Ethics in Accounting

Ethical Decisions in Accounting Alfonso Oddo Niagara University

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Ethical Decisions in Accounting Learning Objectives After studying After studying this module you should be should be able to:

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Understand the importance of ethics of ethics Know the history of ethics of ethics in accounting Incorporate ethics into your decision process Know ethical standards for accounting professionals Understand ethical implications of the of the U.S. transition to IFRS Appreciate lessons learned from recent business scandals

© 2010 John Wiley and Sons, Inc.

SECTION 1 — The Importance of Ethics Ethics is an important part of your accounting education and it will play an increasingly important role in all aspects of your professional life. This module is intended to give you an overview of the study of ethics. It is a starting point for the discussion of ethics that will continue throughout all of your accounting studies. We will begin with a definition of ethics and then review some ethical theories that provide a framework for developing ethical standards for accounting students and professionals. Finally, we will discuss why ethics is important to you as you prepare for a career in accounting. Definition of Ethics

What exactly is ethics? According to Webster’s Dictionary ethics is “a discipline dealing with good and evil and moral duty, and with moral principles and practice.” Accounting ethics basically involves applying moral principles to accounting and business decisions. Business ethics is a more general form of applied ethics that relates moral principles to business situations. Business ethics examines behavior toward the outside world considering ethical principles and business codes of ethics. Simply put, ethics is doing the right thing. It is not easy to define ethics because ethics can be different for different people. You have your own personal values and these values are very important in the decisions you make. When you are in business you will be required to follow codes of conduct that are established by your company and by any professional associations that you belong to. Following the ethical standards of these organizations is important, but you should always bring your own personal values into your business model. Ethical Theories

Philosophers have developed many theories to provide a framework for making ethical business decisions. These theories provide a point of reference for developing codes of conduct for companies and professional associations. Most ethical codes in business are based on the following moral theories: Rights theory . The moral choice is the choice that best protects and respects the moral rights of those involved with a decision. This theory suggests that humans have a dignity that is based on their human nature and their ability to freely choose what they do with their lives. Therefore they have a right to be treated as ends and not merely as means to other ends. •

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Utilitarian theory . The ethical action is the action that provides the most good or does

the least harm. The ethical business action is the one that produces the greatest good and does the least harm for all who are affected— business stakeholders such as customers, employees, shareholders, the community, and the environment. 3

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Common good theory. The relationships of society are the basis of ethical reasoning

and respect and compassion for others is the basis for moral decisions. This theory addresses the common conditions that are important to the welfare of everyone. •

Virtue theory. Ethical actions should be consistent with ideal virtues that provide for

the full development of humanity. Honesty, courage, compassion, generosity, tolerance, love, fidelity, integrity, fairness, self ‐control, and prudence are examples of virtues. •

Fairness theory. Ethical actions treat all human beings fairly based on some standard

that is defensible. We might pay people more, based on the difficulty of their work or the greater amount that they contribute to a company. Importance of Ethics

Information provided by accountants and auditors is relied upon by people who make decisions about companies and organizations. For example, if you are considering buying stock in a company you need accurate and reliable information upon which you can base your decision. Lenders such as banks and financial institutions need reliable information to determine if they will loan money to companies. Government agencies such as the Internal Revenue Service collect taxes based on the financial information provided by companies. People rely on the accountants who prepare financial reports. Knowledge of ethics will help you to make good decisions that will give proper information to those who rely on you. With proper information, better decisions will be made. Business decisions can affect many people or stakeholders. For example, when you make a decision for your company it can affect the owners and employees of the company, banks who provide resources to the company, customers of the company, and people in the community where the company is located. In addition to the effect of your decision on the profits of the company, your decision may also have other non‐financial factors that have important effects on stakeholders. What if you were considering two alternative projects for your company: (1) a project that would make significant profit for your company and also pollute the environment with harmful chemicals; (2) another project that would earn less profit but would have no negative effects on the environment and would not harm any stakeholders. Which project would you choose?

Should non‐pecuniary factors enter into the decision process? If you consider factors that are not fiscal‐only in nature, then how do you measure them? Often, the most important factors in a decision are the ones that cannot be easily measured. Because some things cannot be measured easily, however, does not mean that we should not consider them in our decisions. 4


That is the main point about the importance of ethics in accounting—an awareness that ethics is an important part of business decisions. We often use the cost‐benefit decision model to evaluate business projects. We list the costs on one side and the benefits on the other side and the greater number often decides the project. If the benefits are greater than the costs we accept the project; if the costs exceed the benefits the project is rejected. Where does ethics fit into the process? Ethical issues deserve a place in the cost‐benefit model. It is really quite simple—you consider the possible costs and benefits of ethical issues and place them on the scale along with other costs and benefits. Because ethical issues often are difficult or impossible to measure does not mean that they are not important or that they should not be considered in the decision. A more ethical decision is likely to result if ethical factors are at least brought into the picture when making business decisions. Again, awareness of the ethical implications of business decisions is the key to good business decisions. Not all decisions use the cost benefit model. Some decisions involve choosing different courses of action, such as recording accounting transactions when different alternatives are available under generally accepted accounting principles. You will need to choose the correct action according to the circumstances involved, and not based solely on the amount of profit your company can make. As the U.S. moves toward adopting international accounting standards, the accounting guidance will be based more on principles than on specific rules. The use of judgment will likely play a more prominent role in making accounting choices and ethical principles will play an even more important role in business decisions.

Discussion Questions 1. Soon you will graduate from college and get a job. What ethical codes of conduct will you have to follow? How will your personal values affect your business decisions? What penalties are there for failure to follow ethical standards? 2. Look at the ethical standards of the AICPA or the IMA included in section 4 of this module. What principles will guide you in making accounting choices?

SECTION 2 — The History of Ethics in Accounting In the wake of recent, high‐profile accounting scandals, you might think that ethics is a relatively new topic to the field of accounting. Actually, ethics has been an important part of accounting since methods of keeping financial records gained momentum in the thirteenth 5

century. A code of ethics now applies to all accounting professionals and ethics has become an integral feature of accounting education.

Brief History of Ethics in Accounting

Luca Pacioli, an Italian mathematician and Franciscan friar, described a method of keeping financial accounts in 1494 when he published his first book Summa de Arithmetica, Geometria, Proportioni, et Proportionalita (translated “everything about arithmetic, geometry, and proportions”). In this book he wrote about many topics, including the first ever double ‐entry bookkeeping system, cost accounting – and accounting ethics. Over the years, ethical standards have been developed by many different professional associations, government agencies, and private companies. These organizations created ethical codes of conduct which their members or employees are expected to follow when they perform their professional work. An important organization in the early development of accounting ethical standards was the American Association of Public Accountants (AAPA) which was created in 1887. During that year, accounting became a profession, or a group of people whose members must meet certain standards to engage in the practice of accounting. In 1907, the AAPA incorporated professional ethics into its membership rules. However, membership in the AAPA was voluntary and therefore the ethical standards of the AAPA could not be enforced on a widespread basis. The AAPA was later renamed to the American Institute of Certified Public Accountants (AICPA). The code of ethics of the AICPA is a major force in applied accounting ethics in today’s business world. The ethical standards of the AICPA are fully described in Section 4 of this module— Ethical Standards for Accounting Professionals. Members of the AICPA are Certified Public Accountants (CPAs) who must comply with the AICPAs ethical standards. Noncompliance could result in losing a license to practice as a CPA.

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Ethics in the Accounting Profession

In the middle of the twentieth century the Commission on Standards of Education and Experience for Certified Public Accountants identified seven characteristics of a profession: 1. A specialized body of knowledge 2. A formal education process to acquire the specialized body of knowledge 3. A standard of professional qualifications to enter the profession 4. A standard of conduct 5. Recognition of status 6. An acceptance of social responsibility 7. An organization devoted to the advancement of the social responsibility Characteristic 4—requiring a standard of conduct and characteristic 6—accepting social

responsibility, relate most directly to accounting ethics. What standards of conduct should accountants follow and what is the social responsibility accountants have toward the public they serve? Standards of conduct and accounting codes of ethics as developed by current professional accounting organizations are more fully addressed in section 4 of this module— Ethical Standards for Accounting Professionals. A professional must accept a moral responsibility to act in the best interests of the public. This means that business must look beyond profits to the common good and be sure not to harm the public good. The purpose of business is to make a profit, but profit should not be the only motive for business. Adam Smith maintained that business should seek a profit within the ethical principles of justice and fairness. Therefore, a business professional must protect the public interest while pursuing the profit motive. Many would argue that acting in the best interest of the public is also in the best interest of the company. In other words, ethics is good for business and makes the company successful even as the company looks out for the common good. Ethics in Accounting Education

Colleges and universities in the U.S. have included ethics in their curricula since Harvard University was founded as the oldest institution of higher learning in the United States. Many colleges since then have included ethics courses in their liberal arts programs. In the 1980’s, however, applied accounting ethics really gained momentum and many colleges in the U.S. started incorporating ethics into accounting and business classes. This incorporation of ethics into business and accounting is called applied ethics because the ethical principles learned in the philosophy classes is applied to practical accounting situations in accounting classes. With applied ethics, students get to add a new dimension to their business decision process—soft ethical issues in addition to the hard numbers traditionally used to evaluate business projects.

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Discussion Questions 1. Some argue that ethics cannot be taught in college because students have already formed their values when they come to college. Do you think ethics should be included in the accounting curriculum in colleges and universities? 2. Do you feel that good ethical behavior is good for company profits? Describe a situation in which making a decision in the interest of the public good would increase the profitability of a business in the long run.

SECTION 3—Ethics in the Decision Process While you are in college studying accounting you will need to develop a thinking process that will guide you in making business decisions. When you graduate from college and enter the accounting profession you will use the knowledge you learned in college to help your company be successful and to create a better society. Learning accounting is not just about learning numbers, but also about learning to make good decisions.

Ethics in Accounting Education

How can you incorporate ethical decision‐making when you study accounting? Many organizations exist that provide guidance to universities regarding how to incorporate ethics into accounting education programs. In addition, there are many tools students can use to solve an ethical dilemma. Some ethics tools with links to good web sites are provided at the end of this section. The main way you can bring ethics into your decision process, however, is simply to be aware of ethical issues in accounting situations and to consider these ethical issues as part of your decision model. The need for ethics in education is apparent in light of recent high‐profile business fraud cases. In the United States, the American Assembly of Collegiate Schools of Business (AACSB) is the accrediting body for business schools. AACSB makes the education standards for business schools, and the AACSB standards do include ethics. Because ethical values differ among countries and cultures, there is no universally accepted code of ethics. Nonetheless, there are basic ethical principles that cross international borders, and International Federation of Accountants (IFAC) has attempted to provide some guidance for teaching ethics in all countries. International Education Standards (IES) prescribe standards of generally accepted ethical

principles in the education of accounting students. The standards express the benchmarks that you are expected to meet in your accounting education program. They establish the essential 8


elements of the content and process of education and development at a level that is aimed at gaining international recognition, acceptance and application. The standards cannot legally override local laws and regulations but will provide an authoritative reference for informing and influencing local regulators regarding generally accepted ethical principles. The International Accounting Education Standards Board (IAESB) recognizes the wide diversity of culture, language, and educational, legal, and social systems in the countries of the member bodies and of the variety of functions performed by accountants. Therefore, each individual member body will determine the detailed requirements of the education programs. International Education Standards for Professional Accountants are intended to establish only the essential elements on which ethical principles for all professional accountants and accounting students should be based. The IAESB has issued eight International Education Standards. These standards cover the entry requirements for accounting education programs, as well as the experience and continuing professional development requirements you will be required to follow when you become an accounting professional: International Education Standards (IES)

IES 1: IES 2: IES 3: IES 4: IES 5: IES 6: IES 7:

Entry Requirements to a Program of Professional Accounting Education Content of Professional Accounting Education Programs Professional Skills Professional Values Ethics and Attitudes Practical Experience Requirements Assessment of Professional Capabilities and Competence Continuing Professional Development: A Program of Lifelong Learning and Continuing Development of Professional Competence IES 8: Competence Requirements for Audit Professionals IES 4 prescribes the professional values, ethics and attitudes you should acquire during your education program. The aim of this standard is to ensure that you are equipped with the appropriate professional values, ethics, and attitudes to function as a professional accountant. IFAC recognizes that the accountancy profession throughout the world operates in environments with different cultures and regulatory requirements. IFAC has, nevertheless, established an international Code of Ethics for Professional Accountants. Professional values, ethics and attitudes relate directly to IFAC’s mission to develop and enhance the profession to enable it to provide services of consistently high quality in the public interest.

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IES 4 requires that university accounting programs should provide you with a framework of professional values, ethics, and attitudes for exercising professional judgment and for acting in an ethical manner that is in the best interest of society and the profession. The required values, ethics, and attitudes of professional accountants include a commitment to comply with local codes of ethics which should be in conformity with the IFAC Code of Ethics. The coverage of ethics in accounting education programs should include: the nature of ethics differences of rules‐based and principles‐based approaches to ethics compliance with fundamental ethical principles professional behavior and compliance with technical standards concepts of independence, accountability, and public expectations social responsibility ethics and law consequences of unethical behavior to the individual, the profession, and to society ethics in relation to business and good governance whistle blowing, conflicts of interest, ethical dilemmas and their resolution • • • • • • • • • •

IES 4 recommends that the presentation of ethics may be treated, at least initially, as a separate subject in the accounting program. As you progress through your accounting curriculum and gain a wider knowledge of other subjects, your business curriculum will likely integrate the various topics covered in other business courses. This will encourage you to look for the possible ethical implications of problems being discussed in your accounting classes and in other business classes you are taking. As an accounting professional you will also need to understand relevant codes of ethics. You can study ethical standards for accounting professionals using the AICPA code of ethics and the IMA ethical standards. You also can examine the ethical standards of other professions and discuss other potential approaches for ethical standards in the accountancy profession. You know from your own accounting education program that you often learn best when you are actively involved learning process, using techniques such as: case studies role playing discussion of selected readings and videos analysis of real life business situations involving ethical dilemmas discussion of disciplinary pronouncements and findings seminars using speakers with experience in corporate or professional decision making • • • • • •

Such active learning strategies give you a greater awareness of the ethical implications and potential conflicts that may arise from having to make difficult accounting decisions. It is important for you to learn from your ethical experiences. You should consider an experience,

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what went well, what did not work, and what approach may be taken in the future in similar circumstances. In this way, you will develop a decision model for ethical accounting choices. All accounting professional associations have codes of ethics that you will be required to follow. Unfortunately, fraud and ethical lapses persist in the business world. What can you do to improve ethical behavior? Awareness of ethical issues and a business decision model that incorporates ethics will help you to apply ethics in your business decisions. Just as you learn to apply financial models in your business decisions, you can also learn ethical models and apply them to business decisions. When you practice ethical situations in your accounting and business classes in college you will be better prepared to make good ethical decisions after you graduate and enter the accounting profession. How can accounting professionals incorporate ethical thinking into their business decisions? Accountants are good at working with numbers, but they need to look beyond the numbers when evaluating business projects. Ethical issues often are not easily measureable in dollars but their impact on accounting and business decisions may be significant and very important. The first step in the process is to be aware that there may be some ethical issues that could affect your decision. Again, awareness is the key. When you bring ethical considerations into the decision process then at least you are considering the possible ethical implications for people who may be affected by the decision you make. Accounting professionals who are CPAs must fulfill continuing education requirements to maintain their CPA license. Continuing education in ethics is required in most states. Many CPA firms and large companies have ethics specialists to provide training and serve as resources to address ethical issues. Ethics Tools

What are some tools that you can use right now as an accounting student to help you solve ethical dilemmas and develop a process for making ethically good decisions? One tool might be to follow a defined set of steps in making an ethical decision. The Markkula Center for Applied Ethics at Santa Clara University suggests the following process for making an ethical decision: Recognize an ethical issue Get the facts Evaluate alternative actions Make a decision and test it Act and reflect on the outcome • • • • •

There are also many web sites with resources that will help you learn and apply ethical principles. Here are some websites you can review throughout your accounting career: Ethics Toolkit www.ethics.org/page/ethics‐toolkit •

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Cyber Students

www.scu.edu/ethics‐center/cydent

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Toolbox, Quiz, and More

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http://cba.lmu.edu/academicprograms/centers/ethicsandbusiness/toolbox.htm A Framework for Thinking Ethically http://www.scu.edu/ethics/practicing/decision/framework.html

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Ethics Cases

www.scu.edu/ethics/practicing/focusareas/cases.cfm?fam=BUSI

Discussion Questions 1. As an accounting student, how are ethical issues addressed in your accounting curriculum? How can you include ethical issues in a cost‐benefit decision model? 2. How should ethical issues be considered in making business decisions? In other words, because ethical factors often cannot be measured, how would you evaluate the effect of ethical issues when you are making a business decision?

SECTION 4—Ethical Standards for Accounting Professionals Having discussed the importance and history of ethics in accounting and some ethical theories that form the basis of accounting ethics, we now turn our attention to the ethical standards of professional organizations. These are the rules that you will need to follow as an accounting professional. We will start with a preview of professional associations of public accountants and management accountants. Then we will look at the American Institute of Certified Professional Accountants’ Code of Professional Ethics and the Institute of Management Accountants’ statement of ethical professional practice. Professional Associations

As an accounting professional you will belong to a professional accounting association such as the American Institute of Certified Professional Accountants (AICPA) or the Institute of Management Accountants (IMA). Professional accounting organizations have codes of ethics that you will be required to follow as a member of that organization. Violations of ethical codes can result in disciplinary action, loss of your professional license, and possible legal prosecution. In addition to the national accounting organizations, states also have licensing bodies and professional associations that have codes of ethical conduct. The National Association of State Boards of Accountancy (NASBA) promotes ethical standards through its Center for Public Trust, www.centerforpublictrust.org. Of course, in addition to the ethical standards of professional associations, you also will be required to follow your company’s code of ethics and your personal value system. AICPA Code of Professional Conduct It is important to know that following ethical standards does not mean simply following the law. You need to distinguish between ethical standards and legal rules. As a CPA when you 12


accept membership in the AICPA you assume an obligation of self ‐discipline above and beyond the requirements of laws and regulations. The Code of Professional Conduct of the AICPA consists of two sections—(1) the Principles and (2) the Rules. The Principles provide the framework for the Rules, which govern the performance of professional services by members. Principles

The six principles of the AICPA code express the profession's recognition of its responsibilities to the public, to clients, and to colleagues. 1. Responsibilities ‐ In carrying out their responsibilities as professionals, members should exercise sensitive professional and moral judgments in all their activities. 2. The public interest ‐ Members should accept the obligation to act in a way that will 3. 4.

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serve the public interest, honor the public trust, and demonstrate commitment to professionalism. Integrity ‐ To maintain and broaden public confidence, members should perform all professional responsibilities with the highest sense of integrity. Objectivity and independence ‐ A member should maintain objectivity and be free of conflicts of interest in discharging professional responsibilities. A member in public practice should be independent in fact and appearance when providing auditing and other attestation services. Due care ‐ A member should observe the profession's technical and ethical standards, strive continually to improve competence and the quality of services, and discharge professional responsibility to the best of the member's ability. Scope and nature of services ‐ A member in public practice should observe the Principles of the Code of Professional Conduct in determining the scope and nature of services to be provided.

Rules

The bylaws of the American Institute of Certified Public Accountants require its members to adhere to the Rules of the Code of Professional Conduct. Members must be prepared to justify departures from these Rules. Rule 101—Independence. A member in public practice shall be independent in the performance of professional services as required by standards promulgated by bodies designated by the AICPA. Rule 102—Integrity and objectivity. In the performance of any professional service, a member shall maintain objectivity and integrity, shall be free of conflicts of interest, and shall not knowingly misrepresent facts or subordinate his or her judgment to others. Rule 201—General standards. A member shall comply with the general standards of professional competence, due professional care, planning and supervision, and sufficient relevant data. Rule 202—Compliance with standards. A member who performs auditing, review, compilation, management consulting, tax, or other professional services shall comply with standards promulgated by bodies designated by the AICPA. •

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Rule 203—Accounting principles. Prohibits a member from expressing an unqualified

opinion on financial statements that contain a material departure from GAAP. Rule 301—Confidential client information. A member in public practice shall not disclose any confidential client information without the specific consent of the client. Rule 302—Contingent fees. A member shall not charge a fee on condition that no fee will be charged unless a specific finding or result is attained. Rule 501—Acts discreditable. A member shall not commit an act discreditable to the profession. Rule 502—Advertising and other forms of solicitation. A member in public practice shall not seek to obtain clients by advertising or other forms of solicitation in a manner that is false, misleading, or deceptive. Solicitation by the use of coercion, over‐reaching, or harassing conduct is prohibited. Rule 503—Commissions and referral fees. A member shall not for a commission recommend or refer to a client any product or service when the member also performs an audit for that client. Rule 505—Form of organization and name. A member may practice public accounting only in a form of organization permitted by law or regulation whose characteristics conform to resolutions of the AICPA.

IMA Statement of Ethical Professional Practice

The IMA ethical standards are based on the overall principles of honesty, fairness, objectivity, and responsibility. Members must act in accordance with these principles and encourage others in their organization to do so. Based on these principles the IMA requires its members to adhere to the following ethical standards: Competence

1. Maintain an appropriate level of professional expertise by continually developing knowledge and skills. 2. Perform professional duties in accordance with relevant laws, regulations, and technical standards. 3. Provide decision support information and recommendations that are accurate, clear, concise, and timely. 4. Recognize and communicate professional limitations or other constraints that would preclude responsible judgment or successful performance of an activity. Confidentiality

1. Keep information confidential except when disclosure is authorized or legally required. 2. Inform all relevant parties regarding appropriate use of confidential information. Monitor subordinates' activities to ensure compliance. 3. Refrain from using confidential information for unethical or illegal advantage. Integrity

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1. Mitigate actual conflicts of interest; regularly communicate with business associates to avoid apparent conflicts of interest. Advise all parties of any potential conflicts. 2. Refrain from engaging in any conduct that would prejudice carrying out duties ethically. 3. Abstain from engaging in or supporting any activity that might discredit the profession. Credibility

1. Communicate information fairly and objectively. 2. Disclose all relevant information that could reasonably be expected to influence an intended user's understanding of the reports, analyses, or recommendations. 3. Disclose delays or deficiencies in information, timeliness, processing, or internal controls in conformance with organization policy and/or applicable law. When you encounter an ethical dilemma the IMA recommends the following procedure to resolve the ethical issue: 1. Discuss the issue with your immediate supervisor except when it appears that the supervisor is involved. In that case, present the issue to the next level. If you cannot achieve a satisfactory resolution, submit the issue to the next management level. If your immediate superior is the chief executive officer or equivalent, the acceptable reviewing authority may be a group such as the audit committee, executive committee, board of directors, board of trustees, or owners. Contact with levels above the immediate superior should be initiated only with your superior's knowledge, assuming he or she is not involved. Communication of such problems to authorities or individuals not employed or engaged by the organization is not considered appropriate, unless you believe there is a clear violation of the law. 2. Clarify relevant ethical issues by initiating a confidential discussion with an IMA Ethics Counselor or other impartial advisor to obtain a better understanding of possible courses of action. 3. Consult your own attorney as to legal obligations and rights concerning the ethical conflict. Ethics on Professional Examinations

When you graduate from college you may take a professional certification exam such as the CPA or CMA. Ethics is covered on most professional exams including the CPA exam and the CMA exam. For example, ethics and professional and legal responsibilities are included in the Regulation section of the CPA exam, accounting for 15% to 20% of the exam content. The topics include codes of professional conduct, independence, ethics in tax practice, licensing and disciplinary systems, legal responsibilities, and privileged communications and confidentiality. You will most likely cover these topics in your accounting and law classes, and you should consider taking a professional CPA review course to better prepare you for the CPA exam.

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The CMA exam also includes coverage of ethics. The new two‐part format of the CMA exam includes ethical principles and practical considerations on both Part 1 and Part 2 of the exam. In Part 1 of the exam, ethics is tested from the perspective of the individual, and Part 2 of the exam addresses ethical issues from the perspective of business and accounting organizations. Professional ethics makes up 5% of the exam content in Part 1 and another 5% of the content in Part 2 of the CMA exam.

Discussion Questions 1. Discuss the similarities and differences between the AICPA Code of Professional Conduct and the IMA Statement of Ethical Professional Practice. 2. As an accounting professional you will be guided by a code of conduct for the company or firm you work for, and also by the ethical codes of professional associations you are a member of. Discuss any potential conflicts between the codes and how you would resolve them.

SECTION 5—The U.S. Transition to IFRS In the previous section we presented the ethical codes of the AICPA and the IMA. These are the ethical standards of the major accounting associations in the United States. Over the next few years, the United States will move toward the adoption of International Financial Reporting Standards (IFRS). In this section we will take a look at how this transition to IFRS may affect ethical standards of accounting in the U.S. We will start by looking at countries that have already adopted IFRS, and then discuss the difference between standards that are rule‐based and standards that based on principles. Finally, we will look at another code of ethics developed by the International Federation of Accountants (IFAC) and the implications this may have for accounting students and accounting professionals when the U.S. adopts IFRS. Countries Using IFRS

As of 2010, about 120 countries have adopted IFRS, including all countries in the European Union. What has been their experience, what ethical issues have they faced, what are some advantages and disadvantages, and how has the IFRS principles‐based system worked for them? Because IFRS provides general guidance based on broad principles, accountants are allowed more flexibility to properly report financial transactions according to the unique circumstances that may apply. Rather than having to follow specific rules that may not fit exactly to a particular situation, accountants can use more judgment to decide the best way to account for a transaction. The principles‐based system relies more on the substance and intent of a transaction than on precise rules that must be followed. Rules‐based vs. principles‐based

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As you can see from the previous section, the ethical standards of U.S. organizations are largely based on detailed rules of conduct (rules‐based ). The global business community is converging toward a common set of international accounting standards. While many countries have already adopted International Financial Reporting Standards (IFRS), some countries, including the United States, still require national accounting standards. Most countries that have not yet adopted IFRS have made a commitment to adopt IFRS in the near future. What implications will international accounting standards have for global accounting ethics? Standard setting organizations in more than 100 countries have adopted the International Federation of Accountants' (IFAC) Code of Ethics for Professional Accountants, while others are in the process of converging with the code. The code applies to professionals in public practice, business, academia and government. The IFAC code uses a conceptual framework ( principles‐based ) approach to evaluate circumstances that may raise ethical issues. As an accountant you will identify and analyze threats to your independence and apply appropriate measures that eliminate those threats or reduce the threats to an acceptable level. The IFAC code addresses many of the same areas as the AICPA code, such as objectivity, independence, due care and confidentiality. The IFAC code has become more relevant for U.S. accountants and accounting students as business has become increasingly global and as the American Institute of Certified Public Accountants (AICPA) has begun the process of converging its Code of Professional Conduct with the IFAC guidance. IFAC requires that its member bodies agree to have standards of conduct that are not less stringent than those of IFAC. IFAC Code

The IFAC code of ethics requires you to adhere to five fundamental principles: Integrity ‐ A professional accountant should be straightforward and honest in performing professional services. Objectivity ‐ A professional accountant should not allow bias, conflict of interest or undue influence of others to override professional or business judgments. Professional Competence and Due Care ‐ A professional accountant has a continuing duty to maintain professional knowledge and skill at the level required to ensure that a client or employer receives competent professional service based on current developments. A professional accountant should act diligently and in accordance with applicable technical and professional standards when providing professional services. •

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Confidentiality ‐ A professional accountant should respect the confidentiality of

information acquired as a result of professional and business relationships and should not disclose any such information to third parties without proper and specific authority unless there is a legal or professional right or duty to disclose. Confidential information acquired as a result of professional and business relationships should not be used for the personal advantage of the professional accountant or third parties. Professional Behavior ‐ A professional accountant should comply with relevant laws and regulations and should avoid any action that discredits the profession.

The IFAC code was revised in July 2009. The revised Code, which is effective on January 1, 2011, includes the following changes to strengthen independence requirements: Extending the independence requirements for audits of listed entities to all public interest entities Requiring a cooling off period before certain members of the firm can join public interest audit clients in certain specified positions Extending partner rotation requirements to all key audit partners Strengthening some of the provisions related to the provision of non‐assurance services to audit clients Requiring a pre‐ or post‐issuance review if total fees from a public interest audit client exceed 15% of the total fees of the firm for two consecutive years Prohibiting key audit partners from being evaluated on or compensated for selling non‐ assurance services to their audit clients •

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The revised code maintains the principles‐based approach supplemented by detailed requirements where necessary, resulting in a code that is flexible enough to address the diverse circumstances encountered by professional accountants. The principles‐based approach should also help to facilitate global convergence. Conceptual Framework

So what does this mean to you and how can it help you to make better ethical decisions when you become an accountant? The principles‐based system uses a conceptual approach to help you evaluate situations that you may be involved in so you can make good decisions. You will base your decisions on fundamental ethical principles and use the conceptual framework model to evaluate and eliminate any threats to the ethical principles. The conceptual framework helps you to identify threats to fundamental principles, evaluate the threats, and apply safeguards to eliminate or reduce threats. The conceptual approach helps you to comply with the ethical requirements of the code and to meet your responsibility to act in the public interest. Because accounting decisions are often unique, the conceptual framework approach accommodates many variations in facts and circumstances. Therefore, 18


even though the specific circumstances may vary, you can be sure that you are following the fundamental ethical principles when you make accounting decisions. When you identify threats to compliance with a fundamental principle and you determine that the threats are not at an acceptable level, you can determine whether appropriate safeguards can be applied to eliminate the threats or reduce them to an acceptable level. You exercise professional judgment and take into account whether a reasonable third party would conclude that the threats can be eliminated and the fundamental principles are not compromised. You evaluate threats when you know of circumstances that may compromise compliance with the fundamental principles.

Discussion Question 1. International financial reporting standards should make financial reports more transparent and understandable across national borders. Do you think that the move toward international accounting standards will accelerate the adoption of global ethical principles?

SECTION 6—Lessons Learned from Business Scandals What can we take away from all of this? We have looked at ethics and why it is important to accounting students and accounting professionals. We have reviewed the codes of ethical standards developed in the U.S. and by the International Federation of Accountants. Yet in spite of all the good work that has been done in the area of business and accounting ethics, there continues to be instances of fraud and deception in violation of these ethical principles. In this final section we will try to learn some lessons from business scandals. We will start with a discussion of some high‐profile business scandals that happened in recent years, and then we will think about some lessons we can learn from the scandals. Finally, we will look at the Sarbanes‐Oxley legislation that resulted in response to the scandals. Business Scandals

Let’s start by looking at some business scandals in recent years. What exactly happened, what ethical rules were violated, and who was affected? •

Enron. This scandal involved the giant energy company Enron. Basically the company

overstated its revenues to show a better stock price. As you learned in your accounting classes, revenue is recognized when it is earned. If you sell a product that you own you record the full revenue and subtract the cost of the product to compute your net profit. If you are an agent who is just transferring a product that you do not actually own, then you should only record your net fee revenue instead of the total revenue. Enron recorded the full revenue even though it was an agent in many transactions, thereby overstating its revenues. So, the accounting rule of revenue recognition was not applied 19

•

WorldCom. WorldCom was the second largest phone company in the U.S. after AT&T.

The WorldCom story involved capitalizing some costs that should have been recorded as expenses. When you do this you make your income statement and your balance sheet look better than they actually are. Assets are overstated and expenses are understated ‐ profits are inflated. WorldCom capitalized the cost of using other companies’ communication lines when they should have recorded these line costs as current expenses. The accounting matching principle was not followed and the accountants knew that the way they accounted for line costs was not correct. The ethical principles of professional competence and professional behavior were violated. Stockholders lost everything, and creditors lost about 70 cents on the dollar for loans they had made to the company. •

Madoff . Bernard Madoff committed the largest investor fraud ever by an individual,

estimated at about $65 billion. This fraud involved a “Ponzi” scheme, named after Charles Ponzi who committed this kind of fraud in the 1920s. Madoff took money from one investor and give it to another investor, calling it profit or return on investment. But he really was just recycling money and there were no real profits on the investments. Of course Madoff knew what he was doing so the ethical principles of honesty and integrity were not followed, and the generally accepted method of recognizing revenue was violated. He got away with this fraud for some time, but in the end, the real profits were not there and the fraud was discovered. •

Savings and loan scandals. Banks use investors’ money to make loans to other people.

They give a return to investors and hope to earn more on the loans so they can make a profit. But if the loans are bad then the investors can lose their money. In the 1980s and 1990s, many savings and loan companies made bad loans resulting in losses of over $150 billion, most of which was paid for by taxpayers through government bailouts. The root problem with the bad loans was taking too much risk on loans that people could not afford to repay. Some argue that the government shares some of the blame here by backing up the loans and bailing out the banks. The ethical values of objectivity and due care were not properly followed in evaluating the credit rating of customers who applied for loans, and the accounting principles of asset measurement and conservatism were not prudently applied. •

Real estate scandals. This type of scandal often involves overstating the value of real

estate to make an unreasonable profit, leaving borrowers and banks with the losses when the true value of the property is revealed. You learned in your accounting classes about measuring assets at fair market value, but if you overstate the value of an asset then somebody will lose when the true value of the asset is discovered. For example 20


Lessons Learned

What lessons can we learn from the recent business scandals? What ethical principles were violated and what can be done to lessen the chance of future business scandals? There are many factors that contributed to the high‐profile business scandals such as Enron, WorldCom, Madoff, real estate, and the savings and loan failures. Some of these factors and the lessons we can learn from them are: 1. Lack of tone at the top levels of an organization. Ethical behavior in business begins at the top—management must set an example of ethical behavior and make it known that ethics is important in the organization. The top officials in recent scandals acted improperly and therefore set a tone indicating that ethics does not matter in the company. If the top people in an organization feel that ethics is important then employees will follow the lead and consider ethical issues in their business decisions. 2. Conflict of audit and consulting roles of accounting firms. CPA firms are no longer permitted to be both an auditor and a consultant for a company. Auditor independence is more closely scrutinized under the new regulations that took effect after the accounting scandals. 3. Responsibility of top officers. New accounting regulations that were established after the business scandals require that the top officials of companies sign a statement that they assume responsibility for the accuracy of the financial statements and for the internal controls of the company. Before the new legislation some officers claimed that they had no knowledge of improper financial activities being conducted by other employees in the company. Now, it is the responsibility of top management to responsibility for and knowledge of all financial matters of the company. 4. Government regulation cannot prevent fraud. The Security and Exchange Commission (SEC) had extensive regulation and reporting requirements, but the requirements were not able to prevent the fraud that occurred in recent business scandals. While the fraud was eventually detected, it was not prevented. Some would question whether increasing government regulation is needed in light of the inability of current regulation to prevent fraud.

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5. Fraud can happen even when good controls are in place. If someone is inclined to do something that is unethical or illegal, they may be able to get away with it at least for a while. Investors and others who rely on financial information should be alert for unusual or unreasonable information which may be inaccurate. Having learned some lessons from recent business scandals we may be better prepared to understand how they happened and what can be done to improve the situation in the future. Congress passed new legislation in response to the latest round of business scandals. The most important legislation was the Sarbanes‐Oxley Act of 2002 which added many regulations for companies and auditors. This is not the first time that the government has stepped in to regulate the accounting profession. For example, the Securities and Exchange Commission (SEC) was established to regulate the stock market after some unethical business practices. After the stock market crash of 1929, the SEC was created in 1934 to restore public confidence in the capital markets. Let’s take a look at the latest legislation—Sarbanes‐Oxley. Sarbanes‐Oxley

As a result of the business scandals Congress changed the rules for accountants by passing the Sarbanes‐Oxley legislation. The Sarbanes‐Oxley Act of 2002 contains the following sections: 1. Public Company Accounting Oversight Board 2. Auditor Independence 3. Corporate Responsibility 4. Enhanced Financial Disclosures 5. Analyst Conflicts of Interest 6. Commission Resources and Authority 7. Studies and Reports 8. Corporate and Criminal Fraud Accountability 9. White‐Collar Crime Penalty Enhancements 10. Corporate Tax Returns 11. Corporate Fraud and Accountability

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The Public Company Accounting Oversight Board (PCAOB) added many new regulations for companies that trade stock on the public stock exchanges. The duties of the PCAOB are to: • •

• •

•

• •

register public accounting firms that prepare audit establish auditing, quality control, ethics, independence, and other standards relating to the preparation of audit reports conduct inspections of registered public accounting firms conduct investigations and disciplinary proceedings and impose appropriate sanctions on registered public accounting firms promote high professional standards and improve the quality of audit services offered by registered public accounting firms enforce compliance with this Act set the budget and manage the operations of the Board

The U.S. Supreme Court is reviewing the Sarbanes‐Oxley legislation and may decide reduce the authority of the PCAOB. If any Supreme Court rulings do affect the Sarbanes‐Oxley legislation then Congress would need to change the regulations. Perhaps an overall lesson from the business scandals is that ethical behavior cannot be legislated. While ethical standards and effective internal controls can increase the likelihood of ethical behavior, making rules and regulations can never completely prevent fraud.

Discussion Questions 1. In what ways do you think the PCAOB will help to lessen the chance of fraudulent business practices? How would you improve the Sarbanes‐Oxley legislation? 2. How can companies improve the ethical behavior of employees within the organization? Do you think that ethical behavior makes a company more successful?

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Additional resources and references AICPA code of ethics http://www.aicpa.org/about/code/index.htm IMA code of ethics http://www.imanet.org/about_ethics_statement.asp IFAC code of ethics http://www.ifac.org/ethics/ Business ethics links http://www.scu.edu/ethics/links/links.cfm?cat=BUSI Student Center for Public Trust http://www.centerforpublictrust.org/index.php?option=com_content&view=article&id=114 Ethical decision making http://www.scu.edu/ethics/practicing/decision/ Improving professional ethics http://www.nysscpa.org/cpajournal/2004/604/essentials/p58.htm th

A Global Standard for Accounting Ethics, 16 Annual International Conference Promoting

Business Ethics, Niagara University, October 28‐30, 2009 th

Ethics, Catholic Values, and Professional Codes of Ethics in the Business Curriculum, 15 Annual

International Conference Promoting Business Ethics, St. John’s University, October 22‐24, 2008 Ethics in Management Accounting, a presentation at a conference on Ethics and Responsible

Leadership in Business, Odette School of Business and CMA Ontario, Windsor, Ontario, Canada, March 7, 2008 nd

Approaches to Teaching Ethics in Accounting Education, 2

Annual Conference of the Business Research Consortium of Western New York, St. Bonaventure University, NY, April 20‐21, 2007 th

Ethics Disclosures in Financial Reports , 13 Annual International Conference Promoting

Business Ethics, Niagara University, NY, October 25‐27, 2006 A Framework for Teaching Business Ethics, Journal of Business Ethics 16: 293‐297, Kluwer

Academic Publishers, the Netherlands, 1997 Section 3 and Section 4 photo courtesy of www.istockphoto.com.

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Ethics in Accounting

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