Ethical Obligations and Decision Making in Accounting Text and Cases Third Edition
Steven M. Mintz, DBA, CPA Professor of Accounting California Polytechnic State University, San Luis Obispo
Roselyn E. Morris, Ph.D., CPA Professor of Accounting Texas State University–San Marcos
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ETHICAL OBLIGATIONS AND DECISION MAKING IN ACCOUNTING: TEXT AND CASES, THIRD EDITION
Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright © 2014 by McGraw-Hill Education. All rights reserved. Printed in the United States of America. Previous editions © 2011 and 2008. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of McGraw-Hill Education, including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.
Some ancillaries, including electronic and print components, may not be available to customers outside the United States.
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Library of Congress Cataloging-in-Publication Data Mintz, Steven M. Ethical obligations and decision making in accounting: text and cases / Steven M. Mintz, DBA, CPA, Professor of Accounting California Polytechnic State University, San Luis Obispo Roselyn E. Morris, PhD, CPA, Professor of Accounting Texas State University-San Marcos. — Third edition. pages cm ISBN 978-0-07-786221-3—ISBN 0-07-786221-X 1. Accountants—Professional ethics—United States— Case studies. I. Morris, Roselyn E. II. Title. HF5616.U5M535 2014 174′.4—dc23
The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does not indicate an endorsement by the authors or McGraw-Hill Education, and McGraw-Hill Education does not guarantee the accuracy of the information presented at these sites.
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“Whatever we learn to do, we learn by doing it.” — Aristotle
We hope this book inspires students to engage in the learning process, to make ethical choices in their lives, and always strive for excellence in whatever they do.
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About the Authors STEVEN M. MINTZ, DBA, CPA, is a professor of accounting in the Orfalea College of Business at the California Polytechnic State University–San Luis Obsipo. Dr. Mintz received his DBA from George Washington University. His first book, titled Cases in Accounting Ethics and Professionalism, was also published by McGraw-Hill. Dr. Mintz develops individual courses in professional accounting ethics for Bisk Education that meet each state’s board of accountancy mandatory requirements for continuing education in ethics. He also writes two popular ethics blogs under the names “ethicssage” and “work- placeethicsadvice.” Dr. Mintz has received the Faculty Excellence Award of the California Society of CPAs and Service Award from the California Board of Accountancy for his work on the Advisory Committee on Accounting Ethics Curriculum.
ROSELYN E. MORRIS, PH.D., CPA, is a professor of accounting in the Accounting Department at the McCoy College of Business, Texas State University–San Marcos. Dr. Morris received her Ph.D. in business administration from the University of Houston. She is a past president of the Accounting Education Foundation and a member of the Qualifications Committee of the Texas Board of Public Accountancy. Dr. Morris has received the Outstanding Educator Award from the Texas Society of CPAs.
Both Professors Mintz and Morris have developed and teach an accounting ethics course at their respective universities.
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Preface Why Did We Write This Book?
The first edition of Ethical Obligations and Decision Making in Accounting: Text and Cases was written in the wake of the dot.com bubble and accounting scandals at companies such as Enron and WorldCom. The second edition was written in the wake of the financial meltdown of 2007–2008 that was due to high-risk lending and borrowing practices. The result of these scandals has been an increased call by professional and regulatory bodies for ethics education of accounting students in values, ethics, and attitudes to support pro- fessional and ethical judgments and act in the public interest. We dedicate ourselves to this goal through our book.
Several states now require their accounting students to complete an ethics course prior to certification. Texas was first state to do so, and it requires accounting students in Texas and those moving into the state to complete an ethics course at a Texas uni- versity or in their home institution. California and Colorado require separate account- ing ethics courses; states such as Maryland, New York, and West Virginia also have separate ethics course requirements. This book is written to enable instructors to address the content material that state boards typically expect to be covered in qualify- ing courses.
Ethical Obligations and Decision Making in Accounting was written to guide students through the minefields of ethical conflict in meeting their responsibilities under the pro- fessions’ codes of conduct. Our book is devoted to helping students cultivate the ethical commitment needed to ensure that their work meets the highest standards of integrity, independence, and objectivity. We hope that this book and classroom instruction will work together to provide the tools to help you make ethical judgments and carry through with ethical actions.
Our book blends ethical reasoning, components of behavioral ethics, reflection, and the principles of ethical conduct that embody the values of the accounting profession. We incorporate these elements into a framework to consider the ethical obligations of accountants and auditors and how to make ethical decisions that address the following material:
• The role of moral and cognitive development in ethical reasoning, ethical judgment, and ethical orientation
• Professional codes of conduct in accounting • Ethical corporate governance systems • Fraud detection and prevention • Legal and regulatory obligations of auditors • Whistleblowing obligations of accountants and auditors • Earnings management issues and the quality of financial reporting • Ethical systems, global ethics standards, and corporate governance considerations in
doing business worldwide
Attributes of This Textbook Ethical Obligations and Decision Making in Accounting is designed to provide the instructor with comprehensive coverage of ethical and professional issues encountered by accounting professionals. Our material provides the best flexibility and pedagogical
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effectiveness of any book on the market. To that end, it includes numerous features designed to make both learning and teaching easier, such as:
• Ethical reflections that set the tone for each chapter • 160 discussion questions • 76 cases (10 per Chapters 1–7 and 6 in Chapter 8), about one-third of which are from the
SEC enforcement files • 6 additional major cases that can be used for comprehensive testing, a group project, a
research assignment, or a capstone to the book • Dozens of additional cases and instructional resources, which are available to enrich
student learning • Links to videos for instructors
• The book is comprehensive enough to serve as a stand-alone text, yet flexible enough to act as a co-text or supplementary text across the accounting curricula or within an auditing or financial accounting course.
• There is sufficient case and supplementary material to allow the instructor to vary the course over at least two to three terms.
• The writing style is pitched specifically to students, making the material easy to follow and absorb.
• Group discussions and role-play opportunities using case studies • Video links to bring case material to life
The Instructor Edition of the Online Learning Center, www.mhhe.com/mintz3e, offers materials to support the efforts of first-time and seasoned instructors of accounting ethics. A comprehensive Instructor’s Manual provides teaching notes, grading sugges- tions and rubrics, sample syllabi, extra cases and projects, and guidelines for incorporating writing into the accounting ethics course; a Test Bank that provides a variety of multiple- choice, short answer, and essay questions for building quizzes and tests; additional cases that can be assigned, including some that were not carried over from the first and second editions; links to videos to enhance the learning experience and bring case discussions to life; and PowerPoint presentations for every chapter make a convenient and powerful lecture tool.
Changes in This Edition The behavioral approach to ethics leads to understanding and explaining moral behavior in a systematic way. We have expanded our discussion of ethics beyond the traditional philosophical moral reasoning methods that teach students how they should behave when facing ethical dilemmas and now also engage them to understand their own behavior better and compare it to how they would ideally like to behave. We incorporate those discussions in addressing ethical obligations of accountants and auditors under professional codes of conduct and in areas such as whistleblowing considerations under Sarbanes-Oxley (SOX) and the Dodd-Frank Financial Reform Act.
This revision also includes:
• Emphasis on values, ethics, and behaviors in a professional setting • Expanded coverage of professional codes of conduct and failure to maintain indepen-
dence, integrity, objectivity, and professional skepticism • New audit requirements and clarified Statements on Auditing Standards effective in
2014 that collectively better address financial statement fraud and the risk of material misstatements
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• Broadened perspective on earnings management, including the role of earnings expec- tations, the use of accruals, income smoothing, risk assessment and materiality, and financial restatements
• Public interest and ethical considerations in developing international financial report- ing standards, cultural considerations when operating overseas, corporate governance systems, and global bribery
• Restoring public trust and confidence in the accounting profession
This edition of Ethical Obligations and Decision Making in Accounting has dozens of new discussion questions. The material that was replaced to keep the book fresh is avail- able to instructors in the Instructor’s Manual for testing purposes. For the first time, we provide video links to many of the cases in the book in the IM.
In a project of this kind, errors are bound to occur. As authors, we accept full responsi- bility for all errors and omissions. We welcome feedback on the book and suggestions for improvements. The authors have collectively had more than 30 years of experience teach- ing accounting ethics and welcome the opportunity to share our insights with you on how best to use the book and teach ethics to accounting students.
The authors want to express their sincere gratitude to these reviewers for their comments and guidance. Their insights were invaluable in developing this edition of the book.
Russell Calk New Mexico State University Jeffrey Cohen Boston College Dan Hubbard University of Mary Washington
Lorraine Lee University of North Carolina–Wilimington Stephen A. McNett Texas A&M University–Central Texas Barbara Porco Fordham University
We also appreciate the assistance and guidance given us on this project by the staff of Mc-Graw-Hill Education, including Tim Vertovec, Managing Director; James Heine, Executive Brand Manager; Michelle Nolte, Marketing Manager; Lori Bradshaw, develop- ment editor; Judi David, project manager; Jennifer Pickel, buyer; Studio Montage, design coordinator; and Prashanthi Nadipalli, media project manager. We greatly appreciate the role of Shyam Ramasubramony, project manager, and Susan McClung, copyeditor of the book.
Finally, we would like to acknowledge the contributions of our students, who have pro- vided invaluable comments and suggestions on the content and use of these cases.
If you have any questions, comments, or suggestions concerning Ethical Obligations and Decision Making in Accounting, please send them to us at firstname.lastname@example.org and email@example.com.
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Case # Case Name/Description
1-1 Harvard Cheating Scandal Student cheating at Harvard raises questions about responsibilities of instructors and student personal responsibilities
1-2 Giles and Regas Dating relationship between employees of a CPA firm jeopardizes completion of the audit.
1-3 NYC Subway Death: Bystander Effect or Moral Blindness Real-life situation where onlookers did nothing while a man was pushed to his death off a subway platform.
1-4 Lone Star School District Failure to produce documents to support travel expenditures raises questions about the justifiability of reimbursement claims.
1-5 Reneging on a Promise Ethical dilemma of a student who receives an offer of employment from a firm that he wants to work for, but only after accepting an offer from another firm.
1-6 Capitalization versus Expensing Ethical obligations of a controller when pressured by the CFO to capitalize costs that should be expensed.
1-7 Eating Time Ethical considerations of a new auditor who is asked to cut down on the amount of time that he takes to complete audit work.
1-8 A Faulty Budget Ethical and professional responsibilities of an accountant after discovering an error in his sales budget.
1-9 Cleveland Custom Cabinets Ethical and professional responsibilities of an accountant who is asked to “tweak” overhead to improve reported earnings.
1-10 Telecommunications, Inc. Concerns about the ethics of engineers who accept free travel and lodging from a foreign entity after establishing the criteria for a contract awarded to that entity.
Case # Case Name/Description
2-1 WorldCom Persistence of internal auditor, Cynthia Cooper, to correct accounting fraud and implications for Betty Vinson, a midlevel accountant, who went along with the fraud
2-2 Better Boston Beans Conflict between wanting to do the right thing and a confidentiality obligation to a coworker.
2-3 The Tax Return Tax accountant’s ethical dilemma when asked by her supervisor to ignore reportable lottery winnings.
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2-4 Shifty Industries Depreciation calculations and cash outflow considerations in a tax engagement.
2-5 Blues Brothers Identifying enablers and disablers of ethical action and ways to convince others of one’s point of view.
2-6 Supreme Designs, Inc. Ethical dilemma of an accountant who uncovers questionable payments to his supervisor.
2-7 Milton Manufacturing Company Dilemma for top management on how best to deal with a plant manager who violated company policy but at the same time saved it $1.5 million.
2-8 Juggyfroot Pressure imposed by a CEO on external accountants to change financial statement classification of investments in securities to report a market gain in earnings.
2-9 Phar-Mor SEC investigation of Phar-Mor for overstating inventory and misuse of corporate funds by the COO.
2-10 Gateway Hospital Behavioral ethics considerations in developing a position on unsubstantiated expense reimbursement claims.
Case # Case Name/Description
3-1 The Parable of the Sadhu Classic Harvard case about ethical dissonance and the disconnect between individual and group ethics.
3-2 Amgen Whistleblowing Case Whistleblower’s termination after raising issues about the company’s underreporting of complaints and problems with pharmaceutical drugs.
3-3 United Thermostatic Controls Acceptability of accelerating the recording of revenue to meet financial analysts’ earnings estimates and increase bonus payments.
3-4 Hewlett-Packard Use of false and fraudulent means to obtain confidential information from members of the board of directors.
3-5 IRS Whistleblower and Informing on Tax Cheats Ethics of gathering sensitive information about wrongdoing to qualify for whistleblower payouts.
3-6 Bennie and the Jets Ethical and professional obligations in reporting accounting wrongdoing to higher-ups in the organization.
3-7 Exxon-XTO Merger Alleged breach of fiduciary duties of the board of directors of XTO Energy that arose from ExxonMobil’s takeover of XTO.
3-8 Disclosure of Steve Jobs’s Health as Apple CEO: A Public or Private Matter? Shareholder rights to receive negative information about the health of its CEO.
Case Descriptions xi
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3-9 Bhopal, India: A Tragedy of Massive Proportions Evaluation of the decision-making process before, during, and after the leak of a toxic chemical that killed or injured thousands.
3-10 Accountability of Ex-HP CEO in Conflict of Interest Charges Sexual harassment charges stemming from conflict of interest between CEO/board chair and outside contractor.
Case # Case Name/Description
4-1 America Online (AOL) Internet-based company’s improper capitalization of advertising costs and the use of “round-trip” transactions to inflate revenue and earnings.
4-2 Beauda Medical Center Confidentiality obligation of an auditor to a client after discovering a defect in a product that may be purchased by a second client.
4-3 Family Games, Inc. Ethical dilemma for a controller being asked to backdate a revenue transaction to increase performance bonuses in order to cover the CEO’s personal losses.
4-4 First Community Church Misappropriation of church funds and subsequent cover-up by a member of the board of trustees.
4-5 Lee & Han, LLC Alteration of work papers and ethical obligations of auditors.
4-6 Gee Wiz Ethics of working for employer’s customer on the side and evaluating the customer’s receivable account.
4-7 Family Outreach Questions about validity of expense accounts and ethical obligations of the state auditor.
4-8 HealthSouth Corporation Manipulation of contractual allowances to overstate net revenues, and auditors’ inability to gather the evidence needed to stop the fraud.
4-9 Healthcare Fraud and Accountants’ Ethical Obligations Stakeholder considerations and ethical obligations upon discovering Medicare fraud.
4-10 Independence Violations at PwC Investigation of PwC independence procedures after self-regulatory peer review fails to identify violations.
Case # Case Name/Description
5-1 Computer Associates Audit committee’s role in identifying premature revenue recognized on software contracts.
5-2 ZZZZ Best Fraudster Barry Minkow uses fictitious revenue transactions from nonexistent business to falsify financial statements.
5-3 Imperial Valley Thrift & Loan Role of professional skepticism in evaluating audit evidence on collectability of loans and going concern assessment.
xii Case Descriptions
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5-4 Audit Client Considerations and Risk Assessment Risk assessment procedures prior to deciding whether to submit a competitive bid for an audit engagement.
5-5 Krispy Kreme Doughnuts, Inc. “Round-trip” transactions used to inflate revenues and earnings to meet or exceed financial analysts’ EPS guidance.
5-6 Dunco Industries Role and ethical responsibilities of accounting professionals in assessing the validity of audit evidence.
5-7 First Community Bank Valuation of loan loss impairment and risk assessment.
5-8 Fannie Mae: The Government’s Enron Comprehensive case covers manipulation in four areas to project stable earnings—derivatives, loan fees, loan loss reserves, and marketable securities.
5-9 Royal Ahold N.V. (Ahold) U.S. subsidiary of a Dutch company that used improper accounting for promotional allowances to meet or exceed budgeted earnings targets.
5-10 Groupon Competitive pressures on social media pioneer leads to internal control weakness and financial restatements.
Case # Case Name/Description
6-1 SEC v. Halliburton Company and KBR, Inc. Bribery allegations against Halliburton and the application of the Foreign Corrupt Practices Act (FCPA).
6-2 Con-way Inc. Facilitating payments and internal control requirements under the FCPA.
6-3 Insider Trading and Accounting Professionals Insider trading by accounting professionals and providing tips to friends.
6-4 Anjoorian et al.: Third-Party Liability Application of the foreseeability test, near-privity, and the Restatement approach in deciding negligence claims against the auditor.
6-5 Vertical Pharmaceuticals Inc. et al. v. Deloitte & Touche LLP Fiduciary duties and audit withdrawal considerations when suspecting fraud at a client.
6-6 SEC v. DHB Industries, Inc., n/k/a Point Blank Solutions, Inc. SEC action against independent directors and audit committee members in a securities fraud case.
6-7 Livingston & Haynes, P. C. Evaluation of ordinary negligence, gross negligence, and fraud in a securities violation.
6-8 Kay & Lee LLP Auditor legal liability when foreseen third party relies on financial statements
6-9 Reznor v. J. Artist Management (JAM), Inc. Legal liability of manager of lead singer of Nine Inch Nails based on allegations of mismanagement.
6-10 SEC v. Zurich Financial Services Complex accounting for reinsurance transactions and transfer of economic risk.
Case Descriptions xiii
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Case # Case Name/Description
7-1 Nortel Networks Use of reserves and revenue recognition techniques to manage earnings.
7-2 Solutions Network, Inc. Use of the Fraud Triangle to evaluate management’s actions.
7-3 Cubbies Cable Differences of opinion with management over whether to capitalize or expense cable construction costs.
7-4 Solway, Inc. Use of year-end accruals to manage earnings and whistleblowing considerations.
7-5 Dell Computer Use of “cookie-jar” reserves to smooth net income and meet financial analysts’ earnings projections.
7-6 Sweat Construction Company Pressure on the controller to ignore higher estimated costs on a construction contract to improve earnings and secure needed financing.
7-7 Sunbeam Corporation Use of cookie-jar reserves and “channel stuffing” by a turnaround artist to manage earnings.
7-8 Diamond Foods Link between projecting financial results and earnings management.
7-9 The North Face, Inc. Questions about financial structuring and revenue recognition on barter transactions to achieve desired results.
7-10 Vivendi Universal Improper adjustments to EBITDA and operating free cash flow by a French multinational company to meet ambitious earnings targets and conceal liquidity problems.
Case # Case Name/Description
8-1 SEC v. Siemens Aktiengesellschaft Bribery committed by a German company, using slush funds, off-book accounts, and business consultants and intermediaries to facilitate illegal payments.
8-2 Parmalat: Europe’s Enron Fictitious accounts at Bank of America and the use of nominee entities to transfer debt off the books by an Italian company led to one of Europe’s largest fraud cases.
8-3 Satyam: India’s Enron CEO’s falsification of financial information and misuse of corporate funds for personal purposes.
8-4 Royal Dutch Shell plc Overstatement of estimated recoverable proved oil and gas reserves by Dutch-U.K. company in violation of SEC regulations.
xiv Case Descriptions
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8-5 Autonomy Investigations by U.S. SEC and UK Serious Fraud Office into accounting for an acquisition of a British software maker by Hewlett-Packard (HP).
8-6 Olympus Major corporate scandal in Japan where Olympus committed a $1.7 billion fraud involving concealment of investment losses through fraudulent accounting.
Chapter Coverage Case Name/Description
1 Adelphia Communications Corporation SEC action against Deloitte & Touche for failing to exercise the proper degree of professional skepticism in examining complex related-party transactions and contingencies that were not accounted for in accordance with GAAP.
2 Royal Ahold N.V. (Ahold) Court finding that Deloitte & Touche should not be held liable for the efforts of the client to deprive the auditors of accurate information needed for the audit and masking the true nature of other evidence.
3 MicroStrategy, Inc. SEC action against MicroStrategy for improper revenue recognition of accounting for multiple deliverables contracts and questions about independence of PwC.
4 Cendant Corporation SEC action against Cendant for managing earnings through merger reserve manipulations and improper accounting for membership sales, and questions about the audit of Ernst & Young.
5 Navistar International Confidentiality issues that arise when Navistar management questions the competency of Deloitte & Touche auditors by referring to PCAOB inspection reports and fraud at the company.
6 Waste Management Failure of Andersen auditors to enforce agreement with the board of directors to adopt proposed adjusting journal entries that were required in restated financial statements.
Case Descriptions xv
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1 Ethical Reasoning: Implications for Accounting 1
2 Cognitive Processes and Ethical Decision Making in Accounting 54
3 Creating an Ethical Organization Environment and Effective Corporate Governance Systems 91
4 AICPA Code of Professional Conduct 175
5 Fraud in Financial Statements and Auditor Responsibilities 246
Brief Contents 6 Legal, Regulatory, and Professional
Obligations of Auditors 335
7 Earnings Management and the Quality of Financial Reporting 410
8 International Financial Reporting: Ethics and Corporate Governance Considerations 475
MAJOR CASES 542
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Table of Contents Chapter 1 Ethical Reasoning: Implications for Accounting 1
Ethics Reflection 1 Integrity: The Basis of Accounting 3 Religious and Philosophical Foundations of Ethics 4 What Is Ethics? 5
Norms, Values, and the Law 6 Ethical Relativism 8 Situation Ethics 8 Cultural Values 10
The Six Pillars of Character 11 Trustworthiness 12 Respect 15 Responsibility 15 Fairness 15 Caring 16 Citizenship 16
Reputation 16 The Public Interest in Accounting 18
Professional Accounting Associations 18 AICPA Code of Conduct 19
Virtue, Character, and CPA Obligations 20 Modern Moral Philosophies 21
Teleology 22 Deontology 25 Justice 27 Virtue Ethics 28
Application of Ethical Reasoning in Accounting 29 DigitPrint Case Study 31
Scope and Organization of the Text 33 Concluding Thoughts 34 Discussion Questions 35 Endnotes 37 Chapter 1 Cases 41
Case 1-1: Harvard Cheating Scandal 42 Case 1-2: Giles and Regas 43 Case 1-3: NYC Subway Death: Bystander Effect or Moral Blindness 45 Case 1-4: Lone Star School District 46 Case 1-5: Reneging on a Promise 47 Case 1-6: Capitalization versus Expensing 48 Case 1-7: Eating Time 49 Case 1-8: A Faulty Budget 50 Case 1-9: Cleveland Custom Cabinets 51 Case 1-10: Telecommunications, Inc. 52
Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting 54
Ethics Reflection 54 Kohlberg and the Cognitive Development Approach 55
Heinz and the Drug 56 Universal Sequence 58
The Ethical Domain in Accounting and Auditing 59 Rest’s Four-Component Model of Ethical Decision Making 59
Moral Sensitivity 60 Moral Judgment 60 Moral Motivation 60 Moral Character 60
Rest’s Model and Organizational Behavior 61 Professional Judgment in Accounting: Transitioning from Moral Intent to Moral Action 63
Diem-Thi Le and Whistleblowing at the DCCA 64 Behavioral Ethics 67
Ethical Decision-Making Model 68 Application of the Model 71 Concluding Thoughts 72 Discussion Questions 72 Endnotes 74 Chapter 2 Cases 77
Case 2-1: WorldCom 78 Case 2-2: Better Boston Beans 79 Case 2-3: The Tax Return 80 Case 2-4: Shifty Industries 81 Case 2-5: Blues Brothers 83 Case 2-6: Supreme Designs, Inc. 84 Case 2-7: Milton Manufacturing Company 85 Case 2-8: Juggyfroot 87 Case 2-9: Phar-Mor 88 Case 2-10: Gateway Hospital 90
Chapter 3 Creating an Ethical Organization Environment and Effective Corporate Governance Systems 91
Ethics Reflection 91 Seven Signs of Ethical Collapse 92
Pressure to Maintain the Numbers 93 Fear of Reprisals 93
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xviii Table of Contents
Loyalty to the Boss 93 Weak Board of Directors 94
A Culture of Conflicting Interests 94 Innovation and Ethics 95 Community Involvement and Ethics 95 Organizational Influence on Ethical Decision Making 95 Individual-Organization Interchange 96 Ethical Dissonance Model 96
Business Ethics 98 Guiding Principles 98 Values 99 Ethical Standards 99 Business Ethics versus Personal Ethics 100 Ends versus Means 101 Trust in Business 101 Johnson & Johnson: A Case of Dr. Jekyll and Mr. Hyde? 103 Employees Perceptions of Ethics in the Workplace 105
Stakeholder Perspective 107 The Case of the Ford Pinto 107
Fraud in Organizations 109 Fraudulent Business Practices 109 Occupational Fraud 110 Financial Statement Fraud 112
Foundations of Corporate Governance Systems 114
Defining Corporate Governance 115 Views of Corporate Governance 115 The Importance of Good Governance 116 Executive Compensation 117
Corporate Governance Mechanisms 119 The Role of the Board of Directors 119 Audit Committee 120 Internal Controls as a Monitoring Device 122 Internal Auditors 123 Audited Financial Statements 125 NYSE Listing Requirements 125 Code of Ethics for CEOs and CFOs 127 Compliance Function 128
Bernie Madoff’s Ponzi Scheme 128 Whistleblowing 131
Detection, Reporting, and Retaliation 131 Incentivizing Whistleblowing under Dodd-Frank 134 Accountants’ Obligations for Whistleblowing 134 Has the Whistleblowing Program Been Successful? 135 The Ethics of Whistleblowing 136
Concluding Thoughts 137 Discussion Questions 137 Endnotes 140
Chapter 3 Cases 149 Case 3-1: The Parable of the Sadhu 150 Case 3-2: Amgen Whistleblowing Case 154 Case 3-3: United Thermostatic Controls 156 Case 3-4: Hewlett-Packard 160 Case 3-5: IRS Whistleblower and Informing on Tax Cheats 162 Case 3-6: Bennie and the Jets 163 Case 3-7: Exxon-XTO Merger 164 Case 3-8: Disclosure of Steve Jobs’s Health as Apple CEO: A Public or Private Matter? 167 Case 3-9: Bhopal, India: A Tragedy of Massive Proportions 168 Case 3-10: Accountability of Ex-HP CEO in Conflict of Interest Charges 174
Chapter 4 AICPA Code of Professional Conduct 175
Ethics Reflection 175 The Public Interest in Accounting: An International Perspective 177 Investigations of the Profession: Where Were the Auditors? 178
Metcalf Committee and Cohen Commission: 1977–1978 179 House Subcommittee on Oversight and Investigations: 1986 180 Savings and Loan Industry Failures: Late 1980s–Early 1990s 181
Treadway Commission Report: 1985; COSO: 1992; and Enterprise Risk Management: 2004 181 The Role of the Accounting Profession in the Financial Crisis of 2007–2008 183 AICPA Code of Professional Conduct and State Board Requirements 186
National Association of State Boards of Accountancy 187 Professional Services of CPAs 188
AICPA and IFAC Principles of Professional Conduct 190 Conceptual Framework for AICPA Independence Standards 191
Threats to Independence 191 Safeguards to Counteract Threats 193 Financial Relationships That Impair Independence 193 Providing Nonattest Services to an Attest Client 194
SEC Position on Auditor Independence 195 SEC Actions Against Auditing Firms 195 The PeopleSoft Case 196
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Table of Contents xix
Insider Trading Scandals Damage the Reputation of the Accounting Profession: Former KPMG Audit Partner, Scott London 196 Former Deloitte & Touche Management Advisory Partner, Thomas Flannigan 197
SOX Provisions 198 Restrictions on Nonattest Services 198
Integrity and Objectivity 200 Principles of Professional Practice 201 Responsibilities to Clients 203 Other Responsibilities and Practices 206
Commissions and Referral Fees 206 Advertising and Solicitation 207 Form of Organization and Name 208 Acts Discreditable—Client Books and Records; CPA Workpapers 210 Acts Discreditable—Negligence in the Preparation of Financial Statements or Records 212
Ethics and Tax Services 213 Rule 101—Independence 213 Rule 102—Integrity and Objectivity 214 Rule 201—Professional Competence and Due Care 214 Rule 202—Compliance with Professional Standards 214 Tax Compliance Services 214 Statements on Standards for Tax Services (SSTS) 214 Substantial Authority 216 Realistic Possibility of Success 216 Reasonable Basis 216 Tax Shelters 218
PCAOB Rules 219 Rule 3520—Auditor Independence 219 Rule 3521—Contingent Fees 219 Rule 3522—Tax Transactions 219 Rule 3523—Tax Services for Persons in Financial Reporting Oversight Roles 220 Rule 3524—Audit Committee Pre-Approval of Certain Tax Services 220 Rule 3525—Audit Committee Pre-Approval of Nonauditing Services Related to Internal Control over Financial Reporting 221 Rule 3526—Communication with Audit Committees Concerning Independence 221
Concluding Thoughts 221 Discussion Questions 222 Endnotes 225 Chapter 4 Cases 229
Case 4-1: America Online (AOL) 230 Case 4-2: Beauda Medical Center 233 Case 4-3: Family Games, Inc. 234
Case 4-4: First Community Church 235 Case 4-5: Lee & Han, LLC 236 Case 4-6: Gee Wiz 237 Case 4-7: Family Outreach 238 Case 4-8: HealthSouth Corporation 239 Case 4-9: Healthcare Fraud and Accountants’ Ethical Obligations 242 Case 4-10: Independence Violations at PwC 243
Chapter 5 Fraud in Financial Statements and Auditor Responsibilities 246
Ethics Reflection 246 Fraud in Financial Statements and the Audit Function 247 Nature and Causes of Misstatements 249
Errors, Fraud, and Illegal Acts 249 Reporting an Illegal Act 251 Auditors’ Responsibilities for Fraud Prevention, Detection, and Reporting 252 The Fraud Triangle 252 Incentives/Pressures to Commit Fraud 253 Opportunity to Commit Fraud 254 Rationalization for the Fraud 255 Tyco Fraud 255
Fraud Considerations in the Audit 259 Fraud Risk Assessment 260 Fraud Associated with Management Override of Controls 260 Rite Aid Fraud and Failure of Internal Controls 262 Communicating About Possible Fraud to Management and Those Charged with Governance 262 Management Representations and Financial Statement Certifications 263
Contents of the Audit Report 264 Background 264 Introductory Paragraph 265 Management’s Responsibility 265 Auditor’s Responsibility 265 Opinion 267 Types of Audit Opinions 267
Generally Accepted Auditing Standards (GAAS)—Overview 269
GAAS Requirements 271 Audit Evidence 272 Limitations of the Audit Report 273 Reasonable Assurance 273 Materiality 273
What Is Meant by “Present Fairly”? 275 Audit Risk Assessment 277
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Internal Control Assessment 278 Internal Control—Integrated Framework 278
PCAOB Standards 282 AS 4: Reporting on Previously Reported Material Weakness 283 AS 5: An Audit of Internal Control over Financial Reporting That Is Integrated with an Audit of Financial Statements 283 AS 6: Evaluating Consistency of Financial Statements 284 AS 8—Audit Risk 285 AS 9—Audit Planning 285 AS 10—Supervision of the Audit Engagement 285 AS No. 11—Consideration of Materiality in Planning and Performing an Audit 286 AS No. 12—Identifying and Assessing Risks of Material Misstatement 286 AS No. 13—The Auditor’s Responses to the Risks of Material Misstatement 286 AS No. 14—Evaluating Audit Results 286 AS No. 15—Audit Evidence 287 Communications with Audit Committees 287 Auditor’s Evaluation of the Quality of the Company’s Financial Reporting 289 Financial Statements Restatements 291 PCAOB Enforcement Program 293
Concluding Thoughts 294 Discussion Questions 295 Endnotes 297 Chapter 5 Cases 303
Case 5-1: Computer Associates 304 Case 5-2: ZZZZ Best 307 Case 5-3: Imperial Valley Thrift & Loan 311 Case 5-4: Audit Client Considerations and Risk Assessment 317 Case 5-5: Krispy Kreme Doughnuts, Inc. 319 Case 5-6: Dunco Industries 321 Case 5-7: First Community Bank 322 Case 5-8: Fannie Mae: The Government’s Enron 324 Case 5-9: Royal Ahold N.V. (Ahold) 329 Case 5-10: Groupon 333
Chapter 6 Legal, Regulatory, and Professional Obligations of Auditors 335
Ethics Reflection 335 Client Confidentiality, Fraud, and Whistleblowing 337
Confidentiality Obligation and Fraud 337 Dodd-Frank and Whistleblowing 337
Ethical and Legal Responsibilities of Officers and Directors 339
Duty of Care—Managers and Directors 339 Duty of Loyalty 339 Director Duty of Good Faith 339 Business Judgment Rule 340 Caremark Opinion 340 Shareholder Derivative Suit—Citigroup Subprime Lending 340 Clawback of Incentive Compensation from Executive Officers 341 Audit Committee and Business Judgment Rule 342
Legal Liability of Auditors: An Overview 343 Common-Law Liability 343 Liability to Clients—Privity Relationship 344 Liability to Third Parties 345 Actually Foreseen Third Parties 345 Reasonably Foreseeable Third Parties 346 Auditor Liability to Third Parties 348
Statutory Liability 350 Securities Act of 1933 352 Key Court Decisions 353 Securities Exchange Act of 1934 354
Interaction of Ethics and Legal Liability 356 Court Decisions and Auditing Procedures 357 Liability for Securities Violations 359
Honest Services Assessment in Criminal Matters 359 Is There a Difference Between Lying and Stealing in Securities Fraud? 360
Insider Reporting and Trading 361 Leaking Nonpublic Information 361 Auditor Betrayal of Client Confidences and Insider Trading 363
Private Securities Litigation Reform Act (PSLRA) 365
Reporting Requirements 365 Proportionate Liability 366
Sarbanes Oxley (SOX) Legal Liabilities 367 Section 302. Corporate Responsibility for Financial Reports 367 Section 302. Liability in Private Civil Actions 368 Section 302. Liability in Civil and Criminal Government Actions 369 Perspective on Accomplishments of SOX 369
Other Laws Affecting Accountants and Auditors 370 Foreign Corrupt Practices Act (FCPA) 370 SEC Charges Pfizer with FCPA Violations 371 FCPA Violations and Tyco 375 FCPA and Whistleblowing 375
Federal Sentencing Guidelines for Organizations 375
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Concluding Thoughts 377 Discussion Questions 378 Endnotes 380 Chapter 6 Cases 385
Case 6-1: SEC v. Halliburton Company and KBR, Inc. 386 Case 6-2: Con-way Inc. 390 Case 6-3: Insider Trading and Accounting Professionals 392 Case 6-4: Anjoorian et al.: Third-Party Liability 393 Case 6-5: Vertical Pharmaceuticals Inc. et al. v. Deloitte & Touche LLP 396 Case 6-6: SEC v. DHB Industries, Inc., n/k/a Point Blank Solutions, Inc. 397 Case 6-7: Livingston & Haynes, P. C. 400 Case 6-8: Kay & Lee, LLP 405 Case 6-9: Reznor v. J. Artist Management (JAM), Inc. 406 Case 6-10: SEC v. Zurich Financial Services 407
Chapter 7 Earnings Management and the Quality of Financial Reporting 410
Ethics Reflection 410 Motivation for Earnings Management 412
Earnings Guidance 412 Income Smoothing 414
Analysis of Earnings Management from a Financial Reporting Perspective 415
Definition of Earnings Management 415 Ethics of Earnings Management 416 How Managers and Accountants Perceive Earnings Management 418 Accruals and Earnings Management 419 Acceptability of Earnings Management from a Materiality Perspective 420 Current Auditing Standards and Presumptions 424
Financial Statement Restatements 426 The Nature of Restatements 426 Restatements Due to Errors in Accounting and Reporting 427
Earnings Management Techniques 428 Financial Shenanigans 429
1. Recording Revenue Too Soon or of Questionable Quality 429 2. Recording Bogus Revenue 430 3. Boosting Income with One-Time Gains 430 4. Shifting Current Expenses to a Later or Earlier Period 430
5. Failing to Record or Improperly Reducing Liabilities 430 6. Shifting Current Revenue to a Later Period 431 7. Shifting Future Expenses to the Current Period as a Special Charge 431
Descriptions of Financial Shenanigans 431 The Case of Xerox 432 Sanctions by the SEC on KPMG 433 The Case of Lucent Technologies 433 The Story of Enron 435 FASB Rules on SPEs 441 Enron’s Role in the Creation and Passage of SOX 442 Lessons to Be Learned from Enron 442