Module 8
Fraud, Earnings Management, and Ethical Leadership
A. Fraud in Financial Statements
According to the AICPA audit standard on fraud, Consideration of Fraud in a
Financial Statement Audit (AU-C Section 240), the primary responsibility for the
prevention and detection of fraud rests with both those charged with governance of the
entity and management. A strong emphasis should be placed on fraud prevention, which
may reduce opportunities for fraud to take place, and fraud deterrence, which could
persuade individuals not to commit fraud because of the likelihood of detection and
punishment. As we discussed in Chapter 3, this involves a commitment to creating a
culture of ethical behavior, tone at the top, and reinforcement through governance
structures. An auditor conducting an audit in accordance with generally accepted auditing
standards (GAAS) is responsible for obtaining reasonable assurance that the financial
statements as a whole are free from material misstatements, whether caused by fraud or
error. Due to the inherent limitations of an audit, an unavoidable risk exists that some
material misstatements of the financial statements may not be detected, even though the
audit was conducted in accordance with those standards.
When the financial statements are materially misstated, the auditor should not
give an unmodified opinion but should modify the opinion as either qualified because of
that matter or adverse opinion if the material misstatement leads to the conclusion that the
financial statements, taken as a whole, do not present fairly the financial position, results
of operations, and cash flows. This language relates to the statements on auditing
standards issued by the AICPA Auditing Standards Board (ASB). The PCAOB uses the
term “unqualified” rather than “unmodified.” The AICPA’s standards switched from
“unqualified” to "unmodified” in 2012, to align terminology with International Standards
on Auditing issued by the International Federation of Accountants.
Fraudulent financial reporting involves either intentional misstatements or
omissions of amounts or disclosures in financial statements that are intended to deceive
financial statement users. Fraudulent financial reporting generally occurs in one of three
ways: (1) Deception such as manipulation, falsification, or alteration of accounting
records or supporting documents from which the financial statements are prepared; (2)
misrepresentation in, or intentional omission from, the financial statements of events,
transactions, or other significant information; and (3) intentional misapplication of
accounting principles relating to measurement, recognition, classification, presentation,
or disclosure. Accountants and auditors who go along with the fraud fail in their ethical
obligation to place the public interest above all else. Because fraud involves an
intentional act, the perpetrator of the falsehood knows, or should know, that what she
proposes to do is wrong. Once financial statements have been falsified, the trust
relationship between an auditor and the public breaks down.
Misstatements also can exist when transactions are recorded without economic
substance. Transactions should not be recorded in such a manner as to hide the true intent
of the transaction, which would mislead the users of the financial statements. Substance
over form issues can arise when a transaction is extremely complex, which makes it
difficult to ascertain what the substance of the transaction is. For example, Enron sought
to hide debt by setting up special-purpose-entities that executed financing transactions
that ultimately benefited Enron but were left off its books.
An error can occur due to unintentional misstatements or omissions of amounts or
disclosures in the financial statements. Errors may involve mistakes in gathering or
processing data, unreasonable accounting estimates arising from oversight or
misinterpretation of facts, or mistakes in the application of GAAP. Auditors are
responsible for detecting errors that have a material effect on the financial statements and
reporting their findings to the audit committee. Errors are typically recorded by adjusting
the opening balance of retained earnings for the prior period adjustment to net income.
Auditors should be sensitive to red flags that warn fraud is possible, if not likely.
Fraud, whether fraudulent financial reporting or misappropriation of assets, involves
incentive or pressure to commit fraud, a perceived opportunity to do so, and some
rationalization of the act. The intentional act of fraud occurs when an individual(s) in
management, those charged with governance, employees or third parties, use deception in
a way that results in a material misstatement in the financial statements. In its most
common form, management fraud involves top management’s deceptive manipulation of
financial statements.
llegal acts are violations of laws or governmental regulations. For example, a
violation of the Foreign Corrupt Practices Act (FCPA) that prohibits bribery constitutes
an illegal act. Illegal acts include those 4 attributable to the entity whose financial
statements are under audit or as acts by management or employees acting on behalf of the
entity. Such acts expose the company to both legal liability and public disgrace. The
auditor’s responsibility is to determine the proper accounting and financial reporting
treatment of a violation once it has been determined that a violation has in fact occurred.
The auditor should assure herself that the audit committee is informed as soon as
practicable and prior to the issuance of the auditor’s report with respect to illegal acts that
come to the auditor’s attention. The auditor need not communicate matters that are
clearly inconsequential and may reach agreement in advance with the audit committee on
the nature of such matters to be communicated. The communication should describe the
act, the circumstances of its occurrence, and the effect on the financial statements.
B. The Fraud Triangle
Donald R. Cressey, a noted criminologist, is mostly credited with coming up with
the concept of a Fraud Triangle. Albrecht points out that, while researching his doctoral
thesis in the 1950s, Cressey developed a hypothesis of why people commit fraud. He
found that trusted persons become trust violators when they conceive of themselves as
having a financial problem that is nonsharable, are aware that this problem can be
secretly resolved by violation of the position of financial trust, and are able to apply to
their contacts in that situation verbalizations which enable them to adjust their
conceptions of themselves as users of the entrusted funds or property.
Edwin Sutherland, another criminologist, argued that persons who engage in
criminal behavior have accumulated enough feelings and rationalizations in favor of law
violation that outweigh their pro-social definitions. Criminal behavior is learned and will
occur when perceived rewards for criminal behavior exceed the rewards for lawful
behavior or perceived opportunity. So, while not directly introducing the Fraud Triangle,
Sutherland did introduce the concepts of rationalizations and opportunities. It is
interesting to think about how Sutherland’s thesis relies on a utilitarian analysis of harms
and benefits of criminal behavior.
The incentive to commit fraud typically is a self-serving one. Egoism drives the
fraud in the sense that the perpetrator perceives some benefit by committing the fraud,
such as a higher bonus or promotion. The fraud may be caused by internal budget
pressures or financial analysts’ earnings expectations that are not being met. Personal
pressures also might lead to fraud if, for example, a member of top management is deep
in personal debt or has a gambling or drug problem. In a “60 Minutes” interview 9 with
Dennis Kozlowski, the former CEO of Tyco, Kozlowski said his motivation to steal from
the company was to keep up with “the masters of the universe.” This meant keeping up
with other CEOs of large and successful companies that had pay packages in the
hundreds of millions. Kozlowski was generous with his lieutenants because he thought
they would be loyal to the boss. In 2005, a jury found that Kozlowski and ex-CFO Marc
Swartz stole about $137 million from Tyco in unauthorized compensation and made $410
million from the sale of inflated stock.
The second side of the Fraud Triangle connects the pressure or incentive to
commit fraud with the opportunity to carry out the act. Employees who have access to
assets such as cash and inventory should be monitored closely through an effective
system of internal controls that helps safeguard assets. For example, the company should
segregate cash processing responsibilities, including the opening of mail that contains
remittance advices, along with checks for the payment of services; the recording of the
receipts as cash and a reduction of receivables; the depositing of the money in the bank;
and the reconciling of the balance in cash on the books with the bank statement balance.
Obviously, when the fraud is perpetrated by the CEO and CFO, as was the case with
Tyco, access is a given. Then, it is just a matter of circumventing the controls or
overriding them or, in the case of Kozlowski, enlisting the aid of others in the
organization to hide what was going on.
Fraud perpetrators typically try to explain away their actions as acceptable. For
corporate executives, rationalizations to commit fraud might include thoughts such as
“We need to protect our shareholders and keep the stock price high,” “All companies use
aggressive accounting practices,” “It’s for the good of the company,” or “The problem is
temporary and will be offset by future positive results.” In the Tyco case, Kozlowski
stated in his “60 Minutes” interview that he wasn’t doing anything different from what
was done by his predecessor. He took the low road of ethical behavior and rationalized
his actions by essentially claiming that everyone (at least at Tyco) did what he did by
misappropriating company resources for personal purposes. The fact is he established the
culture that condoned such behavior.
The corporate governance system at Tyco completely broke down, thereby
creating the opportunity for fraud to occur and thrive. Most members of Tyco’s board of
directors benefited personally as a result of Tyco’s practices. For example, one board
member worked for a law firm that “just happened” to receive as much as $2 million in
business from Tyco. This person’s pay at the law firm was linked to the amount of work
that he helped bring in from Tyco. Another director received a $10 million payment for
help in engineering an acquisition for Tyco. The problem here was (1) Tyco board
members did business with the company, (2) directors and officers borrowed money from
the company, and (3) related-party disclosures were not made in the financial statements.
Clearly, board members lacked independence from management and the company, and
their own greed contributed to the lax oversight at Tyco.
C. Fraud Considerations and Risk Assessment
Most of the requirements of AU-C 240 call for the auditor to engage in risk
assessment during the audit. Actually, the assessment of risk starts with an evaluation of
evidence about the potential client before agreeing to do the audit. One important step is
to communicate with the predecessor auditor to find out the reasons for the firing or the
reasons for no longer servicing the client. Of particular importance is assessing the
integrity of the top management and key accounting personnel. The successor auditor
also should clarify with the predecessor whether there were any differences of opinion
with management over the application of accounting principles and how these were
handled, including the role of the audit committee.
In 2001, COSO initiated a project to develop a framework that would be readily
usable by managements to evaluate and improve their organizations’ enterprise risk
management (ERM). The framework incorporates internal control principles that enhance
corporate governance and risk management. ERM is defined as a process, effected by an
entity’s board of directors, management, and other personnel and applied in strategy
settings and across the enterprise, designed to identify potential events that may affect the
entity and to manage risk within its risk appetite.
COSO’s ERM is designed to help an entity get where it wants to go and avoid
pitfalls and surprises along the way. ERM adds a number of strategic issues, including
objective setting by management, identification of risks and opportunities affecting
achievement of an entity’s objectives, and risk responses selected by management to
align risk tolerance and risk appetite. In 2009, COSO issued Guidance on Monitoring
Internal Control Systems, an integral part of its framework. Monitoring should be done to
assess the quality of internal control performance over time. To provide reasonable
assurance that an entity’s objectives will be achieved, management should monitor
controls to determine whether they are operating effectively and whether they need to be
redesigned when risks change.
The audit committee should evaluate management’s identification of fraud risks,
implementation of antifraud measures, and creation of the appropriate tone at the top.
Active oversight by the audit committee can help reinforce management’s commitment to
create a culture with “zero tolerance” for fraud. An entity’s audit committee also should
ensure that senior management (in particular, the CEO and CFO) implements appropriate
fraud deterrence and prevention measures to better protect investors, employees, and
other stakeholders.
Whenever the auditor has determined that there is evidence that fraud may exist,
the matter should be brought to the attention of the appropriate level of management.
AU-C 240 requires such communication even if the matter might be considered
inconsequential, such as a minor misappropriation by an employee. Fraud (whether
caused by senior management or other employees) that causes a material misstatement of
the financial statements should be reported directly to those charged with governance. In
addition, the auditor should reach an understanding with those charged with governance
regarding the nature and extent of communications with them about misappropriations
perpetrated by lower-level employees.
The responsibility for preventing and detecting fraud rests with the management
of entities. The auditor has a responsibility to plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement, whether caused by error or fraud. The auditor 11 The auditor has access to
the audit committee as necessary. The chair of the audit committee meets with the auditor
periodically. The audit committee meets with the auditor without management at least
annually unless prohibited by law or regulation. The nature of significant assumptions;
The degree of subjectivity involved in the development of the assumptions; and The
relative materiality of the items being measured to the financial statements as a whole.
should communicate with management and inquire whether any significant fraud or error
has been detected, in part to adjust audit procedures accordingly. However, the auditor
faces the inevitable risk that some significant errors will not be detected, even if the audit
is planned and done properly. Management can override internal controls and create
deceptive accounting for transactions that makes identifying fraud difficult at best.
D. Audit Report and Auditing Standards
The free market for stocks and bonds can only exist if there is sharing of reliable
financial information, strengthened by information that is transparent and unbiased. The
external audit is intended to enhance the confidence that users can place on the financial
statements that have been prepared by management. Since 1926 the New York Stock
Exchange (NYSE) has required an auditor’s report with public companies’ financial
statements. Then the Securities Exchange Act of 1934, which is discussed further in
Chapter 6, required all public companies to have an independent auditor’s report on
annual financial statements. Presently, the PCAOB oversees public companies’ audits
since the Sarbanes-Oxley Act of 2002. The Auditing Standards Board (ASB) of the
AICPA oversees the audits of nonpublic companies. For both public and nonpublic
entities, the auditor’s report on financial statements and related disclosures provides (or
disclaims) an opinion on whether the entity’s financial statements and related disclosures
are presented in accordance with generally accepted accounting principles (GAAP). The
opinion is based on the test of controls and substantive procedures that have been
performed during the audit engagement.
An auditor should give an unmodified or unqualified opinion when the financial
statements “present fairly” financial position, results of operations, and cash flows.
Certain situations may call for adding an additional paragraph: either an emphasis-of-
matter or other-matter paragraph. An emphasis-of-matter paragraph is a paragraph in the
auditor’s report that refers to a matter appropriately presented or disclosed in the financial
statements (e.g., going concern, litigation uncertainty, subsequent events, etc.). It is added
when, in the auditor’s professional judgment, the item is of such importance that it is
fundamental to users’ understanding of the financial statements. Some emphasis-of-
matter paragraphs are required by recently Clarified Statements on Auditing Standards
(SASs) or by the PCAOB, and others are added at the discretion of the auditor.
Recall that Rule 203 of the AICPA Code of Professional Conduct precludes
rendering an opinion that states that the financial statements have been prepared in
accordance with GAAP, or any statement that the auditor is not aware of any material
modifications that should be made to such statements or data to make them conform with
GAAP, if such statements or data contain any departure from an accounting principle that
has a material effect on the statements or data taken as a whole. The result would be the
issuance of a modified opinion on the matter that creates a deviation from GAAP.
From time to time, an auditor might consider withdrawing from an engagement.
Withdrawal generally is not appropriate because an auditor is hired by the client to do an
audit and render an opinion, not walk away from one’s obligations when the going gets
tough. However, if a significant conflict exists with management or the auditor decides
that management cannot be trusted, then a withdrawal may be justified. Factors that
affect the auditor’s conclusion include the implication of the involvement of a member of
management or those charged with governance in any misconduct. Trust issues are a
matter of ethics. Once pressure builds up in the auditor–client relationship and it boils
over, the auditor must consider whether the breakdown in the relationship has advanced
to the point that any and all information provided by the client is suspect. An auditor
should not allow himself to be in the position of questioning the client’s motives with
every statement made and piece of evidence gathered. Withdrawal triggers the filing of
the SEC’s 8-K form by management.
The term reasonable is often used in law to define a standard of behavior to
decide legal issues. For example, an auditor should exercise a reasonable level of care
(due care) to avoid charges of negligence and possible liability to the client. The
reasonable (prudent) person standard typically is used to judge whether an uninvolved
individual looking at the behavior of an auditor, perhaps in relation to independence and
client relationships, can conclude that the auditor has maintained the appearance of
independence. This appearance standard is used because oftentimes it is difficult to know
whether the auditor truly is independent in fact in making audit decisions because
independence in fact relies on what was in the mind of the auditor at the time she decided
to either include or exclude certain audit evidence.
The concept of materiality recognizes that some matters are important to the fair
presentation of financial statements, while others are not. The materiality concept is
fundamental to the audit because the audit report states that an audit is performed to
obtain reasonable assurance about whether the financial statements are free of material
misstatement. Materiality judgments require the use of professional judgment and are
based on management and auditor perceptions of the needs of a reasonable person who
will rely on the financial statements. Materiality is defined in the glossary of Statement of
Financial Accounting Concepts (SFAC) 2, Qualitative Characteristics of Accounting
Information, as: The magnitude of an omission or misstatement of accounting
information that, in the light of surrounding circumstances, makes it probable that the
judgment of a reasonable person relying on the information would have been changed or
influenced by the omission or misstatement.
Without an understanding of the term present fairly, the users of a financial
statement would be unable to assess its reliability. For the purposes of our discussion
about fair presentation, we will proceed with the following guideline: that the auditor’s
assessment of fair presentation depends on whether (1) the accounting principles selected
and applied have general acceptance; (2) the accounting principles are appropriate in the
circumstances; (3) the financial statements, including the related notes, are informative of
matters that may affect their use, understanding, and interpretation; (4) the information
presented in the statements is classified and summarized in a reasonable manner—that is,
neither too detailed nor too condensed; and (5) the financial statements reflect
transactions and events within a range of reasonable limits.
An independent auditor plans, conducts, and reports the results of an audit in
accordance with GAAS. Auditing standards provide a measure of audit quality and the
objectives to be achieved in an audit. Auditing standards differ from auditing procedures
because the procedures are steps taken by the auditor during the course of the audit to
comply with GAAS. The application of auditing standards entails making judgments with
regard to the nature of audit evidence, sufficiency, competency, and reliability.
Materiality considerations also are important to assess whether the audit opinion should
be modified.
Standards of fieldwork establish the criteria for judging whether the audit has met
quality requirements. The standards include (1) to adequately plan the audit work and
supervise assistants so that the audit is more likely to detect a material misstatement; (2)
to obtain a sufficient understanding of the entity and its internal control, to assess the risk
of material misstatement of the financial statements, whether due to error or fraud, and to
plan effectively the nature, timing, and extent of further audit procedures; and (3) to
gather sufficient competent evidential matter through audit procedures including
inspection, observation, inquiries, and confirmations to provide a reasonable basis
(support) for an opinion regarding the financial statements under audit.
There are three reporting standards that guide auditors in rendering an audit report
and in determining the degree of responsibility that the auditor is taking with respect to
the expression of an opinion of the financial statements. They include (1) determination
of whether the statements have been prepared in conformity with GAAP, (2)
identification of situations where the accounting principles have not been observed
consistently in the current period in relation to the preceding period, and (3) discussion in
the report of any situation identified in the footnotes to the financial statements where
informative disclosures are inadequate. In each case, professional judgments are
necessary to meet the requirements of these standards.
Gathering and objectively evaluating audit evidence requires the auditor to
consider the competency and sufficiency of the evidence. Representations from
management, while part of the evidential matter the auditor obtains, are not a substitute
for the application of those auditing procedures necessary to afford a reasonable basis for
an opinion regarding the financial statements under audit. Audit risk and materiality need
to be considered together in determining the nature, timing, and extent of auditing
procedures and in evaluating the results of those procedures. According to AU-C 315, the
auditor should consider audit risk and materiality both in (a) planning the audit and
designing auditing procedures and (b) evaluating whether the financial statements taken
as a whole are presented fairly, in all material respects, in conformity with GAAP.
E. Motivation for Earnings Management
During the 1990s and early 2000s, meeting or beating analysts’ earnings
expectations emerged as an important earnings benchmark. Bartov et al. found that the
stock market has been found to award firms that meet or beat analysts’ forecasts and
punish firms that miss earnings targets. Meeting or beating earnings through earnings and
expectations management has drawn concerns over the integrity of managers. For
instance, an analysis of Nortel Networks Corporation by Fogarty et al. (separate from
Case 7-1 later in this chapter) reveals that earnings expectations management is tied to
many other missteps of managers that collectively contributed to the downfall of the giant
telecommunications firm. Consistent with Fuller and Jensen, this suggests that earnings
expectations management sets in motion a variety of organizational behaviors that often
end up damaging the firm. Erhard et al. suggest that meeting or beating earnings by
manipulating earnings and analysts’ earnings expectations is indicative of low integrity in
relations with the capital markets, resulting in calls for boards of directors to take
accountability for integrity of the entire corporate system. Graham et al. also advocate
changes in the culture of boards of directors by focusing on long-term strategic goals and
shielding managers from the short-term pressure from the capital markets. Taken
collectively, the arguments suggest that, while managing earnings expectations may help
the firm avoid missing earnings targets and market penalties, it can be detrimental to the
long-term value of the firm and the capital markets, point out Liu et al.
In addition to maximizing bonuses, the value of stock options, and meeting
investors’ earnings expectations, another objective of earnings management is to avoid
the consequences of violation of debt covenants. Covenants in a long-term lending
contract, such as required debt-to-equity ratio or minimum working capital requirements,
exist to protect the lender from the potentially adverse actions of managers. Earnings
management can serve as motivation to steer managers away from violating the terms of
a debt contract, because such a violation would be highly costly to the manager and could
affect her ability to operate the firm freely. Earnings management gives a manager the
flexibility to choose those accounting policies that avoid a close proximity to covenant
violation.
Green Mountain manufactures the Keurig single-cup brewing system and many
varieties of the associated “K-Cup” portion packs to brew single servings of coffee and
other related products. The company operates on a razor/razor blade model—selling
brewing machines but making its real money on the K-Cups. Between February 2, 2011,
and November 9, 2011 (the “class period”), plaintiffs purchased or otherwise acquired
Green Mountain common stock. A class-action lawsuit was brought against the company
alleging fraud based on materially misleading statements made to deceive [with scienter]
shareholders about the inventory levels and earnings of the company. The original district
court decision went against the plaintiff-shareholders but it was appealed and the decision
was remanded for further trial. In the end, the shareholders prevailed against Green
Mountain.
Sam Antar, former CFO of Crazy Eddie, a massive fraud in the 1980s that was
discussed in Chapter 6, became a fraud investigator of sorts after serving jail time for his
role in the Crazy Eddie fraud. Antar pointed to suspected inventory manipulation early on
that, he alleged, fraudulently inflated Green Mountain’s earnings. Of course, he turned
out to be right. It is understandable that he would know about such things having been
part of the inventory fraud at Crazy Eddie.
Antar provided some wisdom about auditing inventory when he explained that
even when auditors confirm the existence of inventory in a company’s warehouse, fraud
is still possible. Inventory can be moved from location to location as auditors are making
their rounds, and the same inventory can therefore be counted multiple times. This
inflates the inventory on the balance sheet. Of course, in the case of Green Mountain, the
company was counting the overstock inventory as ending inventory and inflating
earnings while, at the same time, hiding the overstocked amounts from PwC. We’re not
quite sure why the firm did not catch on to the fraud; it was not prosecuted by the SEC.
In a ruling that portends changes to how companies communicate with investors,
the SEC said on April 2, 2013, that postings on sites such as Facebook and Twitter are
just as good as news releases and company Web sites as long as the companies have told
investors which outlets they intend to use. The ruling permits companies to use social
media channels to announce financial and other key information and post earnings
information to the investing public in compliance with Regulation Fair Disclosure
(Regulation FD). The move was sparked by an investigation into a Facebook posting
from Netflix Inc. Chief Executive Reed Hastings, who boasted on the social media site
that the streaming-video company had exceeded 1 billion hours in a month for the first
time, sending the firm’s shares higher. The SEC opened the investigation in December
2012, to determine if the post had violated rules that bar companies from selectively
disclosing information.
Verschoor notes that the constant pressure to report favorable earnings
performance motivates many companies to report income numbers that exclude unusual
events that almost always seem to be costly and depress earnings. These non-GAAP
numbers were, for many years, used to reflect a level of earnings that might put a positive
spin on what otherwise might be not such good results under GAAP. In an effort to
“eliminate the manipulative or misleading use of non-GAAP financial measures and, at
the same time, enhance the comparability associated with the use of that information,”
the Sarbanes-Oxley Act directed the SEC to adopt new rules to address public
companies’ disclosure or release of certain financial information that is calculated and
presented on the basis of methodologies other than in accordance with GAAP. The result
was the adoption of Regulation G in January 2003, “Conditions for the Use of Non-
GAAP Financial Measures.”
Levitt talks about another motivation to manage earnings: to smooth net income
over time. The ideal pattern of earnings for a manager is a steady increase each year over
a period of time. The results make it appear that the company is growing and doing better
than it really is, and the manager should be given credit for the positive results. The
market reacts by bidding up the price of the stock, and the manager is rewarded for the
results by a performance bonus and stock options with a prospective value that increases
over time because of income smoothing that triggers stock price increases.
One industry that routinely uses allowances to smooth net income over time is
banking. Rivard et al. studied income smoothing techniques by banks and found them to
be more aggressive in using loan-loss reserves as a tool of income smoothing. The
provision for loan losses is a noncash accounting expense for banks. In theory, this
expense represents expected future losses, which will eventually occur on loans extended
during the previous period. These expenses accumulate on the bank’s balance sheet in the
loan-loss reserve account. When a loan is charged off, this reserve account is debited.
Because banks have considerable flexibility in determining the size of the annual
provision for loan losses, and because this is a noncash expense, it is an excellent tool for
income smoothing. During periods of lowerthan-normal earnings, the bank may
understate its expected future loan loss and thus increase earnings. When profits are
abnormally high, the opposite occurs. Over an extended period of time, the loan-loss
reserve balance is maintained at the desired level and average earnings are unaffected.
However, the variability of the earnings stream over that period is less than it would
otherwise be. As the authors point out, income smoothing reduces not only earnings, but
also tax liabilities in high-income years, and 23 24 increases them in low-income years.
F. Characteristics of Earnings Management
Gaa and Dunmore point out that earnings may be managed in many different
ways, but they all boil down to two basic possibilities. One is to alter the numbers already
in the financial records by using discretionary accruals and other adjustments, and the
other is to create or structure real transactions for the purpose of altering the reported
numbers. There are also two kinds of motivations for altering the financial reports
through disclosure decisions. Management may either intend to influence stakeholders’
beliefs and behavior or to influence how contracts are performed.
There are a variety of definitions of earnings management. Schipper defines it as a
“purposeful intervention in the external reporting process, with the intent of obtaining
some private gain (as opposed to, say, merely facilitating the neutral operation of the
process).” Healy and Wahlen define it as “when managers use judgment in financial
reporting and in structuring transactions to alter financial reports to either mislead some
stakeholders about the underlying economic performance of the company, or to influence
contractual outcomes that depend on reported accounting numbers.
The authors of this book believe that the acceptability of earnings management
techniques should be judged using the ethics framework established earlier in the book.
Virtue ethics examines the reasons for actions taken by the decision maker as well as the
action itself. McKee’s definition is self-serving from a management perspective and does
not reflect virtues such as honesty (full disclosure) and dependability (reliable numbers).
The definition also ignores the rights of shareholders and other stakeholders to receive
fair and accurate financial information. McKee’s explanation that earnings management
is good because it creates a more stable and predictable earnings stream by smoothing net
income cannot overcome the fact that a smooth net income by choice does not reflect
what investors and creditors need or want to know because it masks true performance.
Further, McKee’s explanation for the “goodness” of earnings management is nothing
more than a rationalization for an unethical act. Hopwood et al. provide cover for their
view of the ethics of earnings management by stating that “the ethics issue might possibly
be mitigated by clearly disclosing aggressive accounting assumptions in the financial
statement disclosures.” We disagree with this characterization because disclosure should
not be used to mask the ills of improper accounting that tests the limits of what does and
does not present fairly financial position, results of operations, and cash flows. A
disclosure may be nothing more than a rationalization for an unethical action with respect
to earnings management, thereby closing the Fraud Triangle.
Elias conducted a study of corporate ethical values and earnings management
ethics. He defined corporate ethical values as a composite of the individual values of
managers and both the formal and informal policies on the ethics of the organization. The
tone at the top signals whether ethics policies are taken seriously by management and is,
therefore, very important to create an ethical corporate environment. The study clearly
shows that accountants in organizations with high ethical values perceived earnings
management actions as more unethical. Certified public accountants (CPAs) in industry
occupations were significantly less likely than those in public accounting to perceive high
ethical values in their organizations. This may be attributable to the greater pressure
internally to meet financial analysts’ earnings projections and provide bonuses and stock
options for top management. In a case study by Phillips and Zvinakis, it was determined
that managers deceive shareholders by manipulating their companies’ receivables,
inventories, loss contingencies, and capital asset depreciation. In the past, audit
committees have often failed to protect shareholders by inadequately monitoring and
controlling the accounting judgments made by management.
Their key findings fall into three broad categories. The first includes results
related to the definition, characteristics, and determinants of earnings quality. On
definition, CFOs believe that earnings are high quality when they are sustainable and
backed by actual cash flows. More specific quality characteristics include consistent
reporting choices over time and avoidance of long-term estimates. Consistent with this
view, current earnings are considered to be high quality if they serve as a good guide to
the long-run profits of the firm.
Accruals are needed on the balance sheet because when cash flows are examined
within a limited time frame, they suffer from matching and timing problems and therefore
often give the wrong picture of the period’s performance. By measuring performance
with earnings, the matching and timing problems inherent in cash flows are decreased
through the use of the revenue recognition and matching principles. The revenue
recognition principle states that revenues should be recognized when the firm has
delivered a product or has produced a substantial portion of it, and the cash receipt is
reasonably certain. Over the lifetime of the firm, cash flows and earnings are the same,
but when accounting principles are applied over finite time periods, cash flows have to be
adjusted to produce the earnings number as is done in the operating section of a cash flow
statement. These adjustments are made with accruals on the balance sheet, and thus,
earnings are the sum of a period’s change in accruals and its cash flows.
G. Earnings Management Judgments and Techniques
The principle of materiality underscores the concept that some financial
transactions are so insignificant that they are not worth measuring and reporting with
exact precision. For example, some companies may define an item as material only if it
affects earnings by more than 5 percent to 10 percent. This principle allows for some
judgment and flexibility in financial reporting. It can be linked to Needles’s idea of a
continuum of ethical and unethical financial reporting through earnings management.
However, the materiality principle can be misused by companies that seek to do so. For
instance, a company could manipulate revenues or expenses deliberately, and yet do so
within an established maximum percentage of acceptability and claim that the
misstatement is not material.
The concept of “materiality” is important in securities law. Whether in a
registration statement, or in a filing under the 1934 Act, or in providing information to
the trading markets, a company will be liable for any material misstatement, or any
material omission of facts necessary to make other statements 45 “not misleading.” This
standard is most often encountered in fraud litigation brought under Section 10(b) and
Rule 10b-5 under the 1934 Act, but also constitutes the linchpin standard for liabilities
arising under Section 11 (false registration statements), Section 12 (false prospectuses),
Section 15 (liability of controlling persons), and Section 17 (criminal fraud in securities
sales) under the Securities Act of 1933. The fundamental disclosure requirements
contained in the two statutes are premised upon a prohibition of material misstatement or
omission.
SOX increased demands on management to prevent and detect material control
weaknesses. To develop the controls, SOX requires that CPAs need to be able to identify
key control exceptions and apply a materiality concept to determine the financial impact
of such exceptions. In this regard, Vorhies identifies four perspectives to help CPAs meet
their responsibilities under SOX, including (1) the actual financial statement
misstatement or error, (2) an internal control deficiency caused by the failure in design or
operation of a control, (3) a large variance in an accounting estimate compared with the
actual determined amount, and (4) financial fraud by management or other employees to
enhance a company’s reported financial position and operating results.
The danger of relying on only a quantitative analysis to make materiality
judgments can be seen in the audit by KPMG of Gemstar–TV Guide International, Inc.
Accounting and Auditing Enforcement Release (AAER) 2125, issued by the SEC,
concludes that $364 million of revenue was reported improperly and that certain
disclosure policies were inconsistent with Gemstar’s accounting for revenue, did not
comply with GAAP disclosure requirements, or both. AAER 2125 found that the KPMG
auditors concurred in Gemstar’s accounting for overstated revenue from licensing and
advertising transactions in March 2000, December 2000, December 2001, and March
2002. Also, KPMG did not object to Gemstar’s disclosure and issued audit reports stating
that KPMG had conducted its audits in conformity with generally accepted accounting
standards (GAAS) and that the financial statements fairly presented its results in
conformity with GAAP. In reaching these conclusions, the KPMG auditors unreasonably
relied on representations by Gemstar management, unreasonably determined that the
revenues were immaterial to Gemstar’s financial statements, or both. The KPMG
auditors’ materiality determinations were unreasonable in that they considered only
quantitative materiality factors (i.e., that the amount of revenue was not a large
percentage of Gemstar’s consolidated financial results) and failed to also consider
qualitative materiality (i.e., that the revenue related to business lines that were closely
watched by securities analysts and had a material effect on the valuation of Gemstar
stock).
One example is when a company resorts to taking a one-time large restructuring
charge/write-down, as opposed to appropriately recording the losses over several fiscal
years. This is to avoid a succession of years of earnings decline that would have
otherwise made the company financial health look bad in the eyes of stakeholders. To
make it more difficult for companies to abuse “big-bath charges,” in 1998, the FASB
adopted SFAS 144 on impairment losses and SFAS 146 on the timing of the recognition
of restructuring obligations. Another example occurred at Sunbeam Corporation that was
discussed previously and in Case 7-7. Sunbeam had huge losses in the late 1990s. The
company fired its CEO and brought in Al Dunlap. Dunlap wanted to look like a
turnaround artist so he established and purposefully overstated cookie-jar-reserves to
make it look as though the losses in the year he took over were higher than reported.
Dunlap then could reverse the overstated expenses and increase income in future years to
make him look better.
CVS Caremark used an acquisition technique that enabled it to manage earnings
in a blatantly fraudulent way. The acquisition of Longs Drugstores by CVS on October
20, 2008, illustrates what can happen when experts allow client management to make the
call on how to account for a transaction. CVS called the shots and the firm that conducted
the valuation of assets of Longs went along with unsubstantiated reductions in asset
values even though its independent analysis showed otherwise. As for the auditors, they
uncritically accepted management’s representations about these and other amounts. The
auditors did not exercise the level of due care or professional skepticism warranted by the
facts. However, the SEC did not file an action against either party, choosing instead to go
after CVS and Laird Daniels, CPA, the retail controller for CVS during the fraud period.
The discussion below is drawn from the SEC’s legal settlement with Daniels.
Given the prominence of revenue recognition techniques in earnings management
cases, we discuss some of the criteria for determining proper revenue, some of which are
addressed in this chapter. Generally, revenue is recognized only when a specific event
has occurred and the amount of revenue is measurable. For example, income is
recognized as revenue whenever the company delivers or performs its product or service
and receives payment for it. Of course sometimes it is not that simple because
uncertainties exist about collectibility, side agreements are made, and/or multiple
elements exist in a revenue transaction that need to be separately valued.
Vendors often provide multiple products or services to their customers as part of a
single arrangement or a series of related arrangements. These deliverables may be
provided at different points in time or over different time periods. As a simple example, a
vendor may enter into an arrangement with a customer to deliver and install a tangible
product along with providing one year of maintenance services. In this arrangement, there
are three deliverables: (1) the product, (2) installation, and (3) maintenance services.
Issues often arise regarding how and whether to separate these deliverables and how to
allocate the overall arrangement consideration. Subtopic 605-25, Revenue Recognition—
Multiple-Element Arrangements, of the Financial Accounting Standards Board’s
Accounting Standards Codification (ASC) provides the guidance that should be followed
in accounting for this and many other revenue arrangements with multiple deliverables.
Global Crossing and Qwest were two telecommunications companies that
engaged in “round-trip” transactions in the early 2000s. What happened is the companies
were round-tripping revenues by recording a series of last-minute deals with other
carriers, in which the contracts were for nearly identical amounts, for routes that had yet
to be specified or, in some cases, on routes that had not yet been built. In a 2001
transaction between Global Crossing and Qwest, Global Crossing signed a $100 million
contract only to “round-trip” the cash by purchasing a similar amount of undefined
capacity from Qwest. Global Crossing would book the incoming contract as a large
chunk of revenue, and then book the outgoing contract as a capital expense. To an
objective observer, these capacity swaps appear to be a transaction solely for the purpose
of boosting revenues. Hence, it fails the economic substance test.
The Financial Accounting Standards Board (FASB) and the International
Accounting Standards Board (IASB) jointly issued a new revenue recognition standard,
Revenue from Contracts with Customers, in May 2014 to converge the revenue
recognition rules of both bodies. The new standard is effective for public companies for
annual and interim periods beginning after December 15, 2017. Earlier application is
permitted only as of annual reporting periods beginning after Dec. 15, 2016. All other
entities are required to apply the guidance to annual reporting periods beginning after
Dec. 15, 2018, and interim reporting periods within annual reporting periods beginning
after Dec. 15, 2019. The new standard provides 65 guidance for helping companies
recognize revenue under both U.S. GAAP and IFRS. The new standard provides a single,
comprehensive accounting model for revenue recognition. The standard is complex so we
limit the discussion to the very basics here.
H. Financial Shenanigans
Financial shenanigans can be broadly classified into two types: (a) schemes that
overstate revenues and profits, which are designed to enhance reported results and
earnings per share and (b) schemes that understate revenues and profits that are typically
done to smooth out net income over time periods and make it appear less volatile.
Companies have numerous avenues to engage in financial shenanigans if they so desire.
These include recognizing revenues prematurely, recording sales made to an affiliate or
recording sales of unshipped items, capitalizing rather than expensing research and
development costs, reclassifying balance sheet items to create income, amortizing costs
or depreciating assets at a slower pace, setting up specialpurpose vehicles to hide debt or
mask ownership, and so on. In most instances of far-reaching and complex fraud,
financial shenanigans were not detected even by a company’s auditors.
A company might choose to accelerate discretionary expenses, such as repairs and
maintenance, into the current period if the current year’s revenue is relatively high in
relation to expected future revenue or if future expenses are expected to be relatively
high. The motivation to shift future expenses to the current period might be to smooth net
income over time.
The delay in recording repairs and maintenance is a technique that McKee would
probably categorize as appropriate, given the goal of providing smooth and predictable
earnings. Recall that in the reported studies on earnings management, the idea of
managing earnings through operating decisions was not perceived to be as big a problem
as altering revenue amounts. However, the decision to delay needed repairs raises several
ethical issues with respect to the company’s operating decisions because it creates a risk
that assets such as machinery and equipment may break down prematurely. The ethical
issues and consequences are (1) the quality of product may suffer, leading to extra quality
control and rework costs; (2) production slows and fails to meet deadlines, thereby
risking customer goodwill; and (3) the costs to repair the machines can be greater than
they would have been had maintenance been completed on a timely basis. Imagine, for
example, that you fail to change the oil in your car on a regular basis. The result may be
serious, costly repairs to the engine later on.
I. Ethical Leadership
The ethical leader understands that positive relationships built on respect,
openness, and trust are critical to creating an ethical organization environment. The
underlying principles of ethical leadership are: integrity, honesty, fairness, justice,
responsibility, accountability, and empathy. Covey addresses a principle-centered
leadership approach to one’s personal life and organization development. He emphasizes
that principle-centered leadership occurs when one’s internal values form the basis of
external actions. Principle-based leaders influence the ethical actions of those in the
organization by transforming their own behavior first. Covey encourages principle-
centered leaders to build greater, more trusting and communicative relationships with
others in the workplace.
Ethical leaders strive to honor and respect others in the organization and seek to
empower others to achieve success by focusing on right action. An ethical organization is
a community of people working together in an environment of mutual respect, where they
grow personally, feel fulfilled, contribute to a common good, and share in the internal
rewards, such as the achievement of a level of excellence common to a practice as well as
the rewards of a job well done. By emphasizing community and internal rewards, ethical
leaders commit to following a virtue-oriented approach to decision making based on a
foundation of values-based leadership.
Ethical problem solving is part of the role of being an accounting professional.
Ethical leadership entails building an environment where those in the organization feel
comfortable in talking to others to share perspectives of the importance of finding an
ethical solution to problems. Internal accountants and auditors may possess ethical
values, but it will mean nothing unless a supportive organization exists to help develop
the courage to put those values into action. Voicing one’s values when conflicts exist
creates challenges that can be exacerbated by an indifferent leader and culture that
operates by rationalizing unethical actions. Pressures imposed by top management to go
along with financial wrongdoing under the guise of “It is expected practice around here”
or “You need to be a team player” challenges a protagonist who must counter those
reasons and give voice to one’s values.
It has been claimed that part of the role of leadership includes creating the “moral
organization,” promoting development in others, and institutionalizing values within the
organization’s culture. Trevino et al. discuss building ethical leadership through two
pillars of character: moral person and moral manager. The executive as a moral person is
characterized in terms of individual traits such as honesty and integrity. As a moral
manager, the executive (i.e., CEO) creates a strong ethics message that gets employees’
attention and influences their thoughts and behaviors. Both are necessary for moral
leadership. To be perceived as an ethical leader, it is not enough to just be an ethical
person. An executive ethical leader must also attend to cultivating the ethics and values
and infuse the organization with principles that will guide the actions of all employees.
distinguishing characteristic of many of the accounting frauds discussed in this
book is that short-term factors were allowed to compromise long-term ethical decision
making in the interest of creating the illusion that earnings were strong and sustainable.
CFOs and CEOs acted based on non-ethical values, such as enhancing share prices and
creating personal wealth. Those on the front line “held their nose” and carried out
unethical orders that led to managed earnings. “Leaders” such as Jeff Skilling at Enron,
Bernie Ebbers at WorldCom, and Dennis Kozlowski at Tyco created a hands-off
environment that sent the message “all is well” while the company was collapsing around
them.
Authentic leaders are focused on building long-term shareholder value, not in just
beating quarterly estimates. Authentic leaders are individuals “who are deeply aware of
how they think and behave and are perceived by others as being aware of their own and
others’ values/moral perspectives, knowledge, and strengths; aware of the context in
which they operate; and confident, optimistic, resilient, courageous, and of high moral
character. Authentic leaders acknowledge the ethical responsibilities of their roles, can
recognize and evaluate ethical issues, and take moral actions that are thoroughly
grounded in their beliefs and values.
The need for good leaders to be ethical in their leadership is embedded within
definitions of transformational leaders. Transformational leadership is defined as a
leadership approach that causes change in individuals and social systems. In its ideal
form, it creates valuable and positive change in the followers with the end goal of
developing followers into leaders. Enacted in its authentic form, transformational
leadership enhances the motivation, morale, and performance of followers through a
variety of mechanisms. These include connecting the follower’s sense of identity and self
to the mission and the collective identity of the organization; being a role model for
followers that inspires them; challenging followers to take greater ownership for their
work; and understanding the strengths and weaknesses of followers, so the leader can
align followers with tasks that optimize their performance.
The flip side of leadership is followership. First introduced by Hollander and
Webb, the term followership is characterized as an independent relationship in which the
leader’s perceived legitimacy can affect the degree to which followers allow themselves
to be influenced. This early work emphasizes the reciprocal relationship in which
followers play an active role not only by receiving but also exerting influence. Servant
leadership advocates a perspective that leaders have a responsibility to serve their
followers by helping them achieve and improve by modeling leaders’ ethical values,
attitudes, and behaviors that influence organizational outcomes through the fulfillment of
followers’ needs. The basic premise of servant leadership is leaders should put the needs
of followers before their own needs. Servant leaders use collaboration and persuasion to
influence followers rather than coercion and control. They understand their stewardship
role and are accountable for their actions. Servant leadership helps to create an ethical,
trusting organizational climate.
Social learning theory has been used to understand how leaders influence
followers more generally. Social learning theory holds that individuals look to role
models in the work context, and model or imitate their behavior. Modeling is
acknowledged to be one of the most powerful means for transmitting values, attitudes,
and behaviors. Employees learn what to do, as well as what not to do, by observing their
leaders’ behavior and its consequences. Leaders become role models by virtue of their
assigned role, their status and success in the organization, and their power to affect the
behavior and outcomes of followers. Through social learning, people may adopt ethical
behaviors, as evidenced by the impact of ethical leadership or antisocial behaviors.
We first discussed Thomas Jones’ moral intensity model in Chapter 3. Jones
conceptualized his model such that moral intensity might influence each of the
components of Rest’s Four Component Model of Moral Behavior. It starts with ethical
awareness. The more intense the ethical issues, the more likely the decision maker will be
aware of the ethical implications of her intended actions.
Jones argued that ethical decisions are primarily contingent upon the
characteristics of the issue at stake so that judgments of ethicality would involve a
systematic evaluation of the moral intensity of the characteristics of the issue. Factors
need to be evaluated for moral intensity, including the magnitude of the consequences of
the moral act; the degree of social consensus that the moral act is unethical; the feelings
of proximity of the moral agent to the moral act; the likelihood that the moral act would
take effect; the temporal immediacy of the effect of the moral act; and the concentration
of the effect. Jones’s model predicts that the perceived overall intensity of a moral issue
would influence the decision maker’s moral judgment and, moral intent, as well as
subsequent moral action.
J. The Role of Moral Intensity, Organizational Culture, and Ethical Leadership in
Accounting
Personal ethical skills are primarily managed by the organizational structure of
audit firms, and rules and processes have been developed with the sole aim of limiting the
audit risk and guaranteeing audit quality. Ethical competencies are managed indirectly
and promoted by the idea of responsible leadership and incentives to promote exemplary
behaviors. Personal and professional ethics have roles to play in cultivating responsible
leadership by management of audit firms. The promotion of responsible leadership is
seen within audit firms as a way to improve audit quality.
Responsible leadership in audit firms is essential to create an ethical environment
within the firm. It is a critical component of setting the proper tone and encouraging
members of the organization to ask probing questions when management’s
representations are unclear or unsubstantiated. Responsible leadership is an integral part
of ethical leadership, although the latter also entails the ability to reason through ethical
dilemmas and resolve conflicts in a morally appropriate way.
The results indicate that a typical audit senior at these firms more frequently
under-reports time than prematurely signing off on audit work. The results also indicate
there was a significant negative correlation between all measures of authentic leadership
and dysfunctional audit behaviors with few exceptions. With respect to ethical culture,
there was a negative relationship between the audit seniors’ perceptions of their firms as
ethical, and instances of dysfunctional audit behavior. The findings support the mediation
of perceptions of authenticity in leaders on the auditors’ perception of ethical firm culture
and on auditors’ instances of dysfunctional behavior. The results seem to indicate that the
four constructs of authentic leadership, whether taken individually or in combination,
have influence over the employee’s perception of the ethical content of a firm’s
organizational culture.
Consider what might have happened at Andersen if Joseph Berardino were an
authentic leader who placed ethical values ahead of non-ethical values. The culture
within the firm would have been quite different. The message sent would have been that
the red flags raised by Carl Bass about accounting for the off-balance-sheet partnerships
had to be dealt with, not swept under the rug. Perhaps Berardino’s biggest fault was in
not balancing processing of information; instead, the negative aspects of what was
happening at Enron were shoved in the background and hidden from view.
In a study published in Behavioral Research in Accounting, Bobek et al. describe
the results of an investigation of how professional role (auditor or tax professional),
decision context (an audit or tax issues), and gender influence public accounting
professionals’ ethical decision making. Participants were asked to respond to hypothetical
sets of facts about contentious client conflicts for which they were asked to recommend
whether to concede to the client’s wishes, and to indicate their own behavioral intentions.
The decision context (an audit or tax environment) was manipulated to explore individual
attributes in contexts with different types of professional responsibility.
Looking at the responses of females, there was no significant difference based on
either condition or professional role. However, it was found that females appeared to use
a different decision-making process than males. Females may be more likely to use an
intuitionist approach. This implies a more deliberative approach may not be used, nor one
that relies more heavily on systematic ethical reasoning to resolve conflicts. If so, the
implications for resolving ethical dilemmas in dealing with clients may be significant.
Another surprising result was that perceptions of moral intensity were seen as a factor
that might mediate context in decision making in males but not females. Thus, the results
show that professional role, context, and moral intensity potentially affect male decision
making in a significant way but not female decision making.
Studies of ethical leadership have relied on manipulating variables such as
integrity and ethical standards (i.e., high versus low), treatment of employees (i.e., fair
versus not fair), and holding of employees accountable for ethical conduct (i.e., held
accountable versus not held accountable). The internal audit function has been
conceptualized as a multi-dimensional construct with a position within the corporate
governance structure of a company based on to whom the internal audit function reports
(i.e., audit committee versus chief financial officer); the primary role of the internal audit
function within the company (i.e., assurance versus consulting); and the work product
produced (i.e., history of finding versus missing deficiencies).
Studies have shown a disconnect exists between the perceptions of organizational
ethics between higher and lower levels of an organization. Employees at higher levels
perceive organizational ethics at a higher level. In accounting, Bobek et al. found a
disconnect exists between tax partners and nonpartner tax practitioners with respect to
perceptions of organizational ethics when they described a self-identified ethical
dilemma. On average, they found tax partners rated the ethical environments of their
firms as stronger than nonpartner tax practitioners, especially with respect to firm
leadership. While tax partners were more likely to describe an actual ethical dilemma
than nontax practitioners, the group who described a dilemma rated the ethical
environment as weaker, and this discrepancy was more pronounced for nontax
practitioners.
K. Ethical Leadership Failure
Ethical leadership failure occurs for many reasons. Linda Thornton identifies a
variety of individual and organizational factors. Individual ones include ignoring ethical
boundaries within a company (i.e., ethics codes); prominent personal values (i.e.,
ignoring what is allowed and acting out of self-interest); and a lack of moral compass
(i.e., it is not specifically prohibited so it is fine for me to do it). Organizational factors
include lack of clarity (i.e., uncertain what is and is not ethical); lack of positive role
models (no one does what is “expected”); and no accountability (no one suffers the
consequences of their actions).
When we examine the volitional account, we see that moral failure is about
knowing what is right and not doing it, while on a cognitive level, it is a matter of being
mistaken either about the content of some moral requirement or about its scope. Applying
an ends-justifies-the-means approach to ethical reasoning, Price associates the volitional
account primarily with egoism, but he acknowledges that a leader might cast aside moral
constraints for the good of the group as well as selfish reasons. He argues that leaders in
particular typically go wrong not because they want to use their position to take
advantage of their followers, but because they are committed to the intrinsic value of
group ends and therefore believe that goal achievement justifies moral costs to followers
and outsiders.
According to Mesmer-Magnus and Viswesvaran, organizational employees have
three options to address an unsatisfactory situation faced within an organization: (1) exit
the organization, (2) voice discontent (i.e., blow the whistle), or (3) remain silent.
Employees with greater organizational commitment may prefer voicing discontent to
exiting. Near and Miceli suggest that internal reporters will demonstrate high levels of
firm loyalty in their initial decision to report.
Commitment to the organization contrasts with colleague commitment, with the
latter dependent on a sense of responsibility and readiness to support colleagues within
the organization. Auditors may choose to act on behalf of their colleagues, mindless of
the welfare of the firm as a whole. Thus, unlike professional identity, which exists
independent of organizational affiliation, organizational colleague commitment and firm
commitment are linked together in many cases with one sustaining the other, and in other
circumstances, such as when a colleague performs an unethical act, they create
conflicting allegiances.
L. Values-Driven Leadership
The starting point of a values-driven organization is the individual leader. A
leader needs to connect with organizational values. Leaders must ask what they stand for
and why. Leaders must consider why others would want to follow them. The goal is to
get in touch with what motivates one’s actions and how best to motivate those in the
organization who look to the leader for direction. Values-based leadership is best
summed up by Kouzes and Posner in The Leadership Challenge: “Clearly articulating
and, more importantly, demonstrating one’s values, forms the basis of a leader’s
credibility—and credibility in leadership is character-based.
Consider the following situation: Amy is an auditor at Black and White, LLP, a
mid-sized accounting firm in New York City. Amy has identified what may be a major
fraud at a client entity. It seems the client engaged in a “sell-through” product agreement
whereby an apparent sale to another party included a side agreement that obligated that
party to resell the merchandise prior to paying for the “acquisition.” Thus, a contingency
existed that should have delayed the recording of the sales revenue but did not. Amy has
already spoken to Pat, the audit manager, who instructed her to leave the transaction
alone. It seems the client has exerted a great deal of pressure on the firm to go along with
its accounting because the revenue involved is sufficient to change a loss for the year into
a profit.
Amy is disappointed in Pat and what may be the firm’s position on the matter.
She knows the firm has a core set of values that do not square with the intended
accounting. In fact, she joined the firm because the firm’s values were consistent with
hers. It seems as though Amy may be facing an instance of organizational dissidence in
that the way in which she expected the organization to act is not the way that it did act.
She wants to find a way to give voice to her values but is not sure how to go about it.
What are the key issues for Amy to consider? What road should she take? Values-based
leadership cuts both ways. Amy may be disappointed in the firm’s leadership but if she
envisions herself as a leader (or potential leader), then she wants to demonstrate
leadership instincts in deciding how to handle the matter. Perhaps she can influence the
actions of the firm if she is successful in voicing her values.
M. Ethical Leadership Competence
Ethical Leadership Competence refers to the ability to handle all kinds of moral
problems that may arise in an organization. It means to develop the problem-solving and
decision-making skills to make difficult decisions. Leaders might try to deal with a moral
problem in an automatic way, essentially using their authority for the basis of decision
making. However, this System 1 approach is fraught with danger because the interests of
all stakeholders may not be adequately considered; subtle moral issues may go unnoticed;
and expediency is emphasized instead of thought and deliberation. As we have pointed
out throughout the text, what is needed is to develop the competency to reason through
ethical conflicts in a systematic way. There is no shortcut to making ethical decisions. It
requires judgment and reflection on what the right thing to do is.
Thornton identifies five levels of ethical competence: personal, interpersonal,
organizational, professional, and societal. On a personal level, accounting professionals
should internalize the values of the profession, including objectivity, integrity, diligence,
and duty to society. Auditors work in teams so how they deal with others (i.e., showing
respect, fair-mindedness) is a critical component of ethical competence. As members of
an accounting firm, auditors should follow the ethics codes and expectations of their
organizations, but they should never compromise their professional identity.
The Ethical Leadership Scale fits nicely with GVV methodology. It engages
participants in reflecting on specific leadership qualities that can support voicing one’s
beliefs when conflicts exist in an organization and when interacting with others in
organizational relationships. In discussing the usefulness of the Scales, Kelly and Earley
point out that techniques of role-playing, simulation, and scenario writing can be used to
enhance the experience.
When people face a moral problem they sometimes have great difficulties in not
confusing moral goals, values, feelings, and emotions with the problem-solving and
decision-making processes and the methods adopted for the solution of the problem. By
now you know these skills can be learned but require practice, commitment, reflection,
and a continuous cycle of re-examining whether you need to adjust your thinking to
match the ethical demands of a situation. We suggest that a worthwhile goal is to strive to
eliminate any cognitive dissonance so that your behaviors match your values and beliefs.
