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- Herausgeber: John Wiley & Sons
- Kategorie: Fachliteratur
- Serie: Foundations of Business Ethics
- Sprache: Englisch
A trusted resource on the complex ethical questions that define the accounting profession
An accountant’s practice depends on making difficult decisions. To achieve the best results, individual accountants and accounting firms need a clear understanding of the ethical duties and decision-making involved in the four major functions of modern accounting—auditing, management accounting, tax accounting, and consulting—as well as a strong sense of ethical conduct to guide the certification and validation of reliable financial records.
Now in its third edition, Accounting Ethics is a thorough and engaging exploration of the ethical issues that accountants encounter in their professional lives. Since the publication of the first edition in 2002, Accounting Ethics has become an indispensable resource for accounting courses and certification programs worldwide, known for its focus on real-world application, practical advice, reader-friendly guidance, and its insight into the effects of global change on the profession. Together with coverage of the contemporary regulatory environment—including the Sarbanes-Oxley Act, the Public Company Accounting Oversight Board, and the Dodd–Frank Wall Street Reform and Consumer Protection Act—this revised edition features expanded pedagogical resources such as new end-of-chapter case studies and discussion questions, and includes the updated AICPA Code of Conduct.
Concise and dependable, Accounting Ethics sustains its reputation as an authoritative resource for practicing accountants, new professionals, students of accounting, and those who are considering the profession.
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Veröffentlichungsjahr: 2018
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Table of Contents
Cover
Title Page
Copyright
Preface to the Third Edition
Introduction to Accounting Ethics
Note
Chapter One
: The Nature of Accounting and the Chief Ethical Difficulty
The Nature of Accounting
Ethics of Disclosure
The Financial Statement
Roles an Accountant can Fulfill
Development of Explicit Accounting Standards and Regulations
The Sarbanes–Oxley Act (SOX)
Recent Scandals that Provoked More Regulation
Conclusion
Discussion Questions
In the News
Notes
Chapter Two
: Ethical Behavior in Accounting
What is Ethics?
Ethics: The Intellectual Enterprise
Actions
Social Practices, Institutions, and Systems
Why Study Ethics?
Being Ethical: How to Determine What to Do
Questions to Ask to Justify an Action: The Basis of Ethical Theory
Is the Action Good for Me?
Is the Action Good or Harmful for Society?
Is the Action Fair or Just?
Does the Action Violate Anyone’s Rights?
Have I Made a Commitment, Implied or Explicit?
Using the Reasons
Ethical Dilemmas
Some Classic Moral Dilemmas
Discussion Questions
In the News
Notes
Chapter Three
: Ethical Behavior in Accounting
Egoism
Utilitarianism
Kant and Deontology
Deontological Ethics
The First Formula of the Categorical Imperative
The Second Formula of the Categorical Imperative
Virtue Ethics
Discussion Questions
In the News
Notes
Chapter Four
: Accounting as a Profession
Discussion Questions
Notes
Chapter Five
: Accounting Codes of Conduct
AICPA Professional Code of Conduct
Code Principles
0.300.020.01 – Responsibilities Principle
0.300.030.01 – The Public Interest Principle
0.300.040.01 – Integrity Principle
0.300.050.01 – Objectivity and Independence Principle
0.300.060.01 – Due Care Principle
0.300.070.01 – Scope and Nature of Services Principles
Criticisms of the Code of Conduct
Discussion Questions
In the News
Notes
Chapter Six
: The Rules of the Code of Conduct
Conceptual Framework
Sub-section 100: Integrity and Objectivity Rule
Sub-section 200: Independence Rule
Section 1.300.001: General Standards Rule
Sub-section 400: Acts Discreditable
Sub-section 500: Fees and Other Types of Remuneration Rule
Sub-section 600: Advertising and Other Forms of Solicitation Rule
Sub-section 700: Confidential Information Rule
Sub-section 800: Form of Organization and Name Rule
Responsibilities to Colleagues
Discussion Questions
In the News
Notes
Chapter Seven
: The Auditing Function
The Ethics of Public Accounting
Trust
The Auditor’s Responsibility to the Public
The Auditor’s Basic Responsibilities
Independence
Independence Risk
Professional Skepticism
Reasonable Assurance
Discussion Questions
Notes
Chapter Eight
: The Ethics of Managerial Accounting
Reasons Used to Justify Unethical Behaviors
Blowing the Whistle
Discussion Questions
Notes
Chapter Nine
: The Ethics of Tax Accounting
Discussion Questions
In the News
Notes
Chapter Ten
: Ethics Applied to the Accounting Firm
Accounting as a Business
The Social Responsibility of Business
Good Ethics is Good Business
Ethical Responsibilities of Accounting Firms
The Accounting Profession in Crisis
Discussion Questions
In the News
Notes
Appendix A: Summary of Sarbanes–Oxley Act of 2002
Appendix B: IMA Statement of Ethical Professional Practice
Principles
Standards
I. Competence
II. Confidentiality
III. Integrity
IV. Credibility
Resolving Ethical Issues
Note
Index
End User License Agreement
List of Illustrations
Chapter 6
Figure 6.1 Steps of the Conceptual Framework.
Guide
Cover
Table of Contents
Title Page
Copyright
Preface to the Third Edition
Introduction to Accounting Ethics
Begin Reading
Appendix A: Summary of Sarbanes–Oxley Act of 2002
Appendix B: IMA Statement of Ethical Professional Practice
Index
End User License Agreement
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Foundations of Business Ethics
Series editors: W. Michael Hoffman and Robert E. Frederick
Written by an assembly of the most distinguished figures in business ethics, the Foundations of Business Ethics series aims to explain and assess the fundamental issues that motivate interest in each of the main subjects of contemporary research. In addition to a general introduction to business ethics, individual volumes cover key ethical issues in management, marketing, finance, accounting, and computing. The books, which are complementary yet complete in themselves, allow instructors maximum flexibility in the design and presentation of course materials without sacrificing either depth of coverage or the discipline-based focus of many business courses. The volumes can be used separately or in combination with anthologies and case studies, depending on the needs and interests of the instructors and students.
John R. Boatright,
Ethics in Finance
, second edition
Ronald F. Duska, Brenda Shay Duska, and Kenneth Wm. Kury,
Accounting Ethics
, third edition
Richard T. De George,
The Ethics of Information Technology and Business
Patricia H. Werhane and Tara J. Radin with Norman E. Bowie,
Employment and Employee Rights
Norman E. Bowie with Patricia H. Werhane,
Management Ethics
Lisa H. Newton,
Business Ethics and the Natural Environment
Kenneth E. Goodpaster,
Conscience and Corporate Culture
George G. Brenkert,
Marketing Ethics
Al Gini and Ronald M. Green,
Ten Virtues of Outstanding Leaders: Leadership and Character
John R. Boatright,
Ethics in Finance
, second edition, third edition
Mark S. Schwartz
Business Ethics: An Ethical Decision-Making Approach
ForthcomingDenis Arnold, Ethics of Global Business
Accounting Ethics
Third Edition
Ronald F. Duska, Brenda Shay Duska, and Kenneth Wm. Kury
This edition first published 2018© 2018 John Wiley and Sons Ltd.
Edition HistoryBlackwell Publishing Ltd (1e, 2003), John Wiley & Sons Ltd, (2e, 2011)
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The right of Ronald F. Duska, Brenda Shay Duska, and Kenneth Wm. Kury to be identified as the authors of this work has been asserted in accordance with law.
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Library of Congress Cataloging-in-Publication Data
Names: Duska, Ronald F., 1937– author. | Duska, Brenda Shay, author. | Kury, Kenneth Wm., author.Title: Accounting ethics / By Ronald F. Duska, Brenda Shay Duska, and Kenneth Wm. Kury.Description: Third edition. | Hoboken, NJ : Wiley, [2018] | Includes index. | Identifiers: LCCN 2018003975 (print) | LCCN 2018024964 (ebook) | ISBN 9781119118794 (pdf) | ISBN 9781119118800 (epub) | ISBN 9781119118787 (pbk.)Subjects: LCSH: Accountants—Professional ethics. | Accounting—Moral and ethical aspects.Classification: LCC HF5625.15 (ebook) | LCC HF5625.15 .D87 2018 (print) | DDC 174/.9657—dc23LC record available at https://lccn.loc.gov/2018003975
Cover Design: WileyCover Image: © Daniel Wildi Photography / Getty Images
Preface to the Third Edition
The first edition of this book was sent to press in early November of 2001, just before the Enron collapse had begun to dominate the front pages of newspapers and lead stories of television news shows across America. Yet most of the problems that came to light with an accounting profession in crisis had been documented in the text. The types of problems that the Enron bankruptcy brought to the fore were nothing new. They had been talked about for years, particularly in a particularly prescient book by Abraham Briloff, The Truth About Corporate Accounting, published in 1980 by Harper and Row. Dr Briloff was at the time the Emanuel Saxe Distinguished Professor of Accountancy at the Baruch College of the City University of New York.
Briloff’s critique of the accounting profession helped us gain a focus on the important and salient issues in the ethics of accounting. Consequently the book recognized the chief ethical difficulties facing the accounting profession, and a section of Chapter ten was entitled, “The Accounting Profession in Crisis”, a name not horribly original, but extraordinarily apt given the high profile case of Enron and Arthur Andersen.
Subsequently, we asked the publishers for some time to revise the book to take into account the difficulties in accounting practices that helped contribute to Enron’s demise. Consequently there are references in the text to this most recent, but regrettably not likely the last, case of accounting irregularities.
To aid the reader sort out the facts of Enron’s collapse and Andersen’s role in that collapse, we appended a chronology of stories run in the Wall Street Journal and provided in the Journal’s online edition. Enron and Andersen made a fruitful case study for a great deal of the problems in accounting ethics. However, we removed those stories from the second edition.
Much happened in accounting since the first edition of this work was finished in 2002. In particular in the United States, Sarbanes–Oxley altered the profession and its approaches to ethical problems. It brought about FASB and the Public Accounting Oversight Board, in place of the defunct Independence Standards Board. The financial crisis of 2008 put more pressure on accountants, with claims about the pros and cons of mark to market and fair value accounting taking prominence. In the second edition we added an Afterword, where we discussed the debates over the use of fair value accounting, and principles vs rules based standards. However, we have moved on from that while preserving the section on the responsibilities of accounting firms, since those responsibilities have not changed. They simply must meet new challenges.
In the third edition we have addressed the changes in the AICPA code of ethics and in response to suggestions from people who have used the book in classes on accounting ethics, we have added, as pedagogical tools, questions about the material covered in each chapter, and cases to be discussed. Finally early on we have added an ethical sensitivity exercise that can be used both at the beginning of the book and at the end to determine the degree of one’s ethical sensitivity at the start of the use of the book and whether it has increased at the end.
Introduction to Accounting Ethics
“To preserve the integrity of his reports, the accountant must insist upon absolute independence of judgment and action. The necessity of preserving this position of independence indicates certain standards of conduct. If the confidence of the public in the integrity of accountants’ reports is shaken, their value is gone.”
Arthur Andersen in a 1932 Lecture on Business Ethics
Rosemarie is the new controller for a small construction company, Acme builders. She is new on her job and grateful that the CEO, Peter, has allowed her to go on flex-time to help her take care of her young daughter, who is in day care. Rosemarie is concerned about the collectability of receivables from Fergus Motel, for whom Acme has done extensive work. Rosemarie thinks that the allowance for these receivables must be adjusted. Upon expressing her concern to Peter, she is told that he thinks adjusting for them might put the approval of a much-needed loan in jeopardy. Rosemarie thinks she should account for them, but it seems clear that when Peter said, “Well … do what you think is right”, he was really saying that he expected her to look out for the company and fudge the figures. Should she be a team player and go along with what Peter obviously wants, but didn’t specifically ask for?
John is a fairly young accountant working at a local CPA firm. John is wrestling with a problem. He is trying to decide whether to cover up a mistake made in not attaching an irrevocable election to a client’s recently submitted tax return. If he does not report the mistake he can relieve a significant portion of the tax burden of an important client. John thinks taxes are unfair anyway, and that his obligation to his client is to look out for the best interest of the client and save him from paying as much tax as possible. John also knows that keeping the client is important for the financial health of the company. Do you think most accountants would cover such a mistake? Would they be justified in covering such a mistake?
Leo is a senior accountant who has been assigned to the audit of a closely held corporation, CHC. Leo discovers that CHC’s income has been materially misstated, probably due to what appears to be a cutoff error, but possibly has been misstated deliberately. Leo takes the information to Adele, the audit manager. The work on the audit has already taken significantly longer than was projected in the budget, and investigating the misstatement would involve too much time. Besides, there are no tax implications due to the mistake, and the managing partner, who is also negotiating a consulting contract with CHC, is pressuring Leo to get the files to him as soon as possible. Adele tells Leo not to mention the adjustment in the working papers, because she sees no tax implications. No harm, no foul. Should Leo follow Adele’s “advice”, or does he have a responsibility beyond that to work for the benefit of the client?1
Situations such as those portrayed in these scenarios happen every day in the world of accountants. They raise ethical concerns that are typical of those that face accountants, whether they are management accountants, tax accountants, auditors, valuation specialists, or accountants performing any number of other accounting activities.
Such situations occurred long before the now infamous Enron bankruptcy case, in which the auditors and consultants from the accounting firm of Arthur Andersen came under criticism for not appropriately carrying out their responsibilities as accountants. In one instance Arthur Andersen, functioning in the role of outside auditor, failed to detect and/or disclose financial transactions wherein Enron shifted assets to a special purpose entity, which allowed the value of the company to look to be worth significantly more than it was. While defenders of Arthur Andersen declared such activity was within the law and generally accepted accounting principles, critics claimed that accountants are obliged to do more.
We have seen the outcome of the Enron/Andersen case with the demise of both Enron and Andersen and passage of Sarbanes–Oxley and the institution of the Public Company Accounting Oversight Board, but it is important to remember that the Enron/Andersen case did not present new ethical difficulties. It simply brought to light ethical questions that had been simmering for well over a quarter of a century, and unfortunately continue to simmer. Enron/Andersen, because it involved billions of dollars and affected so many people’s lives, brought to light in a dramatic fashion the ethical difficulties accountants face. The Enron/Andersen case, and each of the scenarios above raise the ethical questions: What is the appropriate behavior for accountants? What are accountants supposed to do? What are their responsibilities?
The scenarios, ironically, raise another important point. If you look at the citation, you will see that the scenarios were developed for a business ethics program sponsored by none other than the Arthur Andersen firm. It was a project that brought together leading thinkers of the business ethics community to develop teaching tools to be used in college courses on business ethics. The company was dedicated from its inception to doing the right thing. Arthur Andersen had the reputation from his earliest days in Chicago for being a person of impeccable integrity.
What went wrong with his company is a story written many times from many perspectives. From our perspective there are two main reasons. One is on the individual level. Accountants, at least the Houston offices of Andersen, did not do what they were supposed to do. They made the common mistake of many auditors who think their main obligation is to please the client who hires them. Rather, as we will try to show, accounting has a public purpose. It needs to serve the public good first. We will discuss this at length in the book. The second problem is that the company gave in to the systemic temptations that regularly beset the accounting firms, particularly the large firms. Firms, or the human beings who run them, are susceptible to incentives. We get what we reward. As an auditor, Arthur Andersen had a clear mission, to attest that the financial statements they were auditing reflected what was really going on in the company. However, that mission was shunted aside in the name of fees.
A venerable firm like Andersen, at one time, prided itself in its role as auditor. As an auditing firm it filled an important public function. However, as the large accounting firms grew, they forgot their main function and began to expand. What was the purpose of their expansion? To do consulting. Why? To bring in more profits. There was little reflection on how this consulting impacted on the primary function and responsibility of the auditing firm. There was little speculation about how reliance on consulting fees might impact auditing. It is clear what the responsibilities of an auditor are. However, if consulting brings more profit than auditing, human nature being what it is, the pressure will be there to do those things which enhance our income stream by doing more consulting. If we maintain our consulting work by pleasing our customer with soft auditing, so be it. Individuals and systems are much alike. They both give in to temptations. Hence any serious treatise on ethics needs to look at the pressures put on individual accountants and their firms by the systems in place, and the rewards of the system to determine whether they are aligned with the purposes of the system. These are the major concerns we will try to address in this book on accounting ethics.
Ethics is an overarching human concern that covers all areas of life. In this book we will examine how it is applicable and relevant to this one corner of human activity, accounting. Accounting as a human activity has an ethical dimension, for ethics is involved in all human activity. Human activity is precisely the kind of thing for which one is held responsible; it is activity which is done deliberately which one can control. It is also activity that helps or harms either oneself or others, or that is deemed to be either just or unjust, right or wrong. But to understand fully the ethical dimensions of accounting we will need to examine where and how the activity of accounting fits into the larger scheme of human activities.
We will examine in what way accounting is both an essential practice and a vital profession in the economically developed world of today. It is an essential practice because the current economic system could not exist without it. Business and the market, as we know it, would grind to a halt if there were no way to account for the existence and disposition of the wealth and goods of the world. For financial markets to function efficiently it is necessary to have transactions based on accurate portraits of the financial worth of any entity being traded. Those portraits are painted by accountants. Power relationships, property rights, ownership claims, valuations, receivables, and debts are all mental social constructs that define who owns what and owes what to whom. All of these constructs are identified and tracked by accountants and bookkeepers.
Because of this essential role in tracking the indeterminately large nexus of complicated financial relationships in the economic world of today accounting developed into a service profession. We will examine the nature of the accounting profession from the perspective of the general ethical responsibilities that accrue to professionals, as well as from the perspective of the specific responsibilities that arise from being a professional accountant.
To cover all the areas and activities engaged in by accountants that have an ethical dimension would require an inordinately large book. This book will concentrate on what we see as major areas of concern for the ethics of accounting.
Determining, examining, and evaluating the purposes of activities or practices is one of the major tasks of ethics. This approach to ethics is a functional one and involves an evaluation of a function or purpose. For example, if we take a functional approach to a knife we see that a knife has a basic purpose or function – to cut. It is considered a good knife, with respect to its basic function, if it cuts well, and if it is a dull knife which does not cut sharply, it is not a very good knife. But we can also analyze whether the function itself is a worthwhile activity. Whether cutting is worthwhile depends on what is being cut and why, that is, the purpose for which the activity is carried on.
Every activity is either done for its own sake, in which case it is called intrinsically worthwhile, or it is done for the sake of something else, in which case it is instrumentally worthwhile. Cutting is an instrumental activity for the sake of something else, and it is judged as worthwhile or not depending on the purpose for which it is done. A good knife can be used to cut up food, or it can be used to kill human beings.
Accounting, being a practice and an activity, is done for some purpose. Thus, we can determine whether an accountant is acting well if he or she is fulfilling their purpose: to render accurate portraits of a financial entity. But we can ask the larger question: Why is this activity of creating financial portraits being carried out? What is this practice to accomplish? So accounting as an instrumental activity can also be judged on the basis of the purpose for which it is used. It is important in this context to remember that the clever accountant can hide assets as well as disclose them.
Providing accurate financial pictures of business activities, which is the primary activity of an accountant, is an instrumental activity because it provides a necessary service for those who need that information to engage in financial decision making. While instrumental activities can be viewed as noble activities when they provide great benefits to human beings, they can also be instrumental in bringing about great harm. Accounting and the skills of the accountant can be utilized to do great harm to society if the purposes for which the information is used are harmful or illegal. For example, an accountant for organized crime, or an accountant for the Nazis are providing a useful service for their clients, but their clients corrupt that service by putting it to use for evil purposes or ends. But accounting is not simply limited to business activities. The Congressional Budget Office utilizes accounting principles to determine the costs of pending legislation. The members of congress need accurate pictures of true costs.
Hence we judge the purpose of accounting, which is to provide information of economic affairs, as a laudable purpose. Having done that, though, we need to judge the skilled accountant from the perspective of the use to which his or her accounting skills are put. If it is a noble purpose, to keep a worthwhile business or social entity functioning well it will be lauded. If it is a malicious purpose, to cheat the public out of legitimate tax burdens it will be condemned.
With those goals in mind the book will start, in Chapter 1, by briefly examining the history, nature, and purpose of accounting. Accounting is the invention of human beings and, consequently, the result of human conventions. That being the case, it will be helpful to examine the history of how accounting came to be. Financial activities are necessary for survival in our present world, and because accounting helps facilitate these activities, it is usually a beneficial activity. Still, accounting can be misused to benefit some at the expense of others, to deceive and to defraud others. At such times the accounting might be done well, but the practice and skills of the accountant are denigrated by their unethical use.
After examining the nature of accounting, we will turn our attention to the question: What is ethics? We will examine current ethical theories to show how they can be applied to accounting today. In that discussion we will examine both the ethics of purpose as well as the ethics of relationships. We devote Chapters 2 and 3 to a discussion of this question, detailing not only what we have alluded to above as the ethics of purpose, but also to another aspect of ethics, the ethics of relationships. Ethics is about pursuing the good but it is also about fidelity to ethically acceptable relationships.
A crucial relationship is that of a professional toward his or her clients. Since accounting is a skill demanding expertise, and since accountants have clients who depend on that expertise, accounting can be included among the professions. We will try to show in Chapter 4 why the fact that accounting is a profession invests accounting with an ethical dimension. We will look at the characteristics of professionalism and the notion of agency that is involved in any profession. We will show that being a professional puts obligations upon the accountant to look out for the best interests of various constituencies, from the client to the company to the general public.
Accountants, as professionals, have developed various codes of ethics which stipulate the rules accountants themselves lay down if one is to be an accepted member of a profession. We will examine in Chapters 5 and 6 the American Institute of Certified Public Accountants (AICPA) code of ethics since it is the most extensive code and probably representative of most other codes. We will attempt to show the ethics and ethical standards that code puts forward.
After those considerations we will examine specific ethical issues involved in what seem to be the three major functions of the accountant today.
Auditing. What are the ethical issues involved in auditing? In Chapter 7 we will pay particular attention to the conflict of interest problems that arise for public auditors. The question of the responsibility of auditors, and to what extent they need to be independent and avoid conflicts of interest, became a commonplace question in the daily news because of the Enron/Andersen situation. Public policy debates raged about what sorts of limits should be put on auditors in order to assure they perform their function well. The effects of Sarbanes–Oxley on the auditing profession were discussed ad nauseam. We will look at the nature and purpose of auditing and see what responsibilities that function entails.
Management Accounting. External auditors of course function as the watchdogs who examine the financial statements prepared by internal accountants and internal auditors. What are the responsibilities and limits of one doing internal audits, or preparing financial statements for companies to be used by management, and perhaps to be used by other external constituencies? Is the management accountant’s primary responsibility to the company or to the general public? We explore all these issues in Chapter 8.
Tax Accounting. Chapter 9 addresses the responsibilities faced by the tax accountant? How aggressive are they to be in being an advocate of their clients in the face of legitimate government tax requirements?
Finally, after examining these major functions of the accountant, in Chapter 10 we will look at the social responsibilities of accounting firms, examining how the changing world of the financial services and increased competition have changed the nature of the accounting profession and the companies where accountants find their home. It is our hope that this book will aid at least in some small way the understanding of the ethical responsibilities of accountants as well as aid in improving some accounting behavior.
Note
1
These scenarios are adapted from Arthur Andersen and Co.’s
Business Ethics Program: Minicase Indexes
, 1992.
Chapter OneThe Nature of Accounting and the Chief Ethical Difficulty: True Disclosure
In October 2001 Enron began to collapse as a company. On October 16, 2001, Enron took a $1.01 billion charge related to write-downs of investments. Of this, $35 million was attributed to partnerships run by CFO Andrew Fastow. According to The Wall Street Journal, Enron disclosed that it shrank shareholder equity by $1.2 billion as a result of several transactions, including ones undertaken with Mr. Fastow’s investment vehicle. Arthur Andersen was Enron’s auditing firm. On June 15, 2002, Andersen was convicted of obstruction of justice for shredding documents related to its audit of Enron, resulting in the Enron scandal. The United States Securities and Exchange Commission (SEC) does not allow convicted felons to audit public companies. The accounting firm agreed to surrender its CPA licenses and its right to practice before the SEC on August 31, 2002, putting Arthur Andersen out of business in the United States. These two companies will be tied together in financial history as an illustration of scandalous ethical behavior.
Since then there have been numerous accounting scandals. In 2002 WorldCom inflated sales by as much as $11 billion and Tyco’s CEO and CFO inflated company income by $500 million. In 2003 Health South inflated earnings numbers by $1.4 billion. In 2003 $5billion in earnings were misstated at Freddie Mac. In 2005 AIG engaged in accounting fraud of $3.9 billion. In 2008 at Lehman Brothers, the accountants disguised $50 billion in loans disguised as sales. In 2009 Satyam falsely boosted revenue by $1.5 billion. And those are just a few.1
The Enron/Arthur Andersen collapse in 2001 − 2002 was probably a watershed moment in the history of accounting. The problems, practices, conflicts, and issues that led to the collapse were not new and as we have seen still have not been overcome. Even before Enron, there were problems and shoddy practices. In an article from The Washington Post in 1998, then SEC chairman Arthur Levitt, Jr., called attention to what he dubbed a “numbers game” in which companies manipulate accounting data to produce desired results. These results range from “making one’s numbers” – meeting Wall Street projections – to smoothing out quarterly results to produce a steady run of increases. According to Levitt, “This process has evolved over the years into what can best be characterized as a game among market participants.”
How could this happen? We would claim that either the accountants did not understand their purpose in society, or that they deliberately avoided fulfilling that purpose. The purpose of accounting is fairly simple – to make sure that the portrait the company’s accountants paint in the financial statements is as accurate as possible. According to Albert B. Crenshaw in an October 1999 article in The Washington Post, companies try to “game the numbers” in order to meet the pressures of quarterly earnings projections.2 It is our contention throughout this book that the fundamental ethical obligation of the accountant is to do his or her job. But what is the primary job of the accountant? To get clearer about what that job is, we need to look more closely at the nature and purpose of accounting. It should be noted that accounting is, in a sense, what ancient Greeks called an ethos, by which we mean a custom or convention. Accounting was a human convention developed to do certain things. To understand of what those activities consist, we need to examine more thoroughly the nature of accounting.
The Nature of Accounting
Accounting is a technique, and its practice is an art or craft developed to help people monitor their economic transactions. Accounting gives people a financial picture of their affairs. Its original – and enduring – fundamental purpose is to provide information about the economic dealings of a person or organization. Initially, only the person or organization needed the information. Then the government needed the information. As the economy got more complex and regulated, the number of those who needed the information – the number of users of economic statements – increased. The extent of the importance of the information to the user increased the ethical factors governing the development and disbursement of that information. Some people have a right to the information; others do not.
The accountant provides information that can be used in a number of ways. An organization’s managers use it to help them plan and control the organization’s operations. Owners and managers use it to help them appraise an organization’s performance and make decisions about its future. Owners, managers, lenders, suppliers, employees, and others use it to help decide how much time and/or money to devote to the organization. Finally, government uses it to determine how much tax the organization must pay.3 Hence, the accountant’s role is to furnish various entities that have a legitimate right to know about an organization’s affairs with useful information about those economic affairs. That useful information is owed to those various entities, and the accountant has an obligation to provide as true a picture of those affairs as possible.
Accountants issue financial statements that a range of constituencies – from company management, to tax agencies, to potential investors – need to access. Those statements, which are expected to give a reliable and useful picture of the organization’s financial affairs, are made within the guidelines developed by the profession itself. The accounting practice rests on what the Financial Accounting Standards Board of the Financial Accounting Foundation calls a conceptual framework:
The conceptual framework is a coherent system of interrelated objectives and fundamentals that is expected to lead to consistent standards and that prescribes the nature, function, and limits of financial accounting and reporting. It is expected to serve the public interest by providing structure and direction to financial accounting and reporting to facilitate the provision of evenhanded financial and related information that helps promote the efficient allocation of scarce resources in the economy and society, including assisting capital and other markets to function efficiently. (Italics added.)4
For financial markets to work well, stock analysts and investors need to get a “true picture” of a company. The very notion of a “true” picture, however, presents some problems, for there are any number of ways to look at the economic status of an organization, and in reality several pictures of a company can be developed. Often, the picture an accountant develops may serve the interest of the party who hires the accountant more than other need-to-know parties. Depending on the techniques used, a corporate accountant can make an organization look better or worse. For loan purposes, it can be made to look better. For tax purposes it can be made to look worse. We will return to the issue of the true picture later. For now we ask: What kinds of pictures are there? What kinds of financial statements do accountants produce?
There generally are four components of financial statements:
balance sheet;
income statement;
statement of changes in retained earnings;
statement of changes in cash flow
The balance sheet has three elements: (i) assets – the tangible and intangible items owned by the company, (ii) liabilities – the organization’s debts, involving money or services owed to others, and (iii) owners’ equity – funds provided by the organization’s owners and the accumulated income or loss generated over years. The total assets, of course, equal the total liabilities plus the owners’ equity. Owners’ equity equals the total assets minus the total liability. Liabilities equals the total assets minus owners’ equity. These alternative views of the equation indicates how assets were financed: by borrowing money (liability) or by using the owners’ money (owners’ equity).
Developing such statements is where the art and craft of accounting comes in, for it requires skill, judgment, use of the appropriate technique, and the application of principles to determine what counts as assets and liabilities. Sometimes, the assets and liabilities are clear; at other times, they depend on the accountant’s judgment which, for better or worse, can be influenced by the pressures of the situation. As with all general principles, however, there are simply times when the principles used don’t fit the situation and individual judgment is required.
For example, T. Rowe Price’s manager, Richard P. Howard, says that many accountants’ way of looking at companies is out of sync with modern markets, which focus on a company’s earnings rather than its asset value:
One of the problems that accountants have is that they’re still working on the theory that the balance sheet [the statement of assets and liabilities] is sacrosanct. So they err on the side of writing down assets. They think that they’re being conservative, but that’s wrong.5
Howard points out that writing down assets – reducing their value on the company’s books – actually results in aggressive statements of profit:
For example, if you write down the value of a plant, you take a one-time hit, but in future years the depreciation that would be assigned to the plant, and that would be subtracted from earnings, is reduced or gone, so earnings are higher. And as equity is reduced, the same amount of income produces higher return on equity.6
Assets and liabilities can be classified as either current or noncurrent. Noncurrent assets and liabilities are noncurrent receivables and fixed assets such as land, buildings, and long-term investments. Current assets include cash, amounts receivable, inventories, and other assets expected to be consumed or readily converted into cash in the next operating cycle. Hence, the owners’ equity is divided between common or preferred stock, paid-in capital, and retained earnings, where common stock is the set dollar per share, paid-in capital is the premium paid for the stock (shares), and retained earnings is the amount earned/lost in the past and dividends distributed to owners. But what is “expected” to be consumed or converted into cash? Such items can be manipulated or at the least reported in any number of ways to determine what the owners’ equity is.
The income statement shows net income (profit) when revenues exceed expenses and net loss when expenses exceed revenues. The statement of changes in retained earnings explains the changes in those earnings over a reporting period: assets minus liabilities equal paid-in capital and retained earnings. The statement of changes in financial position identifies existing relations and reveals operations that do or do not generate enough funds to cover an organization’s dividends and capital investment requirement.
Because, as we noted, preparation of these statements allows great leeway in what to take account of and what not, as well as where to put things in presenting the statements, opportunities abound to paint different pictures of an organization’s financial affairs. It takes little imagination to envision a manager who, for fear of his job and wanting to impress his board, puts pressure on the managerial accountant to “cook the books” so that retained earnings look much more substantial than they are. But cooking the books and “creative accounting,” as the terms suggest, clearly have an unethical element and are activities that must be examined under the ethics of truth telling and disclosure. More recently, “aggressive accounting” and “pro-forma accounting” are euphemisms, at least in some cases, for presenting pictures of a company’s financial situation that, while not deceptive, are less than candid.
Ethics of Disclosure
The ethics of truth telling and disclosure is a complicated issue for the accountant. Why and to what extent is the accountant ethically obliged to disclose a true picture? Is there such a thing as a true picture? To discern the principles that will help to answer the first question, we will reflect for a moment on three things: first, how accounting is involved in an exchange that encompasses selling; second, how exchange and selling are market transactions; and third, what lack of disclosure in market transactions has in common with lying.
Accounting is developing information that is going to be used. If the use of the information is benign and the information is truthful, no ethical problems arise. But if the information persuades people to act in one way or other, and their action either benefits or harms the persons giving or getting the information, this information giving takes on ethical importance. Depending on the use, giving out information can be very much like selling. For example, the CEO is “selling” the board or the stockholders on the soundness of the company’s financial situation. His bonus might be tied to how rosy a picture he paints. The worth of the CEO’s stock options rests on the financial picture. He may sell the IRS a different picture of the company, and sell still a different picture to potential investors or lenders. Because accounting entails presenting the product to be sold, it enters into and influences market transactions.
In the ideal market transaction, two people decide to exchange goods because they hope the exchange will make both better off. In a market exchange, nothing new has been produced, but the exchange is beneficial to both people. Ideally, there is perfect information about the worth of what is being given and received in return. Such a trade, freely entered into with full information, should maximize satisfaction on both sides. That is the genius of the market and the defense of our free market system – freedom of exchange that leads to the overall improvement of the trader’s lot.
If, however, one of the parties is misled into believing a product is what it is not because the product is misrepresented, that misrepresentation undermines the effect of both sides being better off. Deception usually leads to the deceived party’s getting something different and less valuable from what he or she expected. The deceived party most likely would not have freely entered into the exchange had that party known the full truth about it. The bank would not have made the loan, the public offering of stock would not have been so successful, the CEO’s bonus would not have been so large, if the true picture of the company had been available.
Thus, the conditions for an ideal market transaction include the freedom or autonomy of the participants and full knowledge of the pertinent details of the product. Both conditions are required for what is often called informed consent. Consent cannot be presumed if a party is either forced into an exchange or lacks adequate knowledge of the bargained-for product. It might even be said that a choice based on inadequate information is not a choice at all.
It is important to note that lying is not synonymous with saying something false. Sometimes people simply make a mistake or inadvertently misspeak. In that case, they say something false, but their action can hardly be construed as lying. Telling a lie involves more than simply getting things wrong and not telling the truth. The essence of lying is found in its purpose, which is to alter another’s behavior. Lying involves deliberately misrepresenting something to another person to get that person to act in a certain way, a way the liar suspects the person would not act if that person knew the truth. We can characterize lying, therefore, as an attempt by one person – usually through spoken or written words that are untrue (lying can also be accomplished with gestures or looks) – to get another person to act in a way that person would probably not act if he or she knew the truth. Misrepresentation or lying can thus be defined as a deceptive activity meant to evoke a certain response that would not have occurred if the truth were told. Simply put, we lie and deceive others to get our way. If Enron officials misrepresented the company’s financial health to their employees to persuade them to hold on to their stock in order to keep the value up so the officials could cash their own stock options at an inflated price, the officials did so, realizing that if the employees had known, they probably would have sold their shares, thereby deflating the value of the stock even more.
If we apply the notion of lying to an activity in which we paint a false picture of an organization’s affairs to change a prospective investor’s view of the company’s financial health, we misrepresent the state of the organization to get the investor to do what we think he wouldn’t do if the investor had a true picture. Viewed from this perspective, a deceptive sale is an activity whose goal is to induce the buyer to do what the seller thinks the buyer probably won’t do if the buyer knows the truth. From an economic point of view, such behavior violates the ideal market principle of free exchange based on perfect information. But more important, from a moral point of view, in getting the buyer to do other than the buyer would, the seller takes away the buyer’s real choice in the situation and thereby uses the buyer for the deceiver’s own ends thereby harming the buyer. Such use, as we will see in the next chapter, is unjust and immoral and often called exploitation or manipulation.
We recognize that we shouldn’t lie because people will not trust us if we do. That is true, but it is a somewhat self-centered reason for not lying. From a moral perspective, the primary reason for you not to lie is that it subordinates another to your wishes without the other person’s consent, for your benefit without concern for the other person. It violates the rule, a version of the Golden Rule, which says, “Don’t do to others what you wouldn’t have done to you.” You want to know what you are getting when you buy something. So does everyone else.
Does failure to disclose information fit these considerations? Some would say that not disclosing isn’t lying; it’s just not telling. But that misses the point. Any action of deliberately withholding information, or coloring information to get others to act contrary to the way they would if they had true information, has the same deceptive structure and consequence as an overt lie. It doesn’t allow an informed choice.
But how much must the accountant disclose? Must the accountant disclose everything?
It is an accepted principle of effective salesmanship (not to be confused with ethical salesmanship) not to say anything negative about the product the salesperson is selling and certainly not to disclose shortcomings unnecessarily. A manager selling the worth of his company to a bank where he hopes to obtain a loan is in much the same situation. How many of the company’s “warts” must the manager expose to the bank? What is the accountant’s obligation in this situation? There are pictures, and there are pictures. Is the obligation in business more stringent that the obligation in private affairs?
As an example, if you are selling your home, is it necessary to point out all the little defects that only you know? There are, after all, laws that require disclosure of some things. Are you ethically obliged to go beyond the law? If you do, you might succeed in discouraging every prospect from buying your home. Job applicants, as another example, need to sell themselves. Should they point out their flaws to their potential employers? No job counselor is likely to suggest that.
The questions arise, therefore, about how much a party needs to disclose and to what extent failure to disclose can be construed as market misconduct. Certainly, some failure to disclose is wrong, but how much must be disclosed? The above characterization of lying should help us decide. Whenever you are tempted not to disclose something, ask yourself why. If you are withholding information because you fear the person won’t act as you wish that person would if he or she knew the whole story, you are manipulating.
Some might argue that if a person doesn’t benefit from a nondisclosure, as in some social occasions, it is not lying. For example, when your friends ask how you are, you don’t have to disclose that you feel miserable. They probably don’t want to hear it. Or when your coworker asks you if she looks okay, you don’t have to say, “You look terrible, like you just crawled out of bed.” That kind of social nondisclosure is acceptable because you are not trying to change another’s behavior to benefit personally from it. Hence, if you shade the truth for some reason other than manipulating the behavior of the person to whom you are talking, it may not be wrong. This is what we call a “white lie.”
Nevertheless, a caveat is in order. Paternalism – the desire to help, advise, or protect that may neglect individual choice and personal responsibility – may be involved in such social situations. There also may be many assumptions, perhaps false, about what the other person wants or needs. It is not clear that social nondisclosure is a totally harmless activity.
But to return to our main point: it may be difficult in some situations to decide how much to disclose. The accountant must at least meet the disclosure requirements of governing authorities. What sort of disclosure and auditing requirements do accountants produce? The disclosures occur in the financial statement. Let’s turn our attention to that aspect of accounting.
The Financial Statement
The Securities and Exchange Commission (SEC) oversees financial statements of corporations. The financial statements are prepared by the company’s own accountants. Outside accountants audit the financial statements. (In the United States, certified public accountants execute the audits. In the United Kingdom and its affiliates, chartered accountants perform the audit function.) Accountants certify that the companies’ financial statements are complete in all material aspects and the figures have been calculated through the use of acceptable measurement principles.
The most common measurement principles are generally accepted accounting principles (GAAP). Those principles are supervised by the Financial Accounting Standards Board (FASB), not the SEC, which does have the statutory authority to set financial accounting and reporting standards for publicly held companies under the Securities Exchange Act of 1934. Throughout its history, SEC’s policy has been to rely on the private sector to set standards. In the United States, much of this is now under review, given some of the shortcomings of the regulatory system that surfaced during the Enron/Andersen investigations, and self-regulation has been superseded by the Public Company Accounting Oversight Board (PCAOB).
But even with adherence to GAAP, problems of disclosure arise. Take, for example, the problem of determining and disclosing asset value. Asset measurement presents a problem because it can be based on what assets cost or on what assets could be sold for now. It can be manipulated in other ways, too. For example, according to a 1994 report by Howard M. Schilit in Business Week, Heilig-Meyers Company’s books showed that the company included installment sales in revenues before sales were final. Now such a practice is perfectly legal and in accordance with GAAP, but according to Schilit, such accounting policies “may distort the true financial condition” of the company.7
So what is asset value? Asset value is the value to the owners or what the company would be willing to pay the owners, which can be determined by what the company expects to be able to do with the asset. Asset value depends on three factors: the amount of anticipated future cash flows, the timing, and the interest rate.
Asset value can also be determined by the amount the company could obtain by selling its assets. This determination, however, is rarely used because continued ownership of an asset implies that its present value to the owner is greater than its market value, which is its apparent value to outsiders. (Such a formulation enters into values beyond monetary, even including possible ethical values.)
In addition to asset value, there is asset cost. Most assets are measured at cost because it is difficult to verify forecasts upon which a generalized value system would have to be based. The historical cost of an asset equals the sum of all the expenditures the company made to acquire it. This, obviously, is sometimes difficult to determine.
Consequently, with so much latitude in establishing the value of an organization’s assets, the financial and economic picture can be skewed in any number of ways. Thus, it is important from an ethical standpoint to determine (i) who the financial picture is being created for and for what purposes, (ii) who has the right to the picture and for what purposes, and (iii) what is to be done when different pictures benefit different parties at the expense of other parties entitled to those pictures.
For example, should the financial picture developed for the IRS show less in assets and earnings than the picture developed for a prospective financier? Should those two pictures be different from the one developed for the board or the stockholders? Further, should the 10 K form reflect merely the quantitative picture of the company, or should it point out the red flags and trends that will affect an organization’s operations in the next business cycle?
Finally, to complete our discussion of the financial statement, we need to highlight some of the chief concepts and techniques that accountants utilize:
Net income
. Net income indicates the change in a company’s wealth, during a period of time, from all sources other than the injection or withdrawal of investment funds.
Transactions approach
. This approach recognizes as income only those increases in wealth (that can be substantiated) from data pertaining to actual transactions that have taken place with persons outside the company. The approach does not recognize, for example, the wealth that a service company gains by hiring a dynamic new employee who will produce salable commodities.
8
Recognition of income
. This involves revenue estimates and expense estimates. The accountant needs to estimate the percentage of gross sales, recognizing that for some goods payment will never be received. Expense estimates are based on historical cost of resources consumed. Thus, net income equals the difference between value received from the use of resources and the cost of the resources consumed in the process.
Historical cost less depreciation
