Chapter 1: Ethical Issues in Advanced Accounting

1.1. Ethics and Various Models/Schools of Ethical Decision Making

1.2. Financial Statement Fraud
1.3. Motives for Management to Commit Financial Statement Fraud
1.4. Financial Statement Fraud Schemes
1.5. Cases in Financial Statement Fraud and Manipulation
Overview on:
IFAC Code of Ethics for Professional Accountants
Ethiopian Professional Association of Accountants & Auditors
(EPAAA)
Code of Ethics
Ethiopian Code of Ethics for Professional Accountants, Issued by
Office
of Federal Auditor General (OFAG) (January 2004)
Professional Code of Ethics applicable to auditors only, Issued by
the
OFAG (August 2008)

1.1. Ethics and Various Models/Schools of Ethical Decision

Making
What is Ethics? Some Examples of Ethical Violations

When we read about Floyd Landis and questions about his

performance in the Tour de France from the U.S. Anti-Doping
Agency, we say, Thats unethical!
When we read about Dennis Kozlowski, the former CEO of Tyco,
purchasing a $6,000 shower curtain at company expense, and his
enjoying lavish bonuses as well as the easy cash from officer loan
programs not always approved by Tycos board of directors, we
think, Where are his ethics?
Situations such as these happen every day.
Some conduct is more harmful, such as those situations in which a
criminal statute is violated.

For example, Mr. Kozlowski was tried for fraud, convicted, and
sentenced to 15 to 26 years for his use of company programs and funds.

In some other cases, all we have is discomfort about the

conduct. We feel somethings not right, but there is not always
a criminal wrong or even a punishment.

Definition of Ethics

Ethical standards are not the standards of the law. In fact, they
are higher standards.
Sometimes referred to as normative (to be) standards in
philosophy, ethical standards are the generally accepted
rules of conduct that govern society.
Ethical rules are both standards and expectations for behavior, and we have
developed them for nearly all aspects of life.
For example,
We resent those who tromp up to the cash register in front of us,
ignoring the fact that we were there first and that our time is valuable
too.
An ethical society is legal as laws are formulated to maintain order and
ethics but a legal society may not be ethical. In this sense being legal is
one part of being ethical i.e. legality is a subset of ethics. Ethics is
broader than that.

The minimum behavior a society should demonstrate is being legal, but

if its behavior improves it will be ethical also.

For example, when you become witness in courts, you will tell the
truth as your self interest will be hurted if you falsify and this is
known by the court. But when you are talking something to your
friend (not to the courts), your motivation to falsify is high because
no punishment is associated with such behavior. So telling the truth
to court is simple (i.e. at the minimum you will be legal), but you
may find telling the truth to your friend as a difficult proposition
(i.e. the maximum behavior expected from you is being ethical, but
cant do that easily). So even if you can be legal easily, it is difficult
to be ethical as such.

Contd

Waiting your turn in line is an expectation society has.

Waiting your turn is not an ordinance/decree, a statute, or
even a federal regulation.
Waiting your turn is an expected but unwritten behavior that
plays a critical role in an orderly society.
Waiting your turn is a higher standard than the laws that are
passed to maintain order.
Ethics consists of those unwritten rules we have developed for
our interactions with each other.
These unwritten rules govern us when we are sharing resources
or honoring contracts.
Ethics consists of standards and norms for behavior that are
beyond laws and legal rights.

Ethics is a branch of philosophy which is the systematic

study of:
Reflective/insightful choice (decision problems),
the standards of right and wrong (moral principles)
by which it is to be guided, and
the good or bad (consequences) toward which it may
ultimately be directed.
Ethics also can be defined as:
Ethics is the inner-guiding moral principles, norms,
values, and beliefs that people use to analyze or
interpret a situation and then decide what is the
right or appropriate way to behave

What is ethics? Cont..

An ethical problem occurs when you must

make a choice among alternative actions and
the right choice is not absolutely clear. Often
that choice affects the well-being of other
persons the stakeholders.

Ethical Theories

Ethical theories discuss the right ethical

practices, the rationalization made to engage
in ethical violations and the methods to be
used in solving an ethical dilemma.
1. Divine Command Theory: the resolution of
dilemmas is based upon religious beliefs.
Ethical dilemmas are resolved according to tenets
of a faith, such as the Ten Commandments for
the Jewish and Christian faiths.
In some countries the Divine Command Theory
has influenced the law, as in some Muslim
nations in which adultery is not only unethical
but also illegal and sometimes punishable by
death.

2. Ethical Egoism Theory: Ethical Egoism holds that we

all act in our own self-interest and that all of us should
limit our judgment to our own ethical egos and not
interfere with the exercise of ethical egoism by others.
Ayn Rand, Thomas Hobbes and Adam Smith, with some
modifications, can be mentioned from such school of
thought.
Thomas Hobbes warned that there would be chaos
because of ethical egoism if we did not have laws in place
to control that terrible drive of self-interest. Hobbes felt
we needed great power in government to control ethical
egoism.

Contd

3. Utilitarian theory: resolution of ethical dilemmas

requires a balancing effort in which we minimize the
harms that result from a decision even as we maximize
the benefits.
Jeremy Bentham and John Staurt Mill are credited for
this theory.
John Staurt Mill is known for his greatest happiness
principle, which provides that we should resolve ethical
dilemmas by bringing the greatest good to the greatest
number of people. There will always be a few
disgruntled souls in every ethical dilemma solution, so
we just do the most good that we can.

Some of the issues to which we have applied

utilitarianism include providing health care even as
costs escalate; protecting the environment even as
we generate electricity, drive cars, and operate
factories; and outsourcing manufacturing of
clothing to developing countries.
Utilitarianism is a theory of balancing that requires
us to look at the impact of our proposed solutions
to ethical dilemmas from the viewpoints of all
those who are affected.

Contd

. The Categorical Imperative and Immanuel Kant: Kant

does not allow any resolution of an ethical dilemma in which
human beings are used as a means by which others obtain
benefits.
In Kants theory you cannot use others in a way that gives you
a one-sided benefit. Everyone must operate under the same
usage rules. In Kants words, One ought only to act such that
the principle of ones act could become a universal law of
human action in a world in which one would hope to live.
4

Example:

There are those who find it unethical to have workers in developing nations
labor in garment sweatshops for pennies per hour. The pennies-per-hour wage
seems unjust to them. This may be the view of divine command theory who
treat people worldwide equally. This same situation may be ethically justified
by utilitarian's if the benefit of investing in a developing country exceed the
cost.

However, suppose the company was operating under one of its universal
principles: Always pay a fair wage to those who work for it. A fair wage in
that country might be pennies, and the company owner could argue, I would
work for that wage if I lived in that country. The company owner could also
argue, But, if I lived in the United States, I would not work for that wage,
would require a much higher wage, and would want benefits, and we do
provide that to all of our U.S. workers. The employer applies the same
standard, but the wages are different.

The company has developed its own ethical standard that is

universally applicable, but in different contexts. Context is
everything under the categorical imperative works.
There is one more part to Kants theory: you not only have to be
fair but also have to want to do it for all the right reasons. Selfinterest was not a big seller with Kant, and he wants universal
principles adopted with all goodwill and pureness of heart.
So, to not engage in fraud in business because you dont want to
get caught is not suceint basis for a rule against fraud. Kant
wants you to adopt and accept these ethical standards because
you dont want to use other people as a means to your
enrichment at their expense.

Kants philosophy is similar to divine command theory which

treat all people as equal. But the difference is Kants equality
of people is context specific, not worldwide like the divine
command theory.
Example in divine command theory both black and white people or rich and
poor people are treated equally, but in Kants philosophy, they are not treated
equally. Kants equality of people works only with the cluster i.e. one black
person should be treated equally with another black person. But for Kant, black
and white people should not be expected to be treated equally. So Kants
philosophy can be called context driven universal principle.

Most laws are country specific thus favoring Kants approach

as opposed to divine command theory.

However, there are worldwide laws such as the right to live

peacefully, the right to education, the right to development etc.
Besides the forces of globalization are harmonizing different
countries laws.
All this development will lead us to favor the divine command
theory.
Actually if laws across countries are harmonized both Kants
approach and the divine command theory will give us the same
result.
Furthermore, note that most laws of countries drive their
philosophy from religion that is we adopt the divine command
theory as a basis for harmonized worldwide laws. No religion
preach to do harm on others and as the same time, no country law
permit harming others. Laws are enacted to protect people, not to
harm them.

5. The Contractarians and Justice: Also called the theory of

justice (social contact).
John Locke and John Rawls are credited for this theory.
Kants aw, according to this theory, is that he assumed we could
all have a meeting of the minds on what were the good rules for
society. Locke and Rawls preferred just putting the rules into
place via a social contract that is created under circumstances in
which we reect and imagine what it would be like if we had no
rules or law at all.
If we started with a blank slate rational people would agree
perhaps in their own self-interest, or perhaps to be fairthat
certain universal rules must apply. Rational people if there were
not rules, would develop rules such as Dont take my property
without my permission

Contd

6.Rights Theory: is also known as an Entitlement Theory

and is one of the more modern theories of ethics.
Robert Nozick is the key modern-day philosopher on this
theory, which has two big elements:

(1) everyone has a set of rights, and

(2) its up to the governments to protect those rights.

Under this big umbrella of ethical theory, we have the

protection of human rights that covers issues such as
sweatshops (i.e. overworked and underpaid employees),
abortion, slavery, property ownership and use, justice (as in
court processes), animal rights, privacy, and euthanasia (the
act of killing or facilitating the death of somebody who have
an incurable illness).

Contd

7. Moral

Relativists: Moral Relativists believe in time-and-place

ethics.
Example:
If you live in a neighborhood in which drug dealers are
operating a crystal meth lab or crack house, committing
arson (burning building or other property) to drive away the
drug dealers is ethically justied.
If you are a parent and your child is starving, stealing a loaf
of bread is ethically correct.
Committing
financial statement fraud like earning
management to help the company survive is not ethically
problematic under moral relativists.

The proper resolution to ethical dilemmas is based upon

weighing the competing factors at the moment (hence it is
situation specific) and then making a determination to take the
lesser of the evils as the resolution.
Moral Relativists do not believe in absolute rules (i.e. divine
command theory), virtue ethics (ethics developed over times),
or even the social contract (ethics developed by societys
consensus or agreement).
Moral relativists beliefs center on the pressure of the
moment and whether the pressure justifies the action taken.

Contd

8. Back to Plato and Aristotle: Virtue Ethics: Aristotle and

Plato taught that solving ethical dilemmas requires training,
that individuals solve ethical dilemmas when they develop and
nurture a set of virtues (goodness).
Some modern philosophers have embraced this notion of
virtue ethics and have developed lists of what constitutes a
virtuous business-person. Virtues are difficult traits to develop
and keep. The following list of virtue ethics was developed by
the Robert Solomon:
Virtue and its Standard Definition

Ability: Being dependable and competent

Acceptance: Making the best of a bad situation

Contd

Amiability: Fostering agreeable social contexts

Articulateness: Ability to make and defend ones case
Attentiveness: Listening and understanding
Autonomy: Having a personal identity
Caring: Worrying about the well-being of others despite power
Charisma: Inspiring others
Compassion: Sympathetic
Coolheadedness: Retaining control and reasonableness in heated situations
Courage: Doing the right thing despite the cost
Determination: Seeing a task through to completion
Fairness: Giving others their due; creating harmony
Generosity: Sharing; enhancing others well-being
Graciousness: Establishing a congenial environment
Gratitude: Giving proper credit
Heroism: Doing the right thing despite the consequences
Honesty: Telling the truth; not lying

Contd

Humility: Giving proper credit

Humor: Bringing relief; making the world better
Independence: Getting things done despite bureaucracy
Integrity: Being a model of trustworthiness
Justice: Treating others fairly
Loyalty: Working for the well-being of an organization
Pride: Being admired by others
Prudence: Minimizing company and personal losses
Responsibility: Doing what it takes to do the right thing
Saintliness: Approaching the ideal in behavior
Shame (capable of): Regaining acceptance after wrong behavior
Spirit: Appreciating a larger picture in situations
Toughness: Maintaining ones position
Trust: Dependable
Trustworthiness: Fulfilling ones responsibilities
Wittiness: Lightening the conversation when warranted
Zeal: Getting the job done right; enthusiasm

Behavioral Stage Theory of Moral

Development

Determinants of Ethics
I. Societal Ethics
Standards that govern how members of a
society should deal with one another in
matters involving issues such as fairness,
justice, and the rights of the individual
People behave ethically because they have
internalized certain values, beliefs, and
norms
II. Occupational Ethics
Standards that govern how members of a profession,
trade, or craft should conduct themselves when
performing work-related activities
Medical & legal ethics

Determinants of Ethics Cont..

III. Individual Ethics
Personal standards and values that determine
how people view their responsibilities to other
people and groups
How they should act in situations when their
own self-interests are at stake
IV. Organizational Ethics
Guiding practices and beliefs through which a
particular company and its managers view their
responsibility toward their stakeholders
Top managers play a crucial role in
determining a companys ethics

Ethical Dilemma
Ethical dilemma - is a situation a person faces in which a
decision must be made about appropriate behavior.
As you pass through, you found a brief case containing
important documents and 10,000 dollars.
What do you do? Possible actions and the ethical
classification
Take the money and the brief case and inform no body
Take the money, leave the brief case and inform no
body
Take the money and the brief case and inform your
friends
Take the money, leave the brief case and inform your
friends
Ignore the fortune and leave

Ethical Dilemma

Professionals face ethical dilemmas

How they resolve these dilemmas determine the
moral quality of their lives
the welfare of those affected by their action

Why need ethical conduct in

accounting?
Following are some justifications
Increasing fact and critics over the continuous
deterioration of the ethical standards of
accountants
Wide spread application of cute accounting to
describe stretching the form of accounting
standards to the limit, regardless of the substance
of the underlying business transactions or events.
Increasing practice in cooking the books to indicate
fraudulent financial reporting.

Many topics of advanced accounting

have been the subject of both cute
accounting and cooking the books by
accounting executives of business
enterprises.
The accounting staffs of the business
enterprises have the primary responsibility
for preparing and disseminating financial
statements and reports to users thereof.

Causes of Potential Ethical dilemmas

for Accountants

Monthly financial targets not likely to be

met and/or possible breach of bank
covenants.
Possible manipulation of figures in
financial accounts.
In the UK bonuses/share options for
employees may depend on certain level
of profits being reached
Pressure from client/bank if an audit
report needs to be signed today and
there is insufficient information to know
whether accounts show a true and fair
view

Why need ethical conduct in accounting?

Cont..
Number and size of financial statement frauds are
increasing
Number and size of frauds against organizations
are increasing
Some recent frauds include several peopleas
many as 20 or 30 (seems to indicate moral decay)
Many investors have lost confidence in credibility
of financial statements and corporate reports
More interest in fraud than ever beforenow a
course on many college campuses

2. Financial statement
Fraud
Definition of Financial Statement Fraud :
Is defined as intentional or reckless conduct,
whether act or omission, that results in materially
misleading financial statements. The Acts
Include:
Deliberate misstatements or omissions of amounts
or disclosures of financial statements to deceive
financial statement users, particularly investors and
creditors
Falsification, alteration, Material intentional
omissions or misrepresentations or manipulation of
material financial records, supporting
documents, or business transactions

Financial Statement fraud Cont..

Deliberate misapplication of accounting

principles, policies, and procedures used to
measure, recognize, report, and disclose
economic events and business transactions
Intentional omissions of disclosures or
presentation of inadequate disclosures
regarding accounting principles and
policies and related financial amounts

Costs of Financial Statement

Fraud
More than 50% of U.S. corporations are victims of
fraud with losses of more than $500,000 (Albrecht
& Searcy 2001)
Enron lost about $70 billion in market
capitalization to investors, employees, and
pensioners
Enron, WorldCom, Quest, Global Crossing, and
Tycos loss to shareholders was $460 billion
(Cotton 2002)
Other fraud costs are legal costs, increased
insurance costs, loss of productivity, adverse
impacts on employee morale, customers

Frequency of Types of Occupational

Fraud and Abuse

Effects of Financial Statement

Fraud
Undermines the reliability, quality,
transparency, and integrity of the financial
reporting process
Jeopardizes the integrity and objectivity of the
auditing profession, especially auditors and
auditing firms
Diminishes the confidence of the capital
markets, as well as market participants, in the
reliability of financial information
Makes the capital markets less efficient
Adversely affects the nations economic growth
and prosperity
Results in huge litigation costs

Effects of Fin. Stat. Fraud Cont..

Destroys careers of individuals involved in
financial statement fraud.
Causes bankruptcy or substantial economic
losses by the company engaged in financial
statement fraud
Encourages regulatory intervention
Causes devastation in the normal operations and
performance of alleged companies
Raises serious doubt about the efficacy or
usefulness of financial statement audits
Erodes public confidence and trust in the
accounting and auditing profession

Largest Bankruptcy Filings

(1980 to Present)

from BankruptcyData.com

Company

Assets (Billions)

When Filed

1. WorldCom

$103.9

July 2002

2. Enron

$63.4

Dec. 2001

3. Conseco

$61.4

Dec. 2002

4. Texaco

$35.9

April 1987

5. Financial Corp of America

$33.9

Sept. 1988

6. Global Crossing

$30.2

Jan. 2002

7. PG&E

$29.8

April 2001

8. UAL

$25.2

Dec. 2002

9. Adelphia

$21.5

June 2002

10. MCorp

$20.2

March 1989

Why so many financial statement

frauds all of a sudden?
Moral decay in society
Executive incentives tied with earnings
Wall Street expectationsrewards for short-term
behavior
Nature of accounting rules
Behavior of CPA firms
Greedy investment banks, commercial banks,
and investors
Educator failures

Why Fraud Occurs

Available
Opportunities
poor internal
controls

Situational Pressures
an employee is experiencing
financial difficulties

Personal Characteristics
personal morals of
individual employees

Who Commits Financial Statement Fraud

Senior management
Mid- and lower-level employees
Organized criminals

Why Do People Commit Financial

Statement Fraud

To conceal true business

performance
To preserve personal status/control
To maintain personal income/wealth

1.3. Why Senior Management

Overstates Business Performance
To meet or exceed the earnings or revenue
growth expectations of stock market analysts
To comply with loan covenants
To increase the amount of financing available
from asset-based loans
To meet a lenders criteria for
granting/extending loan facilities
To meet corporate performance criteria set by
the parent company

Why Senior Management Cont..

To meet personal performance criteria
To trigger performance-related compensation or
earn-out payments
To support the stock price in anticipation of a
merger, acquisition, or sale of personal
stockholding
To show a pattern of growth to support a
planned securities offering or sale of the
business

Why Senior Management Cont..

To defer surplus earnings to the next accounting
period.
To take all possible write-offs in one big bath
now so future earnings will be consistently higher.
To reduce expectations now so future growth will
be better perceived and rewarded.
To preserve a trend of consistent growth, avoiding
volatile results.
To reduce the value of an owner-managed
business for purposes of a divorce settlement.
To reduce the value of a corporate unit whose
management is planning a buyout

1.4. Financial Statement Fraud

Schemes

Fictitious revenues
Timing differences
Improper asset valuations
Concealed liabilities and expenses
Improper disclosures

Financial Statement Schemes by

Category

Fictitious Revenues
Recording of goods or services that
did not occur
Fake or phantom customers
Legitimate customers
Sales with conditions

Revenue-Related Transactions and Frauds

Inventory/Cost of Goods Sold Frauds

Red flags Fictitious Revenues

Rapid growth or unusual profitability, especially
compared to that of other companies in the same
industry
Recurring negative cash flows from operations or an
inability to generate cash flows from operations while
reporting earnings and earnings growth
Significant transactions with related parties or special
purpose entities not in the ordinary course of business or
where those entities are not audited or are audited by
another firm
Significant, unusual, or highly complex transactions,
especially those close to period end that pose difficult
substance over form questions
Unusual growth in the number of days sales in
receivables
A significant volume of sales to entities whose substance

Timing Differences

Recording revenue and/or expenses in improper periods

Shifts revenues or expenses between one period and the
next, increasing or decreasing earnings as desired

Red Flags Timing differences

Rapid growth or unusual profitability, especially compared to
that of other companies in the same industry
Recurring negative cash flows from operations or an inability
to generate cash flows from operations while reporting
earnings and earnings growth
Significant, unusual, or highly complex transactions,
especially those close to period end that pose difficult
substance over form questions
Unusual increase in gross margin or margin in excess of
industry peers
Unusual growth in the number of days sales in receivables
Unusual decline in the number of days purchases in
accounts payable

Concealed Liabilities
Liability/expense omissions
Capitalized expenses
Failure to disclose warranty costs and liabilities
Red Flags Concealed Liabilities

Recurring negative cash flows from operations or an

inability to generate cash flows from operations while
reporting earnings and earnings growth

Assets, liabilities, revenues, or expenses based on

significant estimates that involve subjective
judgments or uncertainties that are difficult to confirm

Non-financial managements excessive participation

in or preoccupation with the selection of accounting
principles or the determination of significant
estimates

Red Flags Concealed

Liabilities
Unusual increase in gross margin or margin in excess of
industry peers
Allowances for sales returns, warranty claims, and so on
that are shrinking in percentage terms or are otherwise
out of line with industry peers
Unusual reduction in the number of days purchases in
accounts payable
Reducing accounts payable while competitors are
stretching out payments to vendors

Improper Disclosures

Liability omissions
Subsequent events
Management fraud
Related-party transactions
Accounting changes

Red Flags Improper Disclosures

Domination of management by a single person or small group (in a

non-owner managed business) without compensating controls
Ineffective board of directors or audit committee oversight over the
financial reporting process and internal control
Ineffective communication, implementation, support, or enforcement of
the entitys values or ethical standards by management or the
communication of inappropriate values or ethical standards
Rapid growth or unusual profitability, especially compared to that of
other companies in the same industry

Red Flags Improper

Disclosures
Significant, unusual, or highly complex
transactions, especially those close to period end
that pose difficult substance over form questions
Significant related-party transactions not in the
ordinary course of business or with related entities
not audited or audited by another firm
Significant bank accounts or subsidiary or branch
operations in tax haven jurisdictions for which there
appears to be no clear business justification
Overly complex organizational structure involving
unusual legal entities or managerial lines of
authority

Red Flags Improper

Disclosures

Known history of violations of securities laws or other

laws and regulations, or claims against the entity, its
senior management, or board members alleging
fraud or violations of laws and regulations
Recurring attempts by management to justify
marginal or inappropriate accounting on the basis of
materiality
Formal or informal restrictions on the auditor that
inappropriately limit access to people or information
or the ability to communicate effectively with the
board of directors or audit committee

Improper Asset Valuation

Inventory valuation
Accounts receivable
Business combinations
Fixed assets

Red Flags Improper Asset Valuation

Recurring negative cash flows from operations or an

inability to generate cash flows from operations while
reporting earnings and earnings growth
Significant declines in customer demand and increasing
business failures in either the industry or overall
economy
Assets, liabilities, revenues, or expenses based on
significant estimates that involve subjective judgments
or uncertainties that are difficult to corroborate
Unusual increase in gross margin or margin in excess
of industry peers

Red Flags Improper Asset Valuation

Non-financial managements excessive
participation in or preoccupation with the selection
of accounting principles or the determination of
significant estimates
Unusual growth in the number of days sales in
receivables
Unusual growth in the number of days purchases in
inventory
Allowances for bad debts, excess and obsolete
inventory, and so on that are shrinking in percentage
terms or are otherwise out of line with industry peers
Unusual change in the relationship between fixed
assets and depreciation
Adding to assets while competitors are reducing

An Example of Fraudulent Financial

Reporting
The secs accounting and auditing
enforcement release no. 923 provides an
example of fraudulent financial reporting carried
out by top management (See Chapter 1 page
2).
According to the SEC, the four officers
overstated the companys net income for the
quarters ended Dec 31, 92 and mar 21, 93 by
taking the following cooking the books
actions:
1. Recognizing January 1993 revenues in
December 1992 and April 1993 revenues in
March 1993, and artificially accelerating
product delivery schedules at the end of both
quarters, a trick termed channel stuffing.

2. Deferring write-offs of uncollectible accounts past the end

of the appropriate quarter.
3. Also, according to the SEC, the chief financial officer (a
CPA) overstated quarterly income by:
i. Recognizing in the quarter ended March 31, 1993, a
gain from the sale of an asset during the quarter
ended June 30, 1993.
ii. Recognizing as assets certain expenses incurred
during the quarters ended December 31 1992, and
March 31, 1993.
iii. Making fictitious journal entries in connection with
business combinations accomplished in March 1993,
the effect of which was to understate doubtful
accounts expense.

ETHICAL STANDARDS FOR PREPARERS OF

FINANCIAL STATEMENTS AND FINANCIAL
REPORTS

American Institute of Certified Public

Accountants (AICPA) adopted first code of
ethics in 1917.
The Institute of Management Accountants
(IMA) first issued its Standards of Ethical
Conduct for Management Accountants in
1983.
The Financial Executives Institute (FEI) first
issued its Code of Ethics in 1985.

1.5. Recent Ethical cases in

Accounting
Follow

Cases
Worldcom (expense capitalization)
Satyam Computers (bogus revenue)
Tyco (executive loans, merger magic)
Adelphia (borrowing from company)
Waste Management (materiality)
SunBeam (channel stuffing, cookie jar reserves)
Healthsouth (false earnings)
ENRON (Misstating Financial Statements)
Global Crossing
Xerox
Qwest (Misstating Financial Statements)
Many others (Cendant, Lincoln Savings, ESM, Anicom,
Sunbeam, etc.)

Famous Business Ethics Cases:

1. WorldCom answers

How did WorldCom cook the books?

They capitalized the leasing expenses on the balance sheet

instead of expensing them.

What is the impact on the income statement and the

balance sheet and ratios of such actions taken by
WorldCom? Provide examples.

The capitalizations of leasing expenses increased income and

increased assets on the balance sheet. So ratios with income in
the numerator looked better than before managing earnings.
Also, the leased assets on the balance sheet gets depreciated
over the estimated life, thus spreading the cost over many
income statements

WorldCom numbers
Form Filed
With the
Commission

Reported Line
Cost Expenses

Reported Income
(before Taxes
and Minority
Actual Line
Interests)
Cost Expenses

Actual Income
(before Taxes
and Minority
Interests)

10-Q, 3rd Q. 2000

$3.867 billion

$1.736 billion

$4.695 billion

$908 million

10-K, 2000

$15.462 billion

$7.568 billion

$16.697 billion

$6.333 billion

10-Q, 1st Q. 2001

$4.108 billion

$988 million

$4.879 billion

$217 million

10-Q, 2nd Q. 2001

$3.73 billion

$159 million

$4.29 billion

$401 million loss

10-Q, 3rd Q. 2001

$3.745 billion

$845 million

$4.488 billion

$102 million

10-K, 2001

$14.739 billion

$2.393 billion

$17.754 billion

$622 million loss

10-Q, 1st Q. 2002

$3.479 billion

$240 million

$4.297 billion

$578 million loss

WorldCom answers (contd)

Read the article Twenty pressures to manage earnings

mentioned in the citations. Identify some of the
pressures that caused the management to cook the
books.

Meeting analyst forecast

Excessive profits in an environment where competitors were not
doing as well.
Management greed and compensation

Almost all the red flags (as per the slide before)

Famous Business Ethics Cases:

2. Adelphia answers

Read the complaint on the SEC website. How did the

management cook the books?

Borrowed funds along with other entities that were closely held
but did not show the loans on the books of Adelphia. Liabilities
were thus understated.
Rejected auditor recommendation that at least a footnote
disclosure needs to be made tor the loans
Equity was overstated by doing sham stock transactions
(A=L+SE)
Inflated number of cable subscribers (criteria used in the industry
to analyze cable companies)
Identified source of revenue management fees (did not exist)
Shifted Adelphia expenses to other entities run by the family

Adelphia answers (contd)

Who were the auditors of Adelphia during the fraud period? What
were they accused of doing? How were they punished?
Deloitte & Touche
Deloitte engaged in improper professional conduct and caused
certain of Adelphia's books and records violations by failing to
detect a massive fraud perpetrated by Adelphia and certain
members of the Rigas family. Even though Deloitte identified
Adelphia as one of its highest risk clients, Deloitte failed to
design an audit appropriately tailored to address audit risk areas
that Deloitte had explicitly identified
Deloitte settled the case with the SEC by paying a penalty of $50
million

Famous Business Ethics Cases:

3. Bernie Madoff

Ponzi Scheme - is a fraudulent investment operation that pays

returns to its investors from their own money or the money paid by
subsequent investors, rather than from any actual profit earned by
the individual or organization running the operation.

The Ponzi scheme usually entices new investors by offering higher

returns than other investments, in the form of short-term returns
that are either abnormally high or unusually consistent.
Perpetuation of the high returns requires an ever-increasing flow of
money from new investors to keep the scheme going.

The system is destined to collapse because the earnings, if any,

are less than the payments to investors. Usually, the scheme is
interrupted by legal authorities before it collapses because a Ponzi
scheme is suspected or because the promoter is selling
unregistered securities. As more investors become involved, the
likelihood of the scheme coming to the attention of authorities
increases.

The scheme is named after Charles Ponzi, who became notorious

Famous Business Ethics Cases:

Bernie Madoff Cont..

According to the SEC, two back office workers who worked

for Madoff created false trading reports based on the returns
that Madoff ordered for each customer. For example, once
Madoff determined a customer's return, one of the back office
workers would enter a false trade from a previous date and
then enter a false closing trade in the amount of the required
profit.
Prosecutors allege that a computer program specially
designed to backdate trades and manipulate account
statements was used. In some cases returns were allegedly
determined before the account was even opened.
Madoff admitted during his March 2009 guilty plea that the
essence of his scheme was to deposit client money into a
Chase account, rather than invest it and generate steady
returns as clients had believed. When clients wanted their
money he used the money in the Chase account that
belonged to them or other clients to pay the requested funds.

Famous Business Ethics Cases:

4. ENRON

In 2001, after a series of revelations involving irregular accounting

procedures bordering on fraud perpetrated throughout the 1990s
involving Enron and its accounting firm Arthur Andersen, Enron
suffered the largest Chapter 11 bankruptcy in history at that time.
As the scandal unraveled, Enron shares dropped from over US $90.00
in the summer of 2000 to just pennies. Enron had been considered a
blue chip stock, so this was an unprecedented event in the financial
world. Enron's plunge occurred after the revelation that much of its
profits and revenue were the result of deals with special purpose
entities (limited partnerships which it controlled). This meant that many
of Enron's debts and the losses that it suffered were not reported in its
financial statements.
Enron filed for bankruptcy on December 2, 2001. In addition, the
scandal caused the dissolution of Arthur Andersen, which at the time
was one of the world's top accounting firms. The firm was found guilty
of obstruction of justice in 2002 for destroying documents related to the
Enron audit. Since the SEC is not allowed to accept audits from
convicted felons, Andersen was forced to stop auditing public
companies. Although the conviction was thrown out in 2005 by the
Supreme Court, the damage to the Andersen name has prevented it
from returning as a viable business even on a limited scale.

Enron created offshore entities (units which may be used for

planning and avoidance of taxes, raising the profitability of a
business). This provided ownership and management with full
freedom of currency movement and the anonymity that allowed
the company to hide losses. These entities made Enron look
more profitable than it actually was, and created a dangerous
spiral, in which each quarter, corporate officers would have to
perform more and more financial deception to create the
illusion of billions in profits while the company was actually
losing money. This practice drove up their stock price to new
levels, at which point the executives began to work on insider
information and trade millions of dollars worth of Enron stock.
The executives and insiders at Enron knew about the offshore
accounts that were hiding losses for the company. However,
the investors knew nothing of this. CFO Andrew Fastow led the
team which created the off-books companies, and manipulated
the deals to provide himself, his family, and his friends with
hundreds of millions of dollars in guaranteed revenue, at the

In 1999, Enron launched Enron Online, an Internet-based

trading operation, which was used by virtually every energy
company in the US. Enron president and COO Jeffrey Skilling
began advocating a novel idea: the company didn't really
need any "assets. By pushing the company's aggressive
investment strategy, he helped make Enron the biggest
wholesaler of gas and electricity, trading over $27 billion per
quarter. The firm's figures, however, had to be accepted at
face value. Under Skilling, Enron adopted mark to market
accounting, in which anticipated future profits from any deal
were tabulated as if real today. Thus, Enron could record
gains from what over time might turn out to be losses, as the
company's fiscal health became secondary to manipulating its
stock price on Wall Street during the Tech boom. But when a
company's success is measured by agreeable financial
statements emerging from a black box, a term Skilling himself
admitted, actual balance sheets prove inconvenient.

Enron's unscrupulous actions were often gambles to keep

the deception going and so push up the stock price. An
advancing number meant a continued infusion of investor
capital on which debt-ridden Enron in large part subsisted.
Under pressure to maintain the illusion, Skilling verbally
attacked Wall Street Analyst Richard Grubman,[who
questioned Enron's unusual accounting practice during a
recorded conference call. When Grubman complained that
Enron was the only company that could not release a balance
sheet along with its earnings statements, Skilling replied
"Well, thank you very much, we appreciate that . . . a**hole."
Though the comment was met with dismay and astonishment
by press and public, it became an inside joke among many
Enron employees, mocking Grubman for his perceived
meddling rather than Skilling's lack of tact. When asked
during his trial, Skilling wholeheartedly admitted that industrial
dominance and abuse was a global problem: "Oh yes, yes
sure, it is.

Ken McPhail and Diane Walters, 2009, Accounting and Business Ethics: An
introduction
Paul H. Dembinski and others, 2006, Enron and World Finance - A Case Study
in
Ethics
David
M., 2008, Ethical issues encountered by chartered accountants 28 cases
Larsen, Ethical Issues in Advanced Accounting,
chapter 1

Assignment
Examine the following and identify the basic ethical
standards of each organization.
1.
IFAC Code of Ethics for Professional
Accountants
2.
Ethiopian Professional Association of
Accountants & Auditors (EPAAA)
Code of Ethics
3.
Ethiopian Code of Ethics for Professional
Accountants, Issued by Office of Federal Auditor
General (OFAG) (January 2004)
4.
Professional Code of Ethics applicable to
auditors only, Issued by the OFAG (August
2008)

The End