Chapter 1

Ethical Issues in
Advanced
Accounting
 Scope of Chapter

Why need ethical conduct in accounting?

What is fraudulent financial reporting?
Ethical standards for preparers of
financial statements & reports.
Significant events in establishment of
ethical standards.

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 Scope of Chapter

IMA standards of ethical conduct.

FEI code of ethics.
AICPA code of professional conduct.
Resolutions, articles, definitions, rules,
appendices.
Examples, review questions and case
studies.

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 Why To Study Ethical Issues In
Accounting?

Critics have alleged that ethical standards of

accountants have deteriorated.
Cute accounting to describe stretching the form
of accounting standards to the limit, regardless
of the substance of the underlying business
transactions or events.
Cooking the books to indicate fraudulent
financial reporting.

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 Fraudulent Financial Reporting

Misstatements in financial statements.

Intentional misstatement or omission of
amounts or disclosures in financial statements
to deceive users.
Reasons & Methods of committing fraud.
Manipulation, Falsification, or Alteration of
accounting records or supporting documents.

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 Fraudulent Financial Reporting

Misrepresentation in or intentional
omission from, the financial statements of
events, transactions or other significant
information.
Intentional misapplication of accounting
principles relating to amounts,
classification, presentation or disclosure.

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 Fraudulent Financial Reporting

Fraud frequently involves either a pressure

or an incentive to commit fraud.
Fraud may be concealed through falsified
documentation, including forgery.
Fraud also may be concealed through
collusion among management, employees
or third parties.

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 An Example of
Fraudulent Financial Reporting

The secs accounting and auditing

enforcement release no. 923 provides
an example of fraudulent financial
reporting. According to the SEC, the
four officers overstated the companys
net income for the quarters ended Dec
31, 92 and mar 21, 93 by taking
following cooking the books actions:

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 An Example of
Fraudulent Financial Reporting

1. Recognizing January 1993 revenues in

December 1992 and April 1993 revenues in
march 1993.
2. Deferring write-offs of uncollectible accounts
past the end of the appropriate quarter.
3. Recognizing as assets certain expenses
incurred during the quarters ended December
31, 1992 and march 31, 1993.

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 An Example of
Fraudulent Financial Reporting

4. Making fictitious journal entries in

connection with business combinations
accomplished in march 1993, the effect of
which was to understate doubtful accounts
expense.
5. Recognizing in the 1st quarter of 1993, a
gain from the sale of an asset during the
quarter ended June 30, 1993.

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 Ethical Standards

American Institute of Certified Public

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

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 Significant Events in
Establishment of Ethical Standards

The Seaview Symposium of 1970

The Equity Funding Fraud of 1973
Action by IMA in 1983
Action by FEI
Treadway Commission Recommendations
Sarbanes-Oxley Act in 2002

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 The Equity Funding Fraud

In 1973, a major fraud was discovered at

equity funding corporation of America
(equity), a seller of mutual fund shares
that were pledged by the investors to
secure loans to finance life insurance
premiums. During the nine-year period,
at least $143 million of fictitious pretax
income was generated.

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 The Equity Funding Fraud

A period in which the equity reported a total net

income of $ 76 million, instead of the real
pretax losses totaling more than $ 67 million.
The fraud was carried out by at least 10
executives of equity, including the chief
executive officer (CEO), chief financial officer
(CFO), controller, and treasurer.
Several of the executives were CPAs with
public accounting experience.

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 Treadway Commission

The National Commission on Fraudulent

Financial Reporting.
Sponsored by the AICPA, IMA, FEI, the
American Accounting Association, and the
Institute of Internal Auditors.
Defined Fraudulent Financial Reporting as
intentional or reckless conduct, whether act or
omission, that results in materially misleading
financial statements.

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 Treadway Commission

The Treadway Commission made 49

recommendations for curbing such
reporting.
The recommendations dealt with the
public company; the independent public
accountant; the SEC, financial institution
regulators, and state boards of
accountancy; and education.
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 Treadway Commission

The responsibility for reliable financial

reporting resides first and foremost at the
corporate level.
Public companies should maintain
accounting functions that are designed to
meet their financial reporting obligations.

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 Sarbanes-Oxley Act 2002

Authorized the establishment of Public

Company Accounting Oversight Board
Purpose: Regulate conduct of accountants
both public practice and publicly owned
business enterprises

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 Analysis of Ethical Standards For
Management & Financial Execs.

The ethics pronouncements of IMA, FEI

and AICPA have several similarities.
All three require members to be
competent, act with integrity and
objectivity, maintain confidentiality of
sensitive information, and avoid
discreditable acts.

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 Analysis of Ethical Standards For
Management & Financial Execs.

TheIMA & AICPA codes specifically

prohibit conflicts of interest, but the
FEI code only indirectly addresses
such conflicts in its confidentiality
provision.

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 Analysis of Ethical Standards For
Management & Financial Execs.

Only IMA and FEI codes specifically

require communication of complete
information to users of their
members reports; AICPA members
are indirectly comparably obligated
by rule 202.

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 Analysis of Ethical Standards For
Management & Financial Execs.

The IMA standards in essence

require members to report violations
of the standards by members of their
organization to responsible officials
of the organizations. The FEI and
AICPA codes have no such
requirements.

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 Analysis of Ethical Standards For
Management & Financial Execs.

The FEI code requires members to

conduct their personal, as well as
their business affairs with honesty
and integrity. The IMA and AICPA
standards do not address personal
affairs.

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 Conflict of Interest

Conflictof Interest results when

individuals reap inappropriate
personal benefits from their acts in
an official capacity.

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 Conflict of Interest

For example, a chief accounting officer might

cook the books to overstate pretax income of
the employer corporation in order to obtain a
larger performance bonus.
The controller of a publicly owned corporation
might involve in insider trading to maximize
gains or minimize losses on purchase or
sales of the employer corporation securities.

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 Discreditable Acts

None of the three codes defines

Discreditable Acts.
The term can not be adequately defines
or circumscribed.
A discreditable act to one observer might
not be so construed by another.

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 Concluding Observations

The number of SEC proceedings

against reporting companies from
1981 to 1986 was less than 1% of
the number of financial reports filed
with the SEC during that period.

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 Concluding Observations
The Chairman of the Federal Deposit
Insurance Corporation contended that
management fraud (presumably including
cooking the books) contributed to one-
third of bank failures.
10% of total bankruptcies in a study
authorized by the Treadway Commission,
involved fraudulent financial reporting.
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 Concluding Observations

Former SEC Chairman John Shad

estimated that all fraudulent securities
activities amount to a fraction of 1% of
the $50 billion of corporate and
government securities traded daily.

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 Concluding Observations

Thus, cooking the books, though

serious and despicable, apparently do
not indicate a wholesale breakdown of
ethical conduct by management
accountants and financial executives
of business enterprises.

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 Concluding Observations

Can the codes of conduct for

management accountants and financial
executives established or revised by IMA,
FEI and AICPA help those key players in
corporate financial reporting to resist
pressures, often from top management
but sometimes from within themselves, to
falsify financial statements and reports?

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