Applied Research in Financial Reporting: Text and Cases

1. Applied Research in Financial Reporting: Text and Cases Chapter 9 Ethical Considerations inJudgment and Decision Making in Accounting

2. Presentation Plan • Objectives • Professional Ethics • AICPA’s Code of Professional Conduct • Business Ethics • Ethics Audit Services • Individual Ethics • Ethical Training: The Case Method • Illustrative Case

3. Objectives • AICPA's Code of Professional Conduct and CPA’s responsibilities • Principles, rules, interpretations, and enforcement of the AICPA's Code of Professional Conduct • Definition of business ethics • Various components of a business ethics program

4. Objectives • Corporate ethics audits as an area of assurance about effectiveness of a clients’ business ethics programs • A general framework for individual ethical behavior • A method of measuring individual ethical reasoning • Characteristics of an ethical accountant • A model for analysis of ethical dilemmas

5. Professional Ethics • AICPA’s Code of Professional Conduct: • To serve the public interest in performing the highest quality of professional services • Supported by: • Education • Certification • Licensing • Practice

6. Professional Ethics • AICPA’s Code Components: • Principles of Professional Conduct • Rules of Conduct • Interpretations of Rules of Conduct • Rulings by: • The Professional Ethics Division • Trial Board

7. Professional Ethics • Principles of Professional Conduct (Exhibit 9-1) • Responsibilities • The Public Interest • Integrity • Objectivity and Independence • Due Professional Care • Scope and nature of Services • A problem: Principles are not enforceable

8. Professional Ethics • Rules of Conduct and Interpretations: • 100: Independence, Integrity, and Objectivity • 200: General Standards and Accounting Principles • 300: Responsibilities to Clients • 400: Responsibilities to Colleagues: No longer in force (replaced with peer review in 1988) • 500: Other Responsibilities and Practices

9. Professional Ethics • Rulings by the Professional Ethics Division: • Professional Ethics Division may: • levy automatic penalties (e.g., expulsion) • recommend a course of action (e.g., CPE course) • refer to Trial Board for a hearing • Professional Ethics Division rulings are published in AICPA’s publication: the CPA Letter

10. Business Ethics • Is the profit motive in conflict with ethical conduct? • Two views: Yes and No! • US Sentencing Guidelines • Psychological tendencies in need of correction

11. Business Ethics • Defined: • A management process comprised of programs, management practices, and systems designed to motivate, measure, and monitor the organization's ethical performance

12. Business Ethics Strategies: Code of conduct 208 93.3% Employee training in ethics 99 44.4% Social auditing & reporting 98 43.9% Corporate structural changes 46 20.6% Ethics committees 40 17.9% Ombudsman 17 7.6% Judiciary board 3 1.3% None of the above 2 .9%

13. Business Ethics Components(Exhibit 9-2) Ethical Tone: • Corporate Culture & Climate • Board of Directors • Management Ethical Guidance • Code of Ethics • Training and Development Enforcement • Control Environment • Ombudsman, Officer, Committee, Board • Whistle-blowing • Investigation & Action

14. Ethical Tone: Corporate Culture & Climate • To foster an environment supportive of ethical behavior: • Corporate Culture is • A set of formal and informal understandings that guide employees in their daily conduct • Corporate Climate is • Aggregated employee perceptions of organizational values such as providing warmth and support to colleagues and customers • Ethical climate is a subset of corporate climate

15. Ethical Tone:Board of Directors • The company should have: • A process to select BOD members with reputation for personal integrity • individuals with possible conflicts of interest or undue influence must be disqualified

16. Ethical Tone: Management • The importance of management integrity is recognized in professional standards. • SAS 53 indicates that management is above the controls that constrain employees, or can override them easily -- thus management integrity is important. • Management must exercise constant vigilance and timely intervention to foster the firm's ethical standards (Aguilar, 1994, 95).

17. Ethical Guidance:Code of Ethics • A code of ethics provides a frame of reference • defines areas of ethical concerns • defines core values that are to guide action.

18. Ethical Guidance:Training and Development • Formal training program is needed for: • developing employees' understanding, competence, and commitment with respect to ethical behavior on the job. (Aguilar, 1994, 104) • Similar to any other training program, an ethics training program must have clear objectives to accomplish.

19. Enforcement: Control Environment • Per COSO, 1992, sets: • the tone of an organization • providing discipline and structure integrity • ethical values • competence of ... people • management's philosophy and operating style • the way management assigns authority and responsibility, and organizes and develops its people • and the attention and direction provided by the board of directors.

20. Enforcement: Ombudsman, Ethics Officer, Ethics Committee, Judiciary Board • Ombudsman, ethics officers, ethics committees, or judiciary boards play an important role in the development and enforcement of ethical processes.

21. Enforcement: Whistle-Blowing • The disclosure by organization members of illegal, immoral, or illegitimate practices • "Co-workers who are willing to monitor their peers' behavior and report violations to management represent a potentially important supplemental control resource for organizations." (Trevino & Victor, 1992, p. 38).

22. Ethics Audit Services • An Area of Assurance Services Identified by the AICPA (Elliott & Pallais, 1997) • An ethics audit is similar to the audit performed for ISO 9000 certification and is a "positive confirmation of the existence and effective implementation of best ethical practices." (KPMG, 1996). • Also applicable are a host of SASs (e.g., SAS 78 and SAS 82) • But no SAS directly on Ethics Audits

23. Examples of Ethics Items/Audit Tasks • From Culture & Climate: • Does the client have a positive moral atmosphere ... [i.e., is individual diversity tolerated, encouraged)? (Ponemon, 1994) • From Board of Directors: • Is the board of directors actively involved in the evaluation of management's enforcement of corporate ethical code?" (POB, 1994, 13).

24. Examples of Ethics Items/Audit Tasks • From management: • Assess ethical behavior of management because, "Knowledge that the CEO has 'done the right thing' ethically when faced with a tough business decision sends a strong message to all levels of the organization" (COSO, 1992, 21).

25. Examples of Ethics Items/Audit Tasks • From the Code of Ethics: • Does the code provide guidance on acceptance of gifts from vendors in violation of company policy • From Training and Development: • Does the client have clear cut policies with respect to employee ethics training? (Sears, 1993)

26. Examples of Ethics Items/Audit Tasks • From Control Environment: • Assess organizational structure (SAS 55 Guide, 2.22). • From Ethics Officer: • Does the client have a Report Recipient Office? (Miceli & Near, 1992, p.176) • From Whistle-blowing: • Is anonymity assured? (Miceli & Near, 1992)

27. Individual Ethics • Definition: • The study of what is right in human behavior • Focuses on ultimate goals that ought to be pursued and the actions that ought to be taken to achieve those goals • “Ought to be” has different interpretations based on the ethical principles adopted

28. Individual Ethics • Ethical Principles • “Self-interest”, but not selfishness: not to the point that other people’s interests are unduly harmed • Example: do not trade on insider information because it harms the interest of others • Harm minimization -- “self control” so that physical or psychological harm to others is minimized

29. Individual Ethics • Ethical Principles • Utilitarianism. Optimize public interest: greatest good for the greatest number of people • Universality. Consistency in actions under similar circumstances • Human rights. Justice principle where the freedom and human rights of all others are respected.

30. Individual Ethics • Kohlberg Stage Model of Moral Development (Exhibit 9-3) • Level I - Pre-conventional. Ethics of Convenience and self-interest: • Stage 1: Avoid punishment • Stage 2: Seek personal rewards

31. Individual Ethics • Kohlberg Stage Model of Moral Development (Exhibit 9-3) • Level II - Conventional. Ethics of Conformity: • Stage 3: Group loyalty and acceptance • Stage 4: Belief in obeying the civic or religious laws and professional regulations

32. Individual Ethics • Kohlberg Stage Model of Moral Development (Exhibit 9-3) • Level III - Post-Conventional. Ethics of Conviction: • Stage 5:Commitment to high order principle such as utilitarianism • Stage 6: Commitment to the highest order principles such as justice, duties and equal human rights

33. Individual Ethics • Measures of Ethical Cognition: • Kohlberg’s Moral Judgment Interview (MJI) • Rest’s Defining Issues Test (DIT) • The P-score • Provides norms for various strata of the society (e.g., mean of 31.03 for high school graduates) • Business versus liberal arts students • Men versus women

34. Individual Ethics • Rest’s Model of Moral Behavior: • Component I: Moral sensitivity • Component II: Moral Judgment (or reasoning) • Component III: Moral Motivation • Component IV: Moral Character

35. Individual Ethics • Ethical Training: The Case Method • Identify stakeholders • Identify ethical issues • Identify alternative solutions • Make a decision: Select a preferred solution

36. Antelope Financial: Facts • Explosion of the number and variety of financial instruments in recent years; • A practice known as “gain-on-sale accounting” is used for transactions • Borrowing money at a low rate, and lending at a higher rate and recognize the spread as profit by discounting to present value all scheduled future cash flows for a given sale.

37. Antelope Financial: Facts • Antelope is interested in buying One firm, Put-You-In-Housing Financial (PYIHF). • PYIHF lends to individuals for the purchase of trailer homes, manufactured housing, and small houses • PYIHF has relied on gain-on-sale accounting, securitizing all of its loans for sale, booking profits, and loaning the proceeds to additional customers. PYIHF has over one billion dollars on the books in this manner.

38. Antelope Financial: Facts • As a CFO you are asked to closely inspect PYIHF’s books and report to the CEO • You find high risk of default because • PYIHF’s borrowers have poor credit histories with high rates of default. • The residences are at risk to fire and hurricane due to their small size and construction, yet few homeowners have fire and casualty insurance. • PYIHF has many loans on the books yet to be securitized.

39. Antelope Financial: Facts • You ask that a note be added to the financials and to the SEC Form 8-K, but the CEO disagrees, stating that the board would bar the transaction • What do you do?

40. Antelope Financial: Discussion • Identify Stakeholders • CFO, CEO, Creditors, Stockholders, etc. • Identify ethical issues • Discuss self interest, harm minimization, utilitarianism, universality, and human rights related to each of the stakeholders

41. Antelope Financial: Discussion • Identify Alternative Courses of Action • Agree with acquiring PYIHF, but spin-off bad loans • Difficult given the poor quality of PYIHF’s loans • Report your concern privately to Antelope’s board • CEO will be mad at you for sure • Blow the whistle and resign!

42. Antelope Financial: Discussion • Choose the more preferred option: • The third option, resign, may be preferable under the circumstances • This requires a personal sacrifice, but you have little choice • If you stay and try to spin-off PYIHF’s bad loans and it does not work, Antelope may be in trouble blaming you for it, and perhaps firing you. • If you report to the board, the CEO will be mad at you and may try to make life difficult for you or fire you.