Module 3

Question 1

Business Ethics

Common Business Stakeholders

Answer 1

1. Owners/Shareholders (existing & potential) (stock value)
2. Creditors/Suppliers (credit or investment)
3. Employees (jobs, pensions)
4. Customers (products, private info)
5. Society at large (environment, products)
6. Government Agencies (IRS, SEC, EPA, Funding)

Decisions by accountants and auditors can affect many different groups who rely on their work products. Many of these stakeholders are obvious, but others are not so obvious to everyone. Vendors and suppliers grant credit based on financial data provided directly or from credit rating agencies who use published or available financial data.

Employees or job applicants may rely on financial data in deciding to stay with a company or starting to work for one. Decisions on selecting their 401k plan investment selections that include company stock could also be made in error if provided financial data or auditor reports is unreliable.

Taxing, regulatory and funding agencies also frequently rely on data provided by accountants and auditors in carrying out their responsibilities.

Question 2

Business Ethics

Ethical Issues in Business

Answer 2

• Honesty:
  
  • Should be part of one’s moral values – generally checked by background checks
  • Many people are actually dishonest at time if immaterial are involved (e.g., office supplies, don’t tell cashier of error in their favor)
  • Abe Lincoln once said: “No man has a good enough memory to be a successful liar.” That’s one reason why auditors compare evidence for inconsistencies and potential untruthfulness.
• Fairness:
  
  • Sometimes, we use a lower standard in dealings with competitors.
  • Fairness is the standard for presented F.S.(GAAP compliant)
  • Fairness is also being objective in interpreting GAAP.
  • Fairness is basis for the Truth in Negotiations Act in federal contracting.
• Conflicts of Interest:
  
  • A common solution: Disclosure & then recuse oneself.
  • State of CA has reporting of financial relationships by designated officials.
  • Most research also requires disclosure of potential conflicts of interest.
• Discrimination: This is all about treating everyone with equal respect.
• Information technology: Very important now as it relates to data privacy.
• Fraud – see the next slide

Question 3

Business Ethics

Seven Signs of Ethical Collapse

Answer 3

According to Marianne Jennings, ethical collapse in financial reporting occurs when any organization has drifted from the basic principles of right and wrong.

1. Pressure to maintain numbers
2. Fear and silence
3. Young staff and bigger than life CEO (loyalty)
4. Weak board of directors
5. Conflicts of interests overlooked or unaddressed (Enron’s SPEs)
6. Innovation like no other company (better than others)
7. Goodness in some areas atones for evil in others (rationalization)

Question 4

Business Ethics

Ethical Dissonance Model

Answer 4

• Represents situation where your personal ethical values are at odds with that of your employer, which could mean that you may make different decisions at work than you would in your personal life.
• Four potential fit options:
  
  • 1: high-high (high organization & high individual ethics) = ethical decisions
  • 2: low-low (low organization & low individual ethics) = unethical decisions
  • 3: high-low (high organization & low individual ethics) = conflict; go either way
  • 4: low-high (low organization & high individual ethics) = conflict; go either way
• When employer and personal ethical values differ, there can be a difference between what one believes is the ethical thing to do and what they actually do.
• This frequently occurs when one rationalizes that the end result justifies the means – a rationalization of the decision actually made.
• Ethics hotlines can be used to mitigate such risks IF top management or those charged with governance have similar personal ethical values.

Question 5

Fraud.

Types of Business Fraud

Answer 5

1. Corruption (bribes, kickbacks, gratuities)
2. Misappropriation or Theft of Assets (embezzlement, theft, misuse)
3. Fraudulent Financial Report (including F.S.)

(Association of Certified Fraud Examiners = all 3; AICPA = 2 & 3)

Except for number 1, virtually everyone considers these actions to be unethical. For bribes, some people do not see these as unethical if such is considered commonplace in a location. In the U.S. and many other countries, bribing government officials is illegal both domestically and internationally.

Vendor kickbacks or gratuities to employees are also rationalized as not impacting their judgment and not increasing the prices their employers pay.

Fraudulent financial reporting is what transpired at Phar_Mor.

Question 6

Fraud

Detection of Fraud

Answer 6

1. Tips – About 40 – 50%
2. Since 2010, management review 2nd – 15%
3. Internal (14%) & External Auditors (4%)
4. Accidental – 7%

These statistics about business fraud detection comes from the Association of Certified Fraud Examiners in their latest Annual Report to the Nation.

Because of concealment actions made by perpetrators, the most common way to detect fraud is not from auditors and reviewers, but from tips from insiders. These individuals are commonly referred to as “Whistle Blowers”.

Question 7

Fraud

External Auditor Overall Responsibility

Answer 7

This responsibility applies to all financial statement audits and the level of responsibilities have increased over the years after significant fraud has went undetected and expanded responsibilities were desired by stakeholders. But, as you can see from the limiting words like “reasonable assurance” versus “absolute assurance” and “material” versus “any fraud”, there is a significant risk that auditors will not detect all fraud.

Question 8

Aids to Increase Fraud Detection

Answer 8

• Sarbanes-Oxley Act (SOX) Requirements:
  
  • Implementation of control procedures
  • Corporate Governance
  • Hot Lines (internal, external, regulatory)
• Increased whistle blowing avenues
• Codes of ethics with reminding & training

The Sarbanes-Oxley Act and other legislation passed, and regulations implemented, after the financial crisis of the mid-2000s has increased fraud detection abilities, especially with whistle blowers.

However, do whistle blowers always go far enough to root out fraud they are aware of? How about Sherron Watkins at Enron? She only reported the fraud internally, although she did go to the Chairman of the Board of Directors. Was she too much concerned about her own interests rather that those of others?

Some organizations not only have codes of conduct, but also require annual refresher training – like UC.

Question 9

Fraud

Protection of Whistle Blowers

Answer 9

These whistle blowers highlighted fraud or other wrongdoing. Cynthia Cooper at WorldCom stopped major F.S. fraud by not stopping within her change of command and went to several independent board members. Coleen Rowley was an FBI employee that reported a number of FBI lapses in missing opportunities to stop the 9/11 terrorists attacks. She also went beyond her change of command to Congress Elevating concerns to higher levels or to persons outside of one’s employer can be perceived as too great a risk to one’s self interests.

Question 10

Fraud

Impact of SOX on Fraud

Answer 10

• More fraud detected by management reviews
• More Accountability (CEO & CFO & Below)
• More Emphasis on Internal Controls (risk assessment & testing by companies)
• Required policies and procedures
  
  • Maintenance of records
  • Recording of transactions
  • Prevention or detection of fraud
• Estimated fraud losses reduced 70 to 96%

Most people believe that SOX did reduce the likelihood and severity of financial statement fraud in the U.S. and also the ability to detect fraud that has occurred by both insiders and the external auditors. SOX not only requires more preventions and detection tools, but it also added more accountability.

CEO & CFOs must certify both the financial statements and related internal controls over financial reporting. Some CFOs flow-down the certification to their subordinates as well.

External auditors for issuers (public companies) have their audit performance inspected by a governmental agency rather than another CPA firm. Poor external auditor performance can result in the CPA firm or individual auditors being suspended or banned from doing audits of issuers.

Question 11

Corporate Governance

AICPA Definition

Answer 11

For corporations, these persons are generally the members of the board of directors. For all issuers, this board MUST include non-management or independent members and the board’s audit committee is to be composed of only these independent members. Also, the audit committee for issuers must oversee not only the financial reporting process, but also the hiring and overseeing of the external auditors.

Management is also defines as the person(s) with executive responsibility for the conduct of the entity’s operations. For some entities, management includes some or all of those charged with governance; for example, executive members of a governance board or an owner-manager. Non-issuers do not have to have independent board members, unless required by their lenders or corporate bylaws.

Question 12

Corporate Governance

Protecting Investors

Answer 12

• Defines relationships among:
  
  • Stakeholders
  • Management
  • Board of Directors
• Influences how company is run.

Although the concept of corporate governance is not new, it is now a formal term and has the interest of many stakeholders.

Since the passage SOX, the SEC and the PCAOB have also realized the importance of competent corporate governance in protecting investors.

Question 13

Corporate Governance

Pillars of Corporate Governance

Answer 13

1. Responsibility
2. Accountability
3. Fairness
4. Transparency

The foundations of corporate governance is generally considered to include the proper assignment of responsibility, holding individuals accountable for their actions or inactions, the concept of fairness that we covered earlier and the concept that most corporate actions should not be secret, but shared as appropriate, otherwise known now as transparency.

Question 14

Corporate Governance

Benefits of Good Governance

Answer 14

• More Confidence/Less Risk (perception of stakeholders)
  
  • Better access to capital
  • Aids economic growth
  • Positive impact on stock prices
• Ensures business operates fairly & transparently
• Ensures that management is held accountable
• Helps ensure sustainability (profitability, growth)

There are many benefits to having sound and competent corporate governance and the overall benefit is that the various stakeholders have more trust in their dealings with the corporation. And good organizational governance offers similar to other organizations like universities, nonprofits and governmental entities.

For financial reporting reliability, the attributes of accountability, fairness & transparency generally active involvement of the external members of the board of directors/those charged with governance as their performance is not reported on in the F.S. – unlike that of management.

Question 15

Corporate Governance

Corporate Governance Systems

Answer 15

• Corporate governance systems establish control mechanisms to ensure organizational values guide decision-making and ethical standards are being followed. Characteristics include: Accountability, Oversight and Control.
• Corporate governance can be seen as a set of rules that define the relationship between stakeholders, management and board of directors and influence how that company operates.

Question 16

Corporate Governance

Corporate Agency Theory

Answer 16

• Managers & directors are agents of the shareholders.
• Shareholders are the principals.
• Rules & incentives should encourage behavior of agents that satisfy desires of the principals.

Corporate agency theory is the concept that management and other employees of a corporation are acting as agents of the shareholders or owners and owners should be able to expect that their interests are being protected by their agents.

With the stock option back dating scandals around 2006, management did not protect the interests of stockholders, but that of other executives.

Question 17

Corporate Governance

Why doesn’t agency theory always work?

Answer 17

• Desires and goals of agents and principals may not be in agreement as sometimes reward systems for agents are short-term.
• Difficult to verify the activities of the agents as they develop & control reporting, plus there are significant limits on sharing information with stakeholders under SEC rules.
• These shortcomings to the agency theory are the primary reasons why we have auditors, especially independent auditors

Question 18

Corporate Governance

Agency Cost

Answer 18

• Agents are somewhat more likely to place personal goals ahead of corporate/shareholder goals.
• Consistent with egoism theory.
• Conflict of interests between agents and principals – esp. in financial statements.
• Increases if the Board of Directors fails to exercise due care in their oversight and governance.

These costs can be minimized by ensuring that the shortcomings discussed earlier are avoided or minimized. However, principals generally hope that linking the compensation and rewards to organizational financial performance should add value for the principals in the future. However, financial performance reporting can be manipulated. This is where the accountants and auditors must be good agents for the principals.

Question 19

Corporate Governance.

Stakeholders other than Stockholders

Answer 19

• Employees (job security, pensions)
• Employee Governance
  
  • Employee share ownership
  • Employee representation on Board of Directors
  • Employee involvement in governing committees

Accountants and auditors sometimes do not think about employees as stakeholders in their work and work products. But they frequently are as the result of many financial frauds is company layoffs or decrease in the value of company stock that employees may own. Enron went out of business and the employee 401k plan was heavy on Enron stock. Enron’s external audit firm, Arthur Andersen, also went out of business.

Question 20

Governance Mechanisms

Internal Governance

Answer 20

Internal:

• Independent Directors
• Audit Committee (public companies: independent Dir)
• Management
• Internal Controls
• Internal Audit

Corporate or organizational governance is primarily the responsibility of groups that are part of the corporation or organization. Many board members are from management (officers of the company), but “Independent “members are not part of top management of the organization. However, sometimes the charisma of a CEO can effectively reduce their independence. For public companies, Audit Committee members are only independent directors. Internal audit is more effective when they have a direct link to Audit Committee.

Question 21

Governance Mechanisms

External Governance

Answer 21

External:

• Financial markets and analysts
• Stock exchange listing requirements
• State &federal laws and regulations
• Court decisions/penalties (FCPA)
• Shareholder proposals/Large shareholder
• External auditors
• SOX-Required CEO/CFO Code of Ethics

The existence of external governance mechanisms is primarily at issuers or public companies or public organizations like state universities and colleges. After SOX, external auditors are more linked to Audit Committee and PCAOB is trying to increase communication between them, including sharing of PCAOB inspection results

Question 22

Governance Mechanisms

Role of Board of Directors (BOD) & Officers

Answer 22

• BOD has ultimate responsibility for success or failure of company.
• Principles must be part of the culture:
  
  • Ethical and honest behavior
  • Compliance with laws and regulations
  • Effective management of resources and risks
  • Accountability of personnel
• Establish ethical culture and code of conduct.
• Communicate these principles within organization.
• Board members have fiduciary duty to safeguard assets and make decisions that promote shareholder interest.
• Business Judgment Rule – managers and BOD immune from liability so long as decisions made in good faith and with reasonable skill and prudence.

Question 23

Governance Mechanisms

BOD’s Audit Committee

Answer 23

• Independent directors
• Oversight of financial reporting, internal audit & external auditors
• SOX mandated – independence; financial expertise
• Listing requirement of NYSE
• Seen as the one body that should be able to prevent fraudulent financial reporting.
• Committee should meet separately with the senior executives, internal auditors and the external auditors.

Question 24

Governance Mechanisms

Best Practices of Audit Committees

Answer 24

1. Focus on financial reporting & strong internal controls.
2. Review company’s whistleblower processes & compliance program.
3. Understand significant risks to the company’s operations and financial reporting.
4. Consider whether the company’s disclosures provide investors with the information needed to understand the state of the business.
5. Set clear expectations for the internal audit function and communication with the external auditors.
6. Understand the audit committee’s role in information technology.

Question 25

Governance Mechanisms Dodd-Frank Wall Street Reform and Consumer Protection Act (2010)

Answer 25

* Increased monetary benefits for whistleblowers * Concern: Will whistleblowers go straight to external sources instead of internal?) * Protection from retaliation unless only report internally. * Encourages accountants & auditors to report wrongdoing. * CPAs worried about client confidentiality. * Excludes accountants & auditors with relevant responsibilities: * Individuals with internal compliance or audit responsibilities at an entity * CPAs who acquire knowledge of potential violations through an audit required by federal securities laws * CPAs may report information about potential violations about own firms' performance of audit services of client.

Question 26

Governance Mechanisms IIA Code of Ethics - Principles and Rules

Answer 26

Principles * Integrity * Objectivity * Confidentiality * Competency The code applies to members of the IIA, Certified Internal Auditors (CIA) and other IIA certifications and candidates and to entire Internal Audit departments who adopt them. Integrity: The integrity of internal auditors establishes trust and thus provides the basis for reliance on their judgment. Objectivity: Internal auditors exhibit the highest level of professional objectivity in gathering, evaluating, and communicating information about the activity or process being examined. Internal auditors make a balanced assessment of all the relevant circumstances and are not unduly influenced by their own interests or by others in forming judgments. Confidentiality: Internal auditors respect the value and ownership of information they receive and do not disclose information without appropriate authority unless there is a legal or professional obligation to do so. Competency: Internal auditors apply the knowledge, skills, and experience needed in the performance of internal audit services.

Question 27

Governance Mechanisms IIA Code of Ethics: Integrity

Answer 27

Internal Auditors: * 1.1. Shall perform their work with honesty, diligence, and responsibility. * 1.2. Shall observe the law and make disclosures expected by the law and the profession. * 1.3. Shall not knowingly be a party to any illegal activity, or engage in acts that are discreditable to the profession of internal auditing or to the organization. * 1.4. Shall respect and contribute to the legitimate and ethical objectives of the organization. The rules under the Integrity principle all relate to what the internal auditor shall adhere to in carrying out their duties.

Question 28

Governance Mechanisms IIA Code of Ethics: Objectivity

Answer 28

Internal Auditors: * 2.1. Shall not participate in any activity or relationship that may impair or be presumed to impair their unbiased assessment. This participation includes those activities or relationships that may be in conflict with the interests of the organization. * 2.2. Shall not accept anything that may impair or be presumed to impair their professional judgment. * 2.3. Shall disclose all material facts known to them that, if not disclosed, may distort the reporting of activities under review. Rule 2.1 includes the prohibition from evaluating a function where the auditor recently worked or where a close relative works or recently worked.

Question 29

Governance Mechanisms IIA Code of Ethics: Compentency

Answer 29

Internal Auditors: * 4.1 Shall engage only in those services for which they have the necessary knowledge, skills, and experience. * 4.2. Shall perform internal audit services in accordance with the International Standards for the Professional Practice of Internal Auditing (Standards). * 4.3. Shall continually improve their proficiency and the effectiveness and quality of their services. The rules for competency are designed to ensure that internal auditors are qualified to perform quality audits and advisory services.

Question 30

Governance Mechanisms IIA Code of Ethics: Confidentiality

Answer 30

Internal Auditors: * 3.1. Shall be prudent in the use and protection of information acquired in the course of their duties. * 3.2. Shall not use information for any personal gain or in any manner that would be contrary to the law or detrimental to the legitimate and ethical objectives of the organization. The rules under the Confidentiality principle relate to protecting confidential information or using such information for a self interest or gain.

Question 31

Governance Mechanisms NYSE on Corporate Governance

Answer 31

* Listed companies must adopt & disclose corporate governance guidelines. * CEO must annually certify compliance. * Other Key Elements: * Majority of B of D independent. * Audit Committee at least 3 and all independent * Internal audit function The New York Stock Exchange requires issuers or public companies to have a solid framework of corporate governance with a number of attributes to better ensure that those charged with governance will effectively oversee management.

Question 32

Governance Mechanisms. Internal Controls Objectives:

Answer 32

* Effectiveness and efficiency of operations * Reliability of financial reporting * Compliance with applicable laws and regulations * Safeguarding assets The primary purpose of any internal control is to achieve objectives of the organization. The first 3 objectives comes from the Committee of Sponsoring Organizations' (COSO) Internal Control Integrated Framework. The 4th objective is sometimes stated as a separate objective, but under COSO is part of objective number 2.

Question 33

Governance Mechanisms Internal Controls

Answer 33

* Prevent or detect (& correct) errors and fraud * Ensure management policies followed * Can be overridden by top management * Error or fraud could represent: * Asset misappropriations * Materially misstated financial statements/reportS * Inadequate disclosures/misleading F.S. * Assessing adequacy & compliance of internal controls is a major focus of many internal audit departments. * Management frequently can override internal controls because of their power and authority within an organization. According to the AICPA's auditing standards, there is always a risk of management override of internal controls occurring. Test by looking at unusual transaction, transactions with questionable business purpose, large end of period transactions, transactions where top management was excessively involved. One of the best ways to prevent or detect management override is an effective whistle blower program where employees feel safe from retaliation.

Question 34

Governance Mechanisms Audited Financial Statements

Answer 34

* F.S. prepared by management. * The report financial position and results in accordance with GAAP, IFRS. * GAAP or IFRS are set by independent bodies. * External auditors render an independent opinion on the F.S. * Auditor mitigate conflict between managers (aggressive) and owners (conservative). * Under SOX, public company CEOs & CFOs must also certify F.S. * The SEC reviews F.S. and the PCAOB inspects audits of public companies Accountants and auditors are generally associated with an organization's financial statements rather it is a public or private company or organization. However, there are a number of other groups that have an imp[act on F.S., especially for public companies.

Question 35

Governance Mechanisms SOX Financial Statements Certification

Answer 35

* SOX section 302 requires CEO & CFO to certify: * No untrue statement of material facts * No omission or misleading material facts * SOX requires separate financial reporting code of ethics for CEO, CFO and principal financial officers * Penalties in SOX section 906: * Maximum fine of $1 million * Maximum imprisonment of 10 years * Could include fines and/or imprisonment * Willful false certification: $5 mil or 20 years, or both The textbook (page 145) shows Microsoft's SOX-required code of ethics and it includes coverage on whistle blowing. You can access this online here: Microscoft Code of Professional Conduct. SOX put some serious penalties for intentional misrepresentation of financial statements, but the SEC has generally settled for fines and penalties without any admission of guilt, but have received pressure to get convictions or admissions of guilt.

Question 36

Governance Mechanisms Common Corporate Values

Answer 36

* Ethical behavior/integrity * Commitment to customers * Commitment to employees * Teamwork and trust * Honesty/openness * Accountability * Corporate citizenship Well run and ethically responsible organizations have good core values, such as these, that they expect their employees to adhere to. In some organizations some of these values may be better adhered to than others.

Question 37

Governance Mechanisms Whistleblowers

Answer 37

SOX Section 806 Protection: * Prohibits discharge, demotion, discrimination, threatens or other harmful action to employee. * Employee can file a compliant with Secretary of Labor (delegated to OSHA). * Remedies for employee include reinstatement, back pay, litigation costs and attorney fees. Generally, employees who report suspected ethical violations or other wrongdoing are called whistleblowers. The whistleblowing can be internal within an organization or to external organizations, such as law enforcement or regulators. SOX Section 806 provides protections for whistleblowers Most organizations with a decent code of ethics includes whistleblowing responsibilities for employees, as well as similar protections. The SEC and the IRS have whistleblowing programs with payouts. The U.S. False Claims Act also rewards whistleblowers for reporting over-charging the federal government in contracting , and originates from the Civil War.