Ethics and Financial Reporting

in the United States

ABSTRACT, The purpose of this paper is to describe

briefly the institutional arrangements which condition
the activities of accountants in the United States; to
heighten an awareness of the values which are embodied
in the existing structures of accountability; to appraise
the consistency with which the established ideals of
society have been actualised in financial reporting, and
to discern the shape of the emerging history of financial
reporting in the light of new values and possibilities, I
suggest that the tradition of fair presentation in financial
reporting is in danger of being eliminated by a purely
political response to previous abuses. Mandatory
accounting standards do have a role in preventing these
abuses, but they can also be seen as instruments of distributive justice. To promote an awareness and discussion of the issues, I point out some of the goals and
values underlying a few of the major structures designed
for the distribution of economic costs and benefits.

I. Introduction
The major ethical problem of financial reporting
is that management, which has the responsibility
for preparing financial reports, cannot impartially report on its own achievements (see J. C. Burton, 1972). Accounting Standards are the rules
which accountants use to measure and report
business transactions to the public. They constitute accountants' "authority for defying managements' (their employers') wishes" (G. J.
Benston, 1975). For, as C. E. Johnson (1966)
put it: "Managers would not be human if they
I. C. Stewart is Associate Professor of Accountancy at
the University oJ Auckland. He was formerly a Senior
Lecturer at the Victoria University of Wellington. He
is the author of several articles which have been published in various business journals.

Joumal of Business Ethia 5 (1986) 401-408.

1986 by D. Reidel Puhlishing Company.

/. C. Stewart

did not wish the report card to be favourable"

(p. 91). The purpose of this paper is to describe
very briefly the institutional arrangements which
condition the activities of accountants in the
United States; to heighten an awareness of the
values which are embodied in the existing structures of accountability; to appraise the consistency with which the established ideals of
society have been actualised in financial reporting, and to discern the shape of the emerging history of financial reporting in the light of new
values and possibilities.

II. The institutions

The Financial Accounting Standards Board
(FASB), a private sector body, presently establishes accounting standards. The FASB commenced operations in 1973 with more independence and resources than either of its two
predecessor bodies. The Securities and Exchange
Commission (SEC) requires that publicly owned
corporations use the standards established by
the FASB. The SEC has itself sufficient authority
to promulgate accounting standards as part of its
responsibility to protect the public under the
securities legislation of 1933-34. However,
since 1938 the Commission has chosen to let the
accountancy profession lead the way in the formulation of accounting standards. It has, in a
few cases, overruled an accounting standard or
acted when the FASB or its precedessor bodies
did not.
Although the FASB sets reporting standards,
it does not implement them. It has long been
acknowledged that the accounts of a corporation are primarily the responsibility of manage-

402

/. C. Stewart

ment. Professor Moonitz (1968) has pointed out

that the opposition expressed by management to
accounting standards that its flexibility might
be hampered is "part of the larger process by
which management as a class has sought to consolidate its power" (p. 629). Professors Watts
and Zimmerman (1979) have been researching
the question of how corporate management
respond to new standards proposed by the
FASB (the Board invites written responses from
interested parties to exposure drafts of proposed
new standards). Their conclusion is that management acts in its own self-interest, one benefit
of which might be increased personal compensation if reported net income increases. The same
authors, in another study (1978), argue, however, that the likelihood that reported net
income will be used to justify political action
increases with the size of a corporation. Large
firms may be subject to antitrust action or
regulation because of their dominant market
position. The authors conclude that managers in
these firms find it in their best long-run interests
to have accounting standards that result in lower
reported net income. For example, under FASB
Statement No. 19 (1977) oil and gas producers
were required to adopt successful efforts
accounting. Under this method, exploration and
development costs associated vnth unproductive
efforts woxild be written off against income in
the year incurred. Hence reported profits would
be lower as long as a company is not contracting
its operations. This action was supported generally by large companies (that had reason to fear
government control) and opposed by small companies (many of which would have had to report
much more variable net income). The SEC held
hearings on the standard and decided to permit
companies to use either the successful-efforts or
full-cost method and the FASB rescinded its
standard.
Historically, as R. Boland (1982) put it recently, "accountants have been accused of placing
too much trust in managements, of acquiescing
too readily to managements' interpretations of
accounting principles, of overlooking obvious
abuses of financial reporting, and of being too
sympathetic to their clients' interests" (p. 113).^
As early as 1936 the then chairman ofthe SEC,

Mr Landis, warned that the loyalties of accountants to management were stronger than their
sense of responsibility to the investor (see J. L.
Carey, 1979, p. 262). More recently D. C. Sale
(1981) said of the auditor's role in society that
it had changed from a once feared watchdog to
becoming management's poodle!
III. Values and their actualisation
Since the accountancy profession was introduced
into the United States by British Accountants
during the second half of the nineteenth century, it is not surprising to find the opinion
paragraph of the auditors' report using such
phrases as correctly sets forth, exhibit a true and
fair view, accurately record conditions, represent
the true financial position (G. Cochrane, 1950).
Unlike the United Kingdom, however, auditors
in the United States did not have any statutory
backing before the 1933 securities legislation.
Although individual auditors proclaimed that
financial reporting was a quest for tnith,2 it
soon became apparent that the individual
morality of the auditor could no longer be relied
upon to deter the growing power of the managerial class. In 1926, a Harvard Professor,
William Z. Ripley wrote an article which contained specific criticisms of reporting practices
which he regarded as deceptive. A. A. Berle and
G. C. Means in The Modem Corporation and
Private Property (1932) built on Professor Ripley's criticisms. The authors pointed out methods
of "accounting manipulation" which could be
used to show abnormal profits through inventory valuations, depreciation, issue of bonds
with stock or stock warrants, over-valuation of
assets, charges to surplus that should go to
income, elimination of nonrecurring expenses
from income accounts, and crowding of sales
into the last period.
Professors Merino and Neimark (1982) argue
that "given the quality of financial information
that was being reported at the time, investors
were not necessarily behaving irrationally in
dismissing financial reports as a source of investment information" (p. 42). The authors point
out that prior to the securities legislation of

Ethics and Financial Reporting

1933, reliance was placed on "moral regulation"
and a "two-tiered" market structure in which
the knowledgeable tier would establish price
levels that would provide reliable trading signals
to the lower tier (the average investors). The
authors note that by the 1920s the acceptance
of the two-tiered market structure contributed
to what became widespread advocacy of trading
rules based on trends in prices and trading
volumes rather than on intrinsic analysis (pp.
41-42). In sum, the "information asymmetries
inherent in the two-tiered market structure and
prevailing investor trading practices provided
both incentives and opportunities for market
manipulation" (p. 45). I. Friend and R. Westerfield (1975) contend that the ability of the
knowledgeable to take advantage of inside
information and the relative profitability of
insiders and specialists were much greater in the
pre-SEC period than in the post-SEC period
(p. 471). Fairness in a post-securities acts era
could, therefore, be interpreted to mean that
all had equal access to information as well as
equal opportunity to participate in the securities
market. Mandatory disclosure regulations would
help eliminate information asymmetries and
assist in removing the incentives for manipulative behaviour.
Some eight years before this legislation, a
leading accountant, G. O. May, had initiated
efforts to deal with many of the problems the
legislation was designed to solve (J. L. Carey,
1979). Mr. May feared government intervention,
and so he proposed that standards be established
through co-operation with the accounting profession, the stock exchanges, the investment
bankers and commercial banks. Professor Zeff
(1984) has recently noted that G. O. May's
"very substantial effort to ward off the intervention of the federal government in the establishment of accounting principles failed... the forces
unleashed by the Great Depression were irreversible" (p. 452).
One of the achievements of the Committee on
co-operation with the stock exchanges, which
Mr. May chaired, was to draw up a standard
form of the auditors' report which stated, in part,
that the "balance sheet and related statement of
income and surplus fairly present, in accordance

403

with accepted principles of accounting consistently maintained by the company during the
year under review, its position at December 31,
1933 and the results of its operations for the
year. Accepted principles of accounting was subsequently changed to generally accepted
accounting principles (GAAP).
Mr. Carman Blough, the first chief accountant
of the SEC (1935-38), thought that fairness
was too subjective and not acceptable as a
standard to follow. He concluded that only if
judgments were reached within a framework of
GAAP could there be any test of reasonableness
or honesty of a particular presentation (see J. W.
Pattillo, 1965, p. 66). In 1938, in Accounting
Series Release No. 4, the SEC decided to accept
accounting principles having "substantial authoritative support". This was a major impetus to
the codification of GAAP. The American Institute of Accountant's Committee on Accounting
Procedure (CAP) issued some 51 Accounting
Research Bulletins (ARBs) between 1939-59.
This trend has continued under the Accounting
Principles Board (APB) (1959-73), which issued
some 31 Opinions, and the FASB, which has so
far issued more than 80 standards. As R. Boland
(1982) puts it "moral mysteries [are] being
transformed into impersonal techniques" (p.
120). GAAP has come to be regarded as the
specification of the conditions to be met for the
realisation of fairness in financial repdrting. In
1980, the American Institute of Certified Public
Accountants proposed to delete the words fairly
present from the audit opinion on these
grounds. On his recent retirement from the
FASB, Ralph Walters lamented that:
I'm afraid the accounting profession has had trained
out of its mind the idea of the true and fair view, or
the fair presentation concept. Fair presentation by
itself doesn't seem to mean anything here any more.
Everything is GAAP, and GAAP by and large is a
fairly specific set of rules. (1984)

The consolidation of managerial power

The Committee on Accounting Procedure (CAP,
19391959) experienced occasional disagreements vidth the SEC, and challenges from other

4CM

/. C. Stewart

sources aroused concern about the authority

attaching to ARBs (see S. A. Zeff, 1972). One of
these challenges came from L. Spacek who
charged that the CAP yielded to industry pressures on matters of accounting principle. Mr.
Spacek (1961) believed that flexibility of reporting rules had been used as an excuse to prevent
improvements in financial reporting, not to
advance it. Although an Institute Committee
concluded that Mr Spacek's allegations were
unfounded. Professor Zeff (1984) reports that
Mr Spacek's criticisms were consequential in a
high-level review of the process of establishing
accounting principles. The outcome of this was
the establishment-of the Accounting Principles
Board (APB) in 1959. During the life of the
CAP, the Committee had been constantly faced
with the question of what authority should
attach to its pronouncements. This issue was not
resolved until 1964 when the APB attempted
to eliminate equally acceptable GAAP and
imposed a burden on auditors to justify material
departures from principles accepted in A'PB
Opinions. The APB was also charged to "move
toward the reduction of alternative practices in
accounting" (quoted by S. A. Zeff, 1984,p.458).
This attempt to constrain the choice of
reporting practices resulted in widespread hostility from corporate management. For example.
Professors S. A. Zeff (1972) and C. T. Horngren
(1973) describe how the humber of feasible
alternatives for setting standards was reduced in
the purchase-pool debate and the marketable
securities debate. Research on the former issue
found that during the great merger wave, which
reached its zenith in 196769, firms recorded
mergers by the method that maximised reported
income (R. M. Copeland and J. F. Wojdak, 1969).
It was su^ested that improper accounting
methods stimulated mergers especially of the
conglomerate variety {Economic Concentration
Hearings, 1970, p. 4844). The Federal Trade
Commission reached a similar conclusion. Their
report alleged that some managements took
advantage of the variety of alternative accounting
rules to obscure results, hide profit declines and
to overstate growth in earnings {Economic
Report on Mergers, pp. 23, 141, 159). A. C.
Sampson (1983), now chief accountant at the

SEC, charged that during this period "management were taking advantage of inadequate
guidance in accounting principles to inflate
reported earnings".
Perhaps it was in an attempt to stop the manipulation of corporate earnings that the early
standards (1974-77) of the FASB emphasised
uniformity as a major objective along with a
philosophy that the latitude allowed management to control reported results by making
accounting choices should be reduced (see, for
example, standards on Research and Development, Statement No. 2; Contingencies and Contingency Reserves, Statement No. 5; Foreign
Currency Translation, Statement No. 8; Leases,
Statement No. 13; and Oil and Gas, Statement
No. 19). Since 1978, however, there is some
evidence that management may be given greater
discretion in accounting policy selection (see,
for example, standards on the Effects of Changing Prices, Statement No. 33; Foreign Currency
Translation, Statement No. 52; and Oil and Gas
Accounting, Statement No. 69). Instead of
emphasising the preventative role of accounting
standards the lessening of the chance of scandals and frauds the emphasis now seems to be
on the informativeness of standards. Two significant sentences from the FASB's (1978) concepts statement on objectives of financial reporting are as follows:
1. Financial reporting should provide information
that is useful to present and potential investors
and creditors and other users in making rational
investment, credit, and similar decisions (Paragraph 34).
2. Thus, financial reporting should provide information to help investors, creditors, and others assess
the amounts, timing, and uncertainty of prospective
net cash inflows to the related enterprise (Paragraph 37).

Whereas fairness was defined in terms of investor

protection, now fairness appears to be interpreted in terms of what maximises the usefulness of information for investment analysis.
Whereas fairness represented the goal of financial reporting, it is now defined by the FASB's
objectives of financial reporting.

Ethics and Financial Reporting

IV. An evaluative interpretation
It has only been by mandatory reporting standards (and here the backing of the SEC is decisive)
that a measure of trust has been restored in the
moral capacity of management. As Professor
Benston (1975) put it: "'Generally acceptable
accounting principles' and 'conservatism' are
devices whereby CPAs can and do protect their
integrity" (p. 13). Accountants do not wish to
be considered the tools of unscrupulous managenient. In this sense accounting standards have
been important instruments of social justice.
Although the justice which has resulted from the
process of setting accounting standards may not
fall into the category of morally created values,
if morality is defined purely from the perspective
of the individual auditor's quest for truth, from
the viewpoint of society, these standards do
represent moral achievements (see R. Niebuhr,
1933, pp. 31-32).
The difficulty this gives rise to, however, is
that ends are being transformed into means. As
in many other areas in society, doctrine is being
converted into procedure (see J. Ellul, 1964).
Fairness has no independent meaning apart from
GAAP. The danger is that accounting standards
may come to be regarded as possessing value in
and of themselves quite independently of the
conscience of the accountant who applies them.
J. C. Burton, commenting on the experience of
the APB, observed in 1972 that: "By writing
precise rules the Board made it possible for
people to observe the letter and avoid the spirit
with the blessing and often the assistance of
their auditors" (quoted by R. P. Brief in M.
Chatfield, 1978, p. 5). Thus auditors are
becoming ethically emasculated. Now the FASB
is subjecting GAAP to an analysis of the objectives of financial reporting and the emphasis is
on what is useful information for assessing the
amounts, timing and uncertainties of prospective
cash inflows to the firm within the context of
serving the allocative efficiency of capital
markets.
There are two problems to which this
development gives rise. The first is that allowing
management more discretion to achieve informative disclosures (for example, the standard on

405

Foreign Currency Translation, Statement No.

52), as A. C. Sampson (1983) recently remarked,
increases the responsibility for an effective and
objective application of the standard. If this
discretion is not exercised responsibly, then a
swing back to preventative disclosures with their
rigid uniformities can be expected.
The second, and more fundamental issue, is
whether the FASB should serve the goal of
economic efficiency or whether the Board
should serve as well (or instead) goals defined by
the norms of distributive justice. Of course there
are many approaches to distributive justice and
the various candidate structures have different
goals each of which fosters and preserves different values. A few of these will be mentioned
by way of illustration.
The first is G. Winter's (1966) norms of justice. These are: (1) equal freedom as the right to
consent in decisions; (2) equal right to participate in culture and society and (3) equal access
to the conditions oflife and opportunity (p. 232).
For Professor Winter the goal of this structure is
its adequacy for preserving the human community against its own alienations and for
raising man's social existence to more inclusive
levels of community. His emphasis on human
interdependence places equal access to the conditions of life prior to any other values in the
hierarchy. Similarly, he argues that equal opportunity to participate in common culture and
society take priority over particular interests of
power (p. 250).
If one applies this ethic of interdependence
to the FASB's objectives of financial reporting
one is struck by the lack of fitness of the
Board's objectives to the claims of the historic
situation. As Professors Dopuch and Sunder
(1980) put it:
the dominant-group objectives [investors and creditors], assuming user primacy, do not reflect the
economic reality of the power of suppliers [the
managers] in the accounting market place and are
therefore unworkable (p. 15).

Although the FASB's preference is for neutrality

(see the Board's second concepts statement,
1980), parties adversely affected by its rulings
are not sufficiently convinced that it makes

406

/. C. Stewart

social choices by maintaining a balance between

the conflicting interests in society.^ Professors
Dopuch and Sunder (1980) revive the idea of an
accounting court as a better mechanism for
recognising the vitalities and interests to be
balanced. Mr. Spacek made a similar suggestion
in 1958 when he argued that an accounting
court should adopt a public utilitarian viewpoint.
An accounting principle to be of utility to consumer,
labor, stockholder and management would require
support in each pronouncement as to why the principle adopted produces a fair result from the standpoint of each of these segments of society (1964, p.
. 446).

This proposal accords with the essential structure of justice as outlined by G. Winter. It
affirms equal freedom as a right to consent in
decisions on accounting standards and, it affirms
equal dignity of personal being by participation
in the process by which they are established, not
only by investors and creditors but by all affected parties.
Of course the precise weighting given to these
values can vary. In contrast to G. Winter, who
emphasises the eradication of human alienation,
J. Rawls (1971) emphasises an egalitarian ideal.
His conception of justice as fairness comprises
an initial situation and two principles: (1) "Each
person is to have an equal right to the most
extensive total system of basic liberties compatible with an similar system of liberty for all"
(p. 250) and (2) "Social and economic inequalities are to be arranged so that they are both (a)
to the greatest benefit of the least advantaged
and (b) attached to offices and positions open to
all under conditions of fair equality of opportunity" (p. 83). This is with the proviso that the
first principle is to be held prior to the second
principle. These two principles are the solution
to the problem of choice presented by an original
position in which a nian does not know his
talents, social position or the stage of development of the particular society. This is a justificatory device so that natural or social contingencies do not put some parties at an advantage;
that is, the original conditions ensure fairness
between moral beings. The aim is to constitute a

model of procedural fairness that is acceptable

to everyone. The system is thus designed so that
the resulting distribution is just.
Professor Rawls includes in the economic
institutions for justice the idea of social minimum for the least favoured which is consistent
with required savings and the maintenance of
equality in the assignment of basic rights and
duties. Under this view, the FASB would have to
focus on the least fortunate constituents in
society and ensure that in its decision making it
was maximising their long-run expectations.
J. R. Lucas (1980) argues that Professor
Rawls's theory is open to objection on the score
of fairness. "The dialogue which Rawls conducts
with the worst off, seeking to reconcile him with
his lot, needs to be conducted vsdth each person,
seeking to reconcile him with the outcome,
looking at the pay-off that he receives, considering whether any other outcome, with a larger
pay-off for him, would be better, and if not
why not" (p. 67). The sorts of substantive
reasons that should weigh in such discussions
must be both "inescapable" and "individualised"
(p. 12). Thus justice is "the condition of being <
able to enter into the reasoning behind decisions
and accept them, even though adverse, as our
own" (p. 69).
In emphasising the rationality of justice, J. R.
Lucas contends that the sort of reasoning
employed in this dialogue is characteristically
dialectical in form. "Its logic, instead of being
a deductive logic, where premisses necessitate
their conclusions, is a logic of one side of an
argument and another, of pros and cons, of
proposals and objections, of prima facie cases
which may be countered, and presumptions
which may be rebutted" (p. 39).
Repeated attempts to logically derive
accounting standards from a set of objectives
and definitions overlook that standards depend
not only on premisses, but also on moves made
in response to them, the counters to them, and
so on.
Were the FASB to explicitly recognise the
nature of financial reporting as a social activity,
the Board could, as Professors Dopuch and
Sunder (1980) suggest "...define mechanisms
for arriving at a compromise ruling after a

Ethics and Financial Reporting

hearing has been given to all affected groups in
society" (p. 18).
Then, too, there are those who argue for
deregulation of financial reporting. Professor
G. J. Benston (1981) points out that voluntary
reporting standards are likely to result in a more
efficient use of resources than mandatory
standards. But as R. A. Shiner (1984) has noted,
this particular goal fosters the "...libertarian
individualist value of freedom of choice. It is a
mechanism for distributing economic benefits
and costs given that goal and aim" (p. 236). The
question Professor Shiner raises is: "Do we want
a society with this particular distributional structure, or should we consider designs of distributional structures which give weight to other
factors...?" (p. 236). For example, the ones
emphasised by Professors Winter and Rawls.
Given that accounting standards are a means
of effecting wealth transfers in the community,
the FASB must directly address fairness per se.
Professor Ijiri (1983) has commented "...the
task of providing information useful for
economic decisions is not easy; but it is child's
play compared to the agony of finding a thin
line of fairness between the conflicting interest
of the two parties" (p. 81). C. T. Devine's
(1960) conclusion is still applicable: "Accountants may not be able to reshape the ethical
thinking of the age, but they can make a small
contribution by recognising their social responsibilities" (p. 399). A greater sensitivity to the
tradition of jaimess in financial reporting would
be a step m the right direction.

Acknowledgement
I have benefited from many helpful comments &om my
colleagues on earlier drafts of this article, in particular, I
wish to thank Mike Bradbury, David Emanuel, Tony
Fairfield, Tony Harris, Michael Keenan, Kim Lai,
Michael Morris, Bruce Tabb, Jilnaught Wong and
Emeritus Professor Johnston, as well as Steve Zeff of
Rice University. I have also benefited from the comments of the participants in the Departmental Research
Workshop at the University of Otago.

407

Notes
' I am grateful to Professor K. Moores of Otago University for drawing my attention to this article.
^ See, for example, R. H. Montgomery (1939) who
wrote that from 1889 to 1939 he had been associated
with partners and associates "who have had and have a
passion for finding and telling the truth about accounts."
He went on "It is the only school I know ... I insist that
truth in accounts and in the presentation of accounts is
all that matters" (p. 47). This view was widely shared
(see H. R. Hatfield (1909, p. 170); W. M. Cole (1915, p.
vi); W. A. Paton (1922, p. 425); T. H. Sanders, H. R.
Hatfield and U. Moore (1938, p. 26) and K. MacNeal
(1939, p. 1)).
? The FASB, in its first concepts statement (1978),
argued for a large commonality of interest of all outside
users in the prediction of the amounts, timing and uncertainties of future cash flows (see paragraph 25). However, with user heterogeneity, neutrality becomes more
complex. Standard setters are faced with the problem of
benefiting one group at the expense of another, hence
implicit trade-offs become necessary.

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Department of Accountancy,
University of Auckland,
Private Bag, Auckland,
New Zealand.