”

Business Judgment Rule A corporate director or officer may be able to avoid liability to the corporation or to its shareholders for poor business judgments under the business judgment rule. Directors and officers are expected to exercise due care and to use their best judgment in guiding corporate management, but they are not insurers of business success. Honest mistakes of judgment and poor business decisions on their part do not make them liable to the corporation for resulting damages. To obtain the business judgment rule’s protection, directors must be independent and disinterested as to the matter acted upon. Directors must act with due care and good faith. The due care inquiry is process- oriented, and due care is measured by a standard of gross negligence, not simple negligence. The burden of proof is on the party challenging the board’s decision, to establish facts rebutting the presumption in favor of upholding the decision. Unless a plaintiff succeeds in rebutting the rule, the court will not substitute its views for those of the board’s if the latter’s decision can be “attributed to any rational business purpose.” The business judgment rule generally immunizes directors and officers from liability for the consequences of a decision that is within managerial authority, as long as the decision complies with management’s fiduciary duties and as long as acting on the decision is within the powers of the corporation. Therefore, if there is a reasonable basis for a business decision, it is unlikely that a court will interfere with that decision, even if the corporation suffers as a result.

Honest Services Fraud Jeff Skilling, the former CEO of Enron, was originally sentenced to a 24-year jail sentence for fraud and insider trading. He has appealed the 19 out of 28 charges that he was sentenced for in 2006 all the way up to the U.S. Supreme Court. His lawyers challenged the ruling based on the instructions given to the jury, which asked them to consider whether he had deprived his company of “intangible honest services.” The U.S. Supreme Court found on June 24, 2010, that he had not violated the honest services rule, as he had not solicited or accepted bribes or kickbacks; rather, he conspired to defraud Enron’s shareholders by other means.

Honest services fraud refers to a ruling in 18 U.S.C. § 1346 that addresses any “scheme or artifice to defraud” designed to deprive another of the intangible right of honest services. The statute has been applied by federal prosecutors in cases of public corruption as well as in cases in which private individuals breached a fiduciary duty to another. In the former, the courts have been divided on the question of whether a state law violation is necessary for honest services fraud to have occurred. In the latter, the courts have taken differing approaches to determining whether a private individual has committed honest services fraud—a test based on reasonably foreseeable economic harm and a test based on materiality.

In Skilling v. United States, the U.S. Supreme Court said that one of Skilling’s convictions was flawed when it sharply curtailed the use of the honest services fraud law. The high court ruled prosecutors can use the law only in cases where evidence shows the defendant accepted bribes or kickbacks, and because Skilling&rs