Chapter 1 Thru 5 UPDATED

Ethical Reasoning:
Implications for
Accounting
Chapter 1
Copyright ©2017 McGraw‐Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw‐Hill Education.
Ethical Reasoning
• Ethical dilemma: Penn State, a culture of
indifference
• Ethical blind spots refers to the gap between
who you want to be and who you actually are
• Organizational goals, rewards, compliance
systems, and informal pressures all contribute
to ethical fading
Integrity
The Basis for Ethics in Accounting
• Integrity:
• Meaning on principle
• Traces back to Socrates, Plato and Aristotle
• Is the foundational virtue of the ancient Greek
philosophy of virtue
• Helps withstand pressures to subordinate
judgment
• Is a “must have” for accountants
Religious and Philosophical Foundations of
Ethics
• A version of the Golden Rule appears in each of
the world’s religions
• Ethics can be traced back to ancient Greek
philosophy
• “What is the best sort of life for human beings to
live?”
• Greeks believed the ultimate goal of happiness was
to attain some objectively good status: the life of
excellence
What is Ethics?
• Accepted standards of behavior
• Practices of those in a profession
• Laws
• Expectations of society
Ethics, Morals, Values
• Ethics, derived from the Greek word ethikos
(character), deals with the concepts of right and
wrong; standards of how people ought to act.
• Morals, derived from the Latin word moralis,
deals with manners, morals, character.
• Values are basic and fundamental beliefs that
guide or motivate attitudes or actions.
Ethics: Norms, Values, and Law
• Norms:
• Ethical decision‐making entails following certain well established norms of
behavior
• Does not describe the way people do act (descriptive)
• Deals with the way people should act (prescriptive/normative)
• Values:
• Basic beliefs that guide or motivate attitudes or actions
• Values of a profession (i.e. Accounting) are embedded in its codes of ethics
• “Golden Rule” prescribes that we should treat others the way we want to
be treated
• The Law:
• Being ethical is not the same as following the law
• Existence of specific laws prohibiting certain behaviors will not stop a
person who is unethical from violating those laws
• Laws create a minimum set of standards that ethical people usually go
beyond
Norms, Values and the Law:
The Gray Area
• When facts are unclear and legal issues are
uncertain, consider the following:
• Established standards of ethical behavior.
• Moral philosophies.
• Gray Area/Unclear Rules
• Willingness to take action not in ones own self‐
interest.
• Look beyond self‐interest and consider all perspectives
involved.
• Process followed to decide on a course of action is more
important than achieving the end goal
Ethical Relativism
• If correct, there can be no common framework
to resolve any moral disputes between different
societies
• Theory is rejected by most ethicists
• Societies may differ in their application of
fundamental moral principles but agree on the
principles.
Situation Ethics
• Theory that recognizes the existence of certain
principles but questions whether they should be
strictly applied or used as guidelines in a
particular situation
• Circumstances around ethical dilemma should
influence decision making process
• Problem: it can be used to rationalize actions
such as cheating
• Penn State scandal
• University of North Carolina
Social Networkers and Workplace Ethics
• Ethics Resource Center survey on employees using
social networking on the job
• Discussing company information online
• Active social networkers are unusually vulnerable to
risks
• Witness more misconduct
• Experience more retaliation as a result when reported
• Training and ongoing commitment to an ethical
culture can mitigate the risks presented by social
networking at work
Cultural values
• Cultural dimensions that can explain similarities
and differences in cultures worldwide, include:
• Individualism
• Power distance
• Uncertainty avoidance
• Masculinity
• Long term orientation recently added to this list
Six Pillars of Character
• Trustworthiness
• Respect
• Responsibility
• Fairness
• Caring
• Citizenship
Trustworthiness
• Trustworthiness: being honest, acting with
integrity, being reliable, and exercising loyalty in
dealing with others.
• Honesty: is the most basic ethical value and means
that we should express the truth as we know it and
without deception.
• Integrity: strength and courage of ones convictions.
• Reliability: following through with ones
promises/commitments.
• Loyalty: not violating confidence placed in us.
A Word about Whistleblowing
• Loyalty is the one value that should NEVER take
precedence over other values.
• “Dogs are loyal to their master while cats are
loyal to the house.”
• Loyalty requires a commitment to do the right
thing for the right people in the right way (i.e.,
public interest in accounting)
Respect, Responsibility and Fairness
• Respect: treating every individual with dignity. The
golden rule encompasses respect for others through
notions such as civility, courtesy, decency, dignity,
autonomy, tolerance and acceptance.
• Responsibility: the ability to reflect on alternative
courses of action, persevere and carry out moral
action diligently.
• Fairness: treating others equally, impartially, and
openly. Michael Josephson points out, “fairness
implies adherence to a balanced standard of justice
without relevance to one’s own feelings or
inclinations.”
Caring and Citizenship
• Caring: The essence of caring is empathy. Empathy
is the ability to understand, be sensitive to, and care
about the feelings of others. Caring and empathy
support each other and enable a person to put
herself in the position of another. This is essential
to ethical decision making.
• Citizenship: Josephson points out that “citizenship
includes civic virtues and duties that prescribe how
we ought to behave as part of a community.” An
important part of good citizenship is to obey the
laws, be informed of the issues, volunteer in your
community, and vote in elections.
Reputation
• Reputation: overall quality or character in the
opinion of the public towards a person or group
or organization. It is an important factor in many
professional fields, including accounting.
• Takes a long time to build a reputation of trust
but not long at all to tear it down.
Civility, Ethics, and Workplace Behavior
• Instances of inconsiderate, “in your face”
behavior
• Civility requires restraint, respect, and
responsible action in both personal and
professional activities
• Can be well behaved and gracious to others but
motivated by non‐ethical values such as greed
• Treating others bad and with disrespect shows
non commitment to act in accordance with the
pillars of character
Modern Moral Philosophies
• A few of the philosophies applicable to the
study of accounting ethics include:
• Teleology
• Egoism
• Enlightened Egoism
• Utilitarianism
• Deontology
• Rights Theory
• Justice
• Virtue
Egoism and Enlightened Egoism
• Consequences for individual
• “Do the act that promotes the greatest good for
oneself.”
• Enlightened egoists
• Allow for the well‐being of others
• Help achieve some ultimate goal for self
• Self‐interest remains paramount
Utilitarianism
• Bentham and Mill
• Consider impartially the interests of all persons
affected by an action and pick the greater
benefit
• “Greatest good to greatest number”
• Difficulties
• Impossible to foresee all consequences
• Consequences difficult to measure
Utilitarian Types
• Act‐Utilitarian
• Examines the specific action itself versus rule
• Sets aside the rule only if increase in net utility to all
stakeholders
• Rule‐Utilitarian
• Basis behavior on rules designed to promote the
greatest utility
• Maximizes intrinsic value
Deontology
• Derived from Greek deon meaning duty
• Moral norms establish basis for action
• Based on rights of individuals and motivation
rather than consequences
• Concerned with means rather than end result
• Rights
• Justice
Rights Principles
• Hobbes and Locke
• Kant
• Categorical Imperative
• Motivated by sense of obligation
• Universality of moral actions
• People should never be treated as a means only, i.e.,
a means to an end
• Difficulties
• Moral Absolutes
• No clear way to resolve conflicts between moral
duties
Justice
• John Rawls (1921‐2002)
• “Original Position” – behind the “veil of
ignorance”
• Each permitted the maximum amount of basic
liberty compatible with others.
• Social and economic inequalities are allowed
only if benefit all.
• Treat equals (i.e., those with equal claims) equally
and unequals (i.e., those with differing claims)
unequally
Virtue Ethics
• Greek philosophers, Plato and Aristotle
• Less emphasis on learning rules
• Stress importance of developing good habits of
character
• Cardinal virtues
• Wisdom
• Courage
• Temperance
• Justice
Virtue Ethics
• Other Important Virtues
• Fortitude
• Generosity
• Self‐respect
• Good temper
• Sincerity
• Bad Character Traits, also known as Vices
• Cowardice
• Insensitivity
• Injustice
• Vanity
Virtues in Accounting Practice
• Ethical obligations to clients, employers,
government, and public at large
• Perform services
• Without bias
• Avoid conflicts of interests
• Independence
• Integrity
Acting with Integrity
• Act out of moral principle, not expediency
• Never let loyalty cloud good judgment and
ethical decision‐making
• Have the courage to stand by your convictions in
accordance with the public service ideal of the
accounting profession
Moral Point of View
• Emphasizes practical reason and rational choice
• Deliberation precedes choice of action
• Reason
• Thought
• Voluntary
• Ends do not justify the means
• At least some times we should be willing to act
in the best interests of others and set aside self‐
interest and the interests of an employer or a
client
Personal Integrity
• Essential characteristic for CPA
• Learn to be ethical
• By practice
• Gaining wisdom
• Exercising virtues
• Enable you to lead a life of excellence
Accounting and the Public Interest
• Honoring public trust
• Acting with integrity in performance of
professional services
• Being independent of clients
• Making decisions objectively
• Exercising due care in the performance of
services and professional skepticism
AICPA Code of Conduct
• The code is divided into two sections:
• Principles: are aspirational statements that form the
foundation for the Code’s enforceable Rules of
Professional Conduct. Principles are expectations but are
not legally binding. The principles of professional conduct
include:
• Responsibilities
• Public Interest
• Integrity
• Objectivity and Independence
• Due Care
• Nature and Scope of Services
• Rules: enforceable applications of the Principles
Overriding responsibility of CPAs
• Exercise sensitive professional and moral
judgments in all activities.
• Recognize the primacy of a CPA’s responsibility
to the public as the way to best serve the
clients’ and employers’ interest.
• Continued improvement in the level of
competency and quality of services
Virtue, Character and CPA Obligations
Aristotole’s Virtues Ethical Standards for CPAs

• Trustworthiness, • Integrity
benevolence, altruism • Truthfulness, non‐
• Honesty, integrity deception
• Impartiality, open‐ • Objectivity, independence
mindedness • Loyalty (confidentiality)
• Reliability, dependability, • Due care (competence and
faithfulness prudence)
Institute of Management Accountants
(IMA)
• Principles
• Honesty
• Fairness
• Objectivity
• Responsibility
• Standards
• Confidence
• Confidentiality
• Integrity
• Credibility
• Resolution of Ethical Conduct
• Discuss issue with immediate supervisor or higher authority.
• Clarify ethical issues with an IMA Ethics Counselor or other impartial advisor
• Consult attorney.
DigitPrint
• Outsourcing business for high‐speed digital
printing
• $2 million in venture capital
• $200,000 net income for 1st year
• $1 million unrecorded accrued expenses
• Income becomes $800,000 loss
DigitPrint
• IMA Standards
• Integrity, inform Higgins, seek outside counsel
• Utilitarianism
• Greatest benefit to the public, company, and
employees
• Rights Theory
• Venture capitalist (and Higgins) have ethical right to
know
• Justice
• Virtue of integrity and not subordinate judgment
What to DO?
• Take concerns to Higgins
• Whistle‐blowing
• Confidentiality
• Right to do versus the Right thing to do
Concluding Thought
• In accounting, integrity is its own reward
because it builds trust in client relationships and
helps honor the public trust that is the
foundation of the accounting profession.
Videos on Cases
• Harvard Cheating Scandal
• http://www.youtube.com/watch?v=hHUJuEYw0SU
• http://www.youtube.com/watch?v=1PBsVH68Iig
• NYC Subway Death
• http://www.youtube.com/watch?v=3UkS8VfotU8
• Bystander Effect
• http://www.youtube.com/watch?v=3UkS8VfotU8
• Other
• http://www.youtube.com/watch?v=NxdbzcR4nfA
• http://www.youtube.com/watch?v=Lhwhgf01Ozw
Cognitive Processes and
Ethical Decision Making in
Accounting
Chapter 2
Copyright ©2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Cognitive Development Approach
• Cognitive development refers to the thought

process followed in one’s moral development
• An Individual’s ability to make reasoned
judgments about moral matters develops in
stages
• These stages characterize the way people think
about ethical dilemmas
Kohlberg and Cognitive Development
• Psychologist
• 20 years of research
• Moral reasoning processes becomes more
complex and sophisticated with development
• Higher stages are consistent with philosophical
theories of rights and justice
Heinz and the Drug
• Heinz’s wife has a rare cancer

• A radium drug could help
• Druggist charged 10 times what drug cost ($200
cost; $2,000 for small dose of drug)
• Heinz could only get together $1,000
• Druggist would make no exceptions to price of
drug
• What should Heinz do?
Sample Responses to the Heinz Dilemma
• Egoism: Steal the drug, depending on how much

Heinz likes his wife and how much risk to stealing
• Ends justify the means: Steal the drug, due to
loving the wife so much and cannot watch her die
• Act Utilitarianism: Weigh the costs and benefits of
alternative actions
• Rule Utilitarianism; justice: Do not steal the drug,
since stealing is against the law
• Rights: Right to life above all else (Constitutionally:
life, liberty, and the pursuit of happiness)
Kohlberg’s Stages of Moral Development
• Lawrence Kohlberg’s six stages of moral

development are divided into three levels of
moral reasoning
• Level 1 – Preconventional
• Level 2 – Conventional
• Level 3 - Postconventional
Level 1 - Preconventional
• Rules are seen as something external imposed

on one’s self
• Individual is very self-centered
• Stage 1 – Obedience to rules; avoidance of
punishment
• Stage 2 – Satisfying one’s own needs (egoism);
follow rules only if they satisfy one’s needs
Level 2 - Conventional
• Individual becomes aware of the interests of

others and one’s duty to society
• Personal responsibility is an important
consideration in decision-making.
• Stage 3 – Fairness to others; commitment to loyalty
in the relationship
• Stage 4 – Law and order; one’s duty to society,
respect for authority, maintaining social order
Level 3 - Postconventional
• Individual recognizes there must be a society

wide basis for cooperation
• Orientation to principles that shape whatever
laws and role systems a society may have
• Stage 5 – Social contracts; upholding the basic rights,
values, and legal contracts of society
• Stage 6 – Universal ethical principles that everyone
should follow, Kohlberg believed this stage rarely
existed; Kant’s categorical imperative
Gilligan’s Ethics of Care
• Care-and-response orientation that

characterizes female moral judgment
• Females look for ways of resolving dilemma
where no one will experience pain
• Criticism: Implication that men lack a caring
response when compared to females
Characteristics of Kohlberg’s Model
• Kohlberg maintains that his stage sequence is universal

• Same in all cultures
• Contrary to Geert Hofstede’s cultural dimensions
• Stages refer not to specific beliefs, but
• Underlying modes of reasoning
• Suggests that people continue to change their decision
priorities over time and with additional education and
experience.
• Individual’s moral development can be influenced by
corporate culture, especially ethics training.
Ethical Domain in Accounting and Auditing
• Four key constituent groups of accountants and

auditors’ domain are the:
• Client organization that hires and pays for
accounting services
• Accounting firm that employs the practitioner
• Accounting profession including various
regulatory bodies
• General public who rely on the attestation and
representation of the accounting firm
Accountants Ethical Behavior
• Accounting profession has professional

standards to encourage ethical behavior
• These standards, an individual’s attitudes and
beliefs, and ethical reasoning capacity influence
professional judgment and ethical decision
making
• Post conventional reasoning is the ethical
position to take even though it may go against
corporate culture of, “go along to get along”
Empirical Studies
• Studies have shown that:

• Ethical reasoning may be an important determinant
of professional judgment
• Unethical and dysfunctional audit behavior may be
systematically related to the auditor’s level of ethical
reasoning
• Ethical reasoning may be an important cognitive
characteristic that may affect individual judgment
and behavior
Moral Reasoning and Moral Behavior
• Moral judgment is the single most influential

factor of a person’s moral behavior
• Morality requires
• Person’s actions be rational
• Motivated by purpose or intent
• Carried out with autonomous free will
• Criticism of Kohlberg
• Draws too heavily from Rawl’s Theory of Justice
• Makes deontological ethics superior to other ethical
perspectives
Rest’s Model of Morality
James Rest’s model of ethical action is based

upon the presumption that an individual’s
behavior is related to her/his level of moral
development. He breaks down the ethical
decision making process into four major
components.
Components of Rest’s Model
• Moral Sensitivity – ability to identify what is

moral and amoral.
• Moral Judgment – ability to reason through
several courses of actions and making the right
decision when faced with an ethical dilemma.
• Moral Motivation – influences that affect an
individual’s willingness to place ethical values
ahead of nonethical values.
• Moral Character – having one’s ethical
intentions match actions taken.
Moral Intent
• Critical component of ethical decision making

• Internalization of virtues
• Acting in accordance with principles
• One must want to make the ethical decision
Components Interact
• All processes must take place for moral behavior

to occur.
• This framework is not a linear decision making
model, the processes instead work through
sequence of “feed-back” and “feed-forward”
loops.
• Moral failure can occur when there is a
deficiency in any one component.
Moral Intensity
• Developed by Thomas Jones

• Characteristics of moral issue (Moral Intensity)
affects decision making
• Model links moral intensity to Rest’s Model
• Magnitude of Consequences
• Temporal Immediacy
• Social Consensus
• Proximity
• Probability of Effect
• Concentration of Effect
Libby and Thorne: Virtues Important for
Auditing
• Intellectual virtues: indirectly influence

individual’s intentions to exercise professional
judgment
• Most important: integrity, truthful, independent,
objective, dependable, principled, and healthily
skeptical
• Instrumental virtues: directly influence
individual’s actions
• Most important: diligent, alert, careful, resourceful,
consultative, persistent, and courageous
Linda Thorne’s Integrated Model of Ethical
Decision Making
Perception
Sensitivity Identification of
Dilemma
Moral Development
Prescriptive Ethical Judgment

Understanding Reasoning
Moral Virtue Ethical Ethical Intention

Motivation
Virtue
Ethical Character Ethical Behavior
Instrumental Virtue
Ethical Decision-Making Models
• Consciously thinking about and analyzing what

one has done (or is doing).
• A systematic process to organize the various
elements of ethical reasoning and professional
judgment.
• Evaluate stakeholder interests
• Analyze the relevant operational and accounting
issues
• Identify alternative courses of action.
Kidder’s Ethical Checkpoints
• Recognize that there is a moral issue.

• Determine the actor.
• Gather the relevant facts.
• Test for right-versus-wrong issues.
• Test for right-versus-right paradigms.
• Apply the ethical standards and perspectives.
• Look for a third way.
• Make the decision.
• Revisit and reflect on the decision.
Integrated Ethical Decision-Making Process
1. Identify the ethical and professional issues

(ethical sensitivity)
2. Identify and evaluate alternative courses of
action (ethical judgment)
3. Reflect on the moral intensity of the situation
and virtues that enable ethical action to occur
(ethical intent)
4. Take action (ethical behavior)
Ace Manufacturing
• Three stockholders: Smith, Williams, & Jones

• Jones hires son Paul to manage the office
• Paul is given complete control over payroll,
approves disbursements, signs checks, reconciles
G/L cash to bank statement
• Paul hires Larry Davis to help with accounting
• While Paul is on medical leave, Davis finds $10,000
total in payments over payroll amount to Paul in
January and February
• What should Davis do?
Application of Decision Making Model to
Ace Manufacturing
• Identify the ethical and professional issues (ethical sensitivity)

• GAAP – Potential fraud, misstated F/S, incorrect taxable income
• Stakeholders – owners, Paul, Davis, IRS, banks
• Ethical/professional standards – objectivity, integrity, due care
• Identify and evaluate alternative courses of action (ethical judgment)
• Legal issues – GAAP, fraudulent F/S, tax understatement
• Alternatives/ethical analysis – do nothing, confront Paul, report to Jones or
all the owners. Rule utilitarianism and rights argue for informing other
partners who have a right to know, although Paul can be approached first
under the theory he has a right to correct the matter
• Reflect on the moral intensity of the situation and virtues that enable
the ethical action to occur (ethical intent)
• Will Davis be responsible for getting Paul in trouble? What is the right thing
to do? Can Davis trust Paul again?
• Take action (ethical behavior)
• Have courage, insist on correction to accounting, give Paul an opportunity to
explain
Behavioral Ethics
• Considers how individuals make decisions in the

real world versus how they would make
decisions in an ideal world.
• Kahneman’s two distinct modes of decision
making:
• System 1: intuitive system of processing info; fast,
automatic, effortless, and emotional decision
processes
• System 2: slower, conscious, effortful, explicit, and a
more reasoned decision process
Leon Festinger
• Recognized the limitation of philosophical

reasoning approaches integrated into decision
making models
• How we think we should behave is different
from how we decide to behave
• Coined term of Cognitive Dissonance in 1956
Cognitive Dissonance
• Inconsistency between our thoughts, beliefs, or

attitudes and behavior creates the need to
resolve contradictory or conflicting beliefs,
values, and perceptions.
• Only occurs when we are “attached” to our
attitudes and beliefs.
• How we think we should behave is different
from how we decide to behave.
• Example of Betty Vinson of WorldCom
Giving Voice to Values
• Behavioral ethics approach with an emphasis on

developing the capacity to effectively express one’s
values in a way that positively influences others
• Finding levers to effectively voice and enact one’s values
• Ask to think about the arguments others might
make that create barriers to expressing one’s values
in workplace
• Ask to think how best to counteract these “reasons
and rationalizations”
• Used post-decision making (already decided what
to do)
GVV Questions
• How you get it done effectively and efficiently?

• What do you need to say, to whom, and in what
sequence?
• What will the objectives or push-back be, and, then
• What will you say next?
• What data and examples do you need to support
your point of view?
• GVV relies on developing arguments, action plans,
and rehearsing how to voice/enact moral values.
Reasons and Rationalizations
• Expected or Standard Practice – “Everyone does

this.”
• Materiality – “The impact is not material. It doesn’t
really hurt anyone.”
• Locus of Responsibility – “This is not my
responsibility; I’m just following orders.”
• Locus of Loyalty – “This is not fair to the client, but I
don’t want to hurt my
reports/team/boss/company.”
• Isolated Incident – “This is a one-time request.”
4 – Step GVV Process
• What are the main arguments you are trying to

counter? That is, what are the reasons and
rationalization you need to address?
• What’s at stake for the key parties, including
those with whom you disagree?
• What levers can you use to influences those
with whom you disagree?
• What is your most powerful and persuasive
response to the reasons and rationalizations you
need to address?
Doing Good by Being Good: GVV
• Matt and Becca head up Accounting Club

fundraising for hurricane victims in the college
community
• Donations totaled $20,367 and 2,000 hours of
volunteer work
• Only $20,000 given to victims
• Where is the other $367 or where is receipt for
the fees on gift cards?
Doing Good Analysis with GVV
• What are the main arguments to counter or reasons and

rationalizations to address?
• Locus of loyalty, materiality, isolated incident, student
graduating
• What’s at stake for the key parties?
• Reputation, leadership stake, faculty advisor and community
• What levers can you use to influence those with whom
you disagree?
• Speak to other officers, approach Matt, go to faculty advisor,
jeopardizing respect
• What is your most powerful and persuasive response to
the reasons and rationalizations?
• Cheating, job in Big 4, loyalty to club, consequences to club and
officers in cover up
Ace Manufacturing Analysis with GVV
• What are the main arguments to counter or reasons and

rationalizations to address?
• No one hurt, private company, sympathy card, materiality, not being
compensated properly, isolated incidents, Jones has approved, will pay
back
• What’s at stake for the key parties?
• Reputations, embarrassment, right to know, loss of job, ability to obtain
loan
• What levers can you use to influence those with whom you
disagree?
• Ask for supporting documents for coding of expenses, harm to company
and embarrassment to dad, long-term effects, telling all the owners
• What is your most powerful and persuasive response to the
reasons and rationalizations?
• Verifying that vendor is not paid twice, using money for personal use is
stealing and no materiality test, challenges Jones about knowing, owners
need (have a right) to know
Concluding Thoughts/Key Issues
• “The road to success is littered with failures, but the

lessons learned are crucial in plotting your course to
success.” Kristi Loucks
• Kohlberg’s model of moral development
• Rest’s model of ethical decision-making
• Cognitive development
• Issues of moral intensity and virtue in Integrated
Decision-Making mode
• Behavioral ethics
• Moral reasoning skills
• Giving Voice to Values
Organizational Ethics and
Corporate Governance
Chapter 3
Organizational Ethics and Ethical Climate
• Organizational ethics
• Sound moral principles
• Organizational ethical climate
• Moral atmosphere
• Level of ethics practiced within a company
• Determined by leaders
• Critical component
• Shared Values, Beliefs, Goals, and Problem-
solving Mechanisms
• Focuses on issues of right and wrong
Ethical Leadership
• Leaders of Good Character

• Possess integrity, courage, and compassion
• Careful and prudent
• Decisions and actions inspire employees to act in an
enhancing way
• Virtues
• Courage, temperance, wisdom, justice, optimism,
integrity, humility, reverence and compassion
• Role Models
Key Markers of Highly Ethical Organizations
• Humility
• Zero tolerance for individual and collective destructive
behaviors
• Justice
• Integrity
• Trust
• A focus on process
• Structural reinforcement
• Social responsibility
• Values-driven organization that encourages openness,
transparency, and provides supportive environment to voice
values without fear of retribution or retaliation
Framework for Understanding Ethical
Decision Making in Business
• Ethical Issue Intensity

• Importance of the issue to the individual, work group and/or
organization (intensity) based on values, beliefs and norms involved
and pressures in the workplace.
• Individual Factors
• Values of individuals
• Organizational and social forces shape behavioral intentions and
decision making
• Organizational Factors
• Organization’s values have a greater influence than a person’s own
values.
• Opportunity
• Conditions that limit or permit ethical or unethical behavior
• Business Ethics Intentions, Behavior, and Evaluations
• Organizational ethical culture is shaped by effective leadership
Organizational Influence on Ethical Decision
Making
• The Jones-Hiltebeitel model looks at the role of

one’s personal code of conduct in ethical
behavior within an organization
• Moral intensity
• When one’s personal code is insufficient to
make the necessary moral decision, the
individual will look at professional and
organizational influences to resolve the conflict
Ethical Dissonance Model
• Interaction between the individual and the

organization, based upon person-organization
ethical fit at various stages of the contractual
relationship in each potential ethical fit scenario
• Four potential fit options:
1. High-High (high organization & high individual ethics)
2. Low-Low (low organization & low individual ethics)
3. High-Low (high organization & low individual ethics)
4. Low-High (low organization & high individual ethics)
Seven Signs of Ethical Collapse
“Occurs when any organization has drifted from the

basic principles of right and wrong” Marianne
Jennings
1. Pressure to maintain numbers
2. Fear and silence
3. Young ‘uns and bigger than life CEO
4. Weak board of directors
5. Conflicts of interests overlooked or unaddressed
6. Innovation like no other company
7. Goodness in some areas atones for evil in others
Pressure to Maintain Numbers and Fear of
Reprisals
• Ethical collapse occurs when there is an

unreasonable and unrealistic obsession with
meeting quantitative goals
• “financial results at all costs”
• Employees are reluctant to raise issues of ethical
concern because they may be ignored, treated
badly, transferred or worse
• “kill the messenger syndrome”
Loyalty to the Boss and Weak Board of
Directors
• Young people selected by the CEO for their

position based on inexperience, possible
conflicts of interest, and unlikelihood to
question the boss' decisions
• Weak board of directors characterizes virtually
all of the companies with major accounting
frauds in the early part of the 2000s
Stakeholder Orientation
• Business Stakeholders
• Investors and shareholders, creditors, employees,
customers, suppliers, government agencies, communities
and others
• Have a “stake” or a claim in some aspect of a company’s
products, operations, markets, industry and outcome
• Stakeholder orientation is the degree to which an
organization understands and addresses stakeholder
demands. Consists of
• Generation of data about stakeholder groups and
assessment of the firm’s effects on these groups
• Distribution of this information throughout the firms
• The responsiveness of the organization as a whole to this
information
The Ford Pinto Case
• Subcompact car
• Unsafe gas tanks could burst into flames
• Initial ethical legalism defense
• Risk/cost benefit analysis
• Too costly to replace the fuel tanks
• Compliance with law versus ethical behavior – met
all safety requirements
• Utilitarian reasoning
• Focusing on costs and benefits
• Ignores rights of various stakeholders
• Ignored cost of potential lawsuits
Establishing an Ethical Culture
• Corporate culture is the shared beliefs of top managers

in a company about how they should manage
themselves and other employees, and how they should
conduct their business (es).
• Tone at the top refers to the ethical environment that is
created in the workplace by the organization’s
leadership.
• Corporate culture starts with an explicit statement of
values, beliefs, and customs from top management.
• A code of ethics serves as a guide to support ethical
decision making.
• It clarifies an organization’s mission, values, and principles,
linking them with standards of professional conduct.
Trust in Business
• Trust means to be reliable and carry through words

with deeds.
• Trust becomes pervasive only if the organization’s
values are followed and supported by top
management.
• Trust can be lost, even if once gained in the eyes of
the public, if an organization no longer follows the
guiding principles that helped to create its
reputation for trust.
• Credo is an aspirational statement that encourages
employees to internalize the values of the company.
Johnson & Johnson:
A Case of Dr. Jekyll and Mr. Hyde?
• J&J’s credo emphasizes primary obligation to those who use

and rely on the safety of its products
• Tylenol Poisoning – J&J put customer safety first
• J&J has been withdrawing from its “trust” bank in recent
years
• Illegally promoted the antipsychotic Risperdal
• Misleading statements about the recall of Motrin
• Included methylene chloride, which is banned by the FDA, in their
baby shampoo
• DePuy Orthopaedics sold metal-on-metal hip implants that were
found to shed minute particles into a patient’s bloodstream over
time
• Ethicon vaginal mesh did not meet reasonable safety standards
• Takes a long time to build a reputation of trust, but not very
long at all to tear it down.
Ethics in the Workplace
• A code of conduct goes beyond what is legal for an organization and

provides normative guidelines for ethical conduct. Support for ethical
behavior from top management is a critical component of fostering an
ethical climate.
• Measures that should be taken to establish an ethical culture:
• Clear policies on ethical conduct including a code of ethics
• Ethics training program that instills a commitment to act ethically and explains
the code provisions
• A top level officer (Chief Ethics and Compliance Officer) to oversee ethics and
compliance
• Use internal auditors to investigate whether ethics policies are followed
• Strong internal controls to prevent and detect unethical behaviors
• Whistleblowing policies, including reporting outlets
• Ethics hot line for anonymous tips
• Ethics statement signed by employees
• Enforce ethics policies fairly and take immediate action against violators
• Reward ethical behavior and include in performance evaluation system
Character and Leadership in the Workplace
• Characteristics of ethical behavior in leaders

include:
• “Managers are people who do things right and
leaders are people who do the right thing.”
Warren Bennis
• Rules for managers to set ethical tone at the
top:
• Consider how your actions affect others.
• Do no harm.
• Make decisions that are universal.
• Reflect before deciding.
KPMG’s Integrity Survey 2013
• People of integrity are self-driven to do the right thing.

• KPMG’s Integrity Survey 2013 surveyed more than 3,500 U.S.
workers
• Nearly 75% of employees observed misconduct within past 12 months
• More than 50% of employees reported what they observed could cause a
significant loss of public trust if discovered
• Causes: Pressure to do “whatever it takes” to meet targets, not taking
code of conduct seriously, fear of losing one’s job for not meeting targets,
rewarding employees for results and not the means used to achieve them
• When employees were asked what they would do on observing a
violation of code of conduct,
• 78% would notify their supervisor or another manger
• 54% would try resolving the matter directly
• 53% would call the ethics or compliance hotline
• 26% would notify someone outside the organization
• 23% would look the other way or do nothing
2013 National Business Ethics Survey
• Views of Employees from 2011-2013:

• Observed misconduct have declined between 2011 and 2013.
• Pressure to compromise ethical standards declined but
retaliation against whistleblowers increased; increase in ethics
training programs and the use of ethical conduct in employees
evaluations.
• Six most observed types of misconduct: (1)stealing or
theft, (2)falsifying time reports, (3) falsifying expense
reports, (4)falsifying and manipulating financial
reporting information, (5)falsifying invoices, books, and
records, and (6) accepting gifts or kickbacks.
• Concern that while misconduct is down overall, a
relatively high percentage of misconduct is committed
by managers.
ACFE 2014 Report to the Nation
Occupational Fraud
• Fraud can be defined as a deliberate

misrepresentation to gain advantage over
another party
• Typical business loses 5% of annual revenues to
fraud; median loss of $145,000
• Occupational fraud is use of one’s position
within organization to misappropriate
organization’s resources or assets for personal
gain
• Frauds lasted a median of 18 months before
detection
• More likely to be detected by tip, using hotlines,
ACFE 2014 Report to the Nation
Occupational Fraud
Frequency of Anti-Fraud Controls

• External audit of financial statements - 81.4%
• Code of conduct - 77.4%
• Internal audit department - 70.8%
• Management certification of financial statements -
70.0%
• External audit of internal controls - 65.2%
• Management review - 62.6%
• Independent audit committee - 62.0%
Behavioral Indicators of Fraud
• Living Beyond Means

• Financial Difficulties
• Unusual Close Association with Vendor/Client
• Control Issues, Unwillingness to Share Duties
• Wheeler-Dealer Attitudes
• Divorce/Family Issues
• Instability, Suspiciousness or Defensiveness
• Addiction Problems
• Complained about Inadequate Pay
• Refusal to Take Vacations
Internal Control Weaknesses
• Internal control includes all of the processes and

procedures that management puts in place to help make
sure that its assets are protected and that company
activities are conducted in accordance with the
organization’s policies and procedures.
• An effective system of internal controls is critical to
establish an ethical corporate culture that should be
supported by the tone at the top.
• An internal control system, no matter how well
conceived and operated, can provide only reasonable -
not absolute – assurance to management and the board
of directors regarding achievement of an entity’s
objectives.
• Management override of internal controls may be a
problem.
Financial Statement Fraud
Fraud schemes occur because an employee – usually top

management – causes a misstatement or omission of material
information in the organizations’ financial reports.
• Methods include:
• Revenue Overstatement
• Recording gross, rather than net, revenue
• Recording of revenues of other companies, acting as a ‘middleman’
• Recording sales that never took place
• Recording future sales in the current period
• Recording sales of products that are out on consignment
• Expense Understatement
• Recording cost of sales as a non-operating expense
• Capitalizing operating costs
• Not recording some expense at all
• Improper Asset Valuations
• Manipulating reserves
• Changing the useful lives of assets
• Failing to take a write-down when needed
• Manipulating estimates of fair market value
Miniscribe Fraud
• Top management committed the fraud and

overrode internal controls
• Company lacked independent members on its
Board of Directors
• Salaries and bonuses often depended on Miniscribe
“making the numbers”
• Inventory hole initially worth $2-4 million, then $15
million
• Miniscribe bought bricks to disguise as hard drives
and conceal as inventory worth $4 million
• Repeatedly signed management letter stating
financial reports were accurate and truthful
Why does Financial Statement Fraud
Occur?
• Situational pressure
• Perceived opportunity
• Rationalization
• A culture is created and tone at the top
established that presents the image of a
company willing to do whatever it takes to paint
a rosy picture about financial results.
Corporate Governance Structures
and Relationships
• Corporate governance is shaped by internal and

external mechanisms.
• Internal mechanisms help manage, direct, and monitor
corporate activities to create sustainable stakeholder
value.
• Examples: independent board of directors, the audit
committee, management, internal controls and the internal
audit function
• External mechanisms are intended to monitor the
company’s activities, affairs, and performance to ensure
that the interests of insiders (management, directors,
and officers) are aligned with the interests of outsiders
(shareholders and other stakeholders).
• Examples: the financial markets, state and federal statues,
court decisions, and shareholder proposals
Best Practices of Governance
• Independent directors enhance governance

accountability
• Separation of the duties of CEO and board chair
• Separate meetings between the audit
committee and external auditors strengthen
control mechanisms
Ethical and Legal Responsibilities
of Officers and Directors
• Directors and officers are deemed fiduciaries of the corporation as

their relationship with the corporation and its shareholders is one
of trust and confidence
• Duty of Care – act in good faith, exercise the care that an ordinarily
prudent person would exercise in a similar situation
• Duty of Loyalty – act in the best interest of corporation; loyalty can
be defined as faithfulness to one’s obligations and duties
• Duty of Good Faith – requires an honesty of purpose that leads to
caring for the well-being of the constituents of the fiduciary
• Business Judgment Rule – expected to exercise due care and to use
their best judgment in guiding corporate management, but they are
not insurers of business success; honest mistakes and poor
business decisions do not make them liable to the corporation for
resulting damages
Audit Committee
• Independent directors with one having financial expertise

• Oversight of financial reporting
• Internal audit function
• External auditors
• CEO and CFO financial statement certification process
• Review formal announcements of earnings, significant financial
reporting judgments, internal controls and risk management
procedures, whistleblower and compliance program, external
auditor’s independence and objectivity and effectiveness of audit
process
• Seen as the one body that should be able to prevent identified
fraudulent financial reporting
• Committee should meet separately with the senior executives, the
internal auditors, and the external auditors
Internal Auditors
• Monitor corporate governance activities and

compliance with organization policies
• Review effectiveness of the organization’s code of
ethics and whistle-blower provisions
• “Eyes and ears” of audit committee
• Assess audit committee effectiveness and
compliance with regulations
• Oversee internal controls and risk management
processes
• Assurance on how effectively the organization assesses
and manages its risk
• Assurance on data security and privacy controls
External Auditors
• An obligation to the public interest that underlies

their corporate governance responsibilities
• Protect the interests of shareholders
• Conduct audits independent of any influence of
management or the company
• Communicate effectively with the audit committee:
accounting policies and procedures, estimates by
management; quality of financial reporting;
potential violations of laws
• Ensures accountability for financial reporting
process
Internal Controls
• Prevent and detect errors and fraud

• Asset misappropriations
• Materially false and misleading financial reports
• Inadequate disclosures
• Ensure management policies are followed
• Ethical systems built into corporate governance
• Can be overridden by top management
• Do what CEO says, not what he does
• Creates cynical attitude
• Managers need to “walk the talk” of ethics
COSO Internal Control – Integrated
Framework
• Emphasizes roles of BOD, management, internal auditors, and

personnel
• Designed to provide reasonable assurance
• Effectiveness and efficiency of operations
• Reliability of financial reporting
• Compliance with laws and regulations
• Framework
• Control environment: ethics of the organization
• Risk assessment
• Control activities
• Monitoring
• Information and communication
• Groupon is an example of internal control failure: had to restate
financial statements because of material weaknesses in internal
controls
• Management caught internal control weaknesses, not auditors
Liability for False Certifications
• SEC’s increased focus on identifying and penalizing misstatements

in public company financials
• Analyzing patterns of internal control problems even absent a
restatement of the financials
• Quality Services Group Inc. (QSGI) CEO and CFO held responsible
for alleged misrepresentations in public disclosures about the
company’s internal controls environment
• Signed Form 10-Ks with management reports on internal controls that
falsely omitted issues
• Signed certifications in which they falsely represented that they had
evaluated the management report on internal controls and disclosed all
significant deficiencies to auditors
• Transparency with the company’s audit committee and with
external auditors regarding evaluations of the company’s internal
controls and whether it protects the company, its investors, and its
officers
Compliance Function
• Organization’s ethics officer

• Ensures that the organization is in compliance with the
laws and regulations, including SEC securities laws, SOX,
and Dodd Frank
• May report to the audit committee, CEO, or general
counsel
• Official member of the c-suite
• Addresses existing requirements and anticipates
regulatory changes and their likely impact
• Ethics and Compliance Officer Association (ECOA)
• Ethics officer plays a critical role in helping create a
positive ethical tone in organizations
Has SOX Accomplished its Intended Goal?
• Section 302 requires CEO and CFO to certify financial

statements contain no material misstatements
• Helps protect the public against fraudulent financial statements
• Very few defendants have been charged with false
certification, and fewer still have been convicted
• Richard Scrushy, former HealthSouth Corporation CEO
• Indicted but found not guilty on false certification
• Weston L. Smith, CFO, pleaded guilty in scandal, sentenced to 27
months in prison
• CFO of DVI pleaded guilty to mail fraud and false certification,
sentenced to 30 months in prison
• SEC increasingly is pursuing claims against CFOs by alleging
that the CFOs subordinates violated securities laws and the
CFO either certified the resulting reports or failed to
implement adequate internal safeguards
Has SEC Accomplished its Goal?, part 2
• Craig Huff, CFO of Nature’s Sunshine Products

• SEC charged him as part of FCPA allegation that a wholly
owned Brazilian subsidiary made payment to custom agents
• SEC seeking disgorgement of bonuses and other
compensation that CFOs received in years in which the
company restated its financials
• James O’Leary, former CFO of Beazer Homes, which was found
to have overstated its income while he was CFO
• Agreed to return $1.4 million in past bonuses and stock profits
• Jury still out on whether SOX serves as an adequate
deterrent to financial fraud
• Laws do not necessarily lead to ethical behavior
• Laws are needed, but they serve as only a minimum standard
of ethical conduct
Whistleblowing
• Employees (former or current) who report suspected

violations to persons or organizations that may be able to
effect action
• Illegal
• Immoral
• Illegitimate
• Four elements:
• The whistleblower
• The whistleblowing act or complaint
• The party to whom the complaint is made
• The organization involved with the complaint
• “Organizational Dissidence” – similar to civil disobedience
• Whistleblower laws protects employees who provide
information on a fraud against retaliation
Morality of Whistleblowing
• Organizational policies should be designed to encourage

moral autonomy, individual responsibility, and
organizational support for whistleblowers
• Moral agency is important for the determination of
moral behavior
• Autonomy means to act according to reasons and
motives that are taken as one’s own and not the product
of policies, laws, etc.
• If pressure exists in an organization not to report
wrongdoing, a rational, moral person will withstand
such pressure, even with perceived retaliation, because
it is a moral requirement to do so
Rights and Duties
• Whistleblowers hope and believe their speaking out

will achieve correction of what they perceive as the
organizational wrongdoing
• “Retaliatory climate” in the organization is the
primary barrier to blowing the whistle on corporate
wrongdoing
• When organizations establish an ethical culture and
anonymous channels to report wrongdoing, it
creates an environment that supports
whistleblowing and whistle-blowers while
controlling for possible retaliation
Menendez v Halliburton, Inc.
• Menendez was the Director of Technical Accounting Research and Training

• Only months before that Halliburton had settled with the SEC after a two-
year accounting probe
• Menendez realized the company was violating very basic accounting
revenue recognition rules
• Accountants were counting the full value of the equipment right away as revenue,
even before it had assembled the equipment, customer could walk away until
delivery, and Halliburton was liable for loss on damaged equipment
• Menendez tried to get Halliburton to change accounting method, but no
action was taken
• He then spoke to the SEC and was told to go to the audit committee
• Halliburton’s general counsel circulated Menendez’s complaints to the CFO, KPMG,
other top executives and accounting department
• He was stripped of his responsibilities and became a pariah at the firm
• Appeals court panel ruled that Menendez had been retaliated against for
blowing the whistle
Accountants’ Obligations for
Whistleblowing
• Dodd-Frank contains provisions to encourage accountants and auditors

to report corporate wrongdoing, and Section 10A of the SEC 1934 Act
requires reporting of fraud
• Whistleblowing in accounting is a duty when it is motivated by a desire to
protect the public, confidentiality obligation not withstanding
• Process in deciding to report fraud
• Whether the violations have a material effect on the financial statements
• Has management or BOD taken remedial action?
• If not, auditor must report to BOD. The board has one business to inform the SEC
and provide copy to external auditor
• If auditing firm does not receive a copy within one business day
• Provide a copy of its own report to the SEC within one business day, or
• Resign from the engagement and provide copy of report to the SEC within one
business day of resigning
• The process must be handled through the client’s internal compliance
system before external auditors turn to whistleblowing
Dodd-Frank Wall Street Reform and
Consumer Protection Act
• 2010 passage of Dodd-Frank established

benefits for whistleblowers who aid in recovery
of $1M or more, can receive 10-30% of the
recovery
• Defines a whistleblower as any individual who
voluntarily provides information to the SEC
relating to a violation of federal securities laws,
is ongoing or is about to occur
• Voluntarily means the whistleblower has not
provided the information previously to the
government, a self-regulatory organization, or
the PCAOB
Internal Accountants’ Eligibility
• Internal accountants, including compliance and internal

auditors, are excluded from receiving whistleblower
awards under Dodd-Frank because pre-existing legal
duty and job responsibilities to report suspicion of illegal
acts and fraud to management.
• Under the following circumstances, internal accountants
are eligible to become Dodd-Frank whistleblowers:
• Disclosure to the SEC is needed to prevent “substantial injury”
to the financial interest of an entity or its investors
• The whistleblower “reasonably believes” the entity is impeding
investigation of the misconduct (e.g., destroying evidence or
improperly influencing witnesses)
• The whistleblower has first reported the violation internally
and at least 120 days have passed with no action.
External Auditor Eligibility
• Whistleblower rules allow the auditor or an employee associated

with the auditor to make a whistleblower submission alleging that
the firm failed to assess, investigate or report wrongdoing in
accordance with Section 10A, or that the firm failed to follow other
professional standards.
• Concerns about permitting CPAs to obtain monetary rewards for
blowing the whistle on their own firms’ performance of services for
clients create significant problems including
• Undermining the ethical obligations of CPAs not to divulge confidential
client information
• Harming the quality of external audits because client management might
restrict access to client information for fear the financial incentive for
whistleblowing could lead to report client-specific information to the SEC
• Overriding the firms’ internal reporting mechanisms for audit-related
disagreements
• Incentivizing an individual to bypass existing programs to report
disagreements including hotlines
Integrity Considerations
• It is the integrity standard that establishes the basis for moral

action of auditors and avoids subordinating judgment
• Interpretation 102-4 establishes the reporting procedures for
accountants and auditors under the AICPA Code (Exhibit 3.13)
• The CPA should seek legal advice when difference of opinion
exists on how best to handle disagreements with the client
and the firm refuses to make the required adjustments.
• The auditor should consider whether the relationship with
the organization should be terminated including possibly
resigning one’s position
• Resignation from the audit firm does not negate the auditor’s
disclosure responsibilities to the SEC
Morality of Whistleblowing
• Michael Davis considers whistleblowing to be morally required when it is

required at all; a moral obligation to prevent serious harm to others if it
can be done with little cost to the individual
• Application of a rule utilitarian perspective could lead to the conclusion
that a categorical imperative exists to do whatever it takes to stop
fraudulent behavior regardless of whether the action might bring more
harm than good to the stakeholders
• DeGeorge thinks “corporations have a moral obligation not to harm.” His
criteria for when whistleblowing is morally permitted includes
• Firm’s actions will do serious and considerable harm to others
• Whistleblowing is justifiable once the employee reports it to her supervisor and
makes her moral concerns known
• Absent any action by the supervisor, the employee should take the matter all the
way up to the board
• Documented evidence must exist that would convince a reasonable and impartial
observer that one’s view of the situation is correct and that serious harm may occur
• The employee must reasonably believe that going public will create the necessary
change to protect the public and is worth the risk to oneself
Whistleblowing Experiences
• Since its inception in 2011, SEC’s whistleblower

program has paid more than $50 million to 16
whistleblowers
• In August 2014, the SEC paid a whistleblower
award of more than $300,000 (20% of
settlement) to a compliance and audit employee
reporting insider trading and numerous
securities violation after the company failed to
take within 120 days of internal report
• Whistleblowing program is the right thing to do
to protect the public interest, but concerns are
• A self-interested and opportunistic person may be
induced to reveal company information to the SEC,
Ethics and Professional
Judgment in Accounting
Chapter 4
Questions for Consideration
• What are the underlying behavioral characteristics

of good judgment?
• What is the link between moral reasoning methods
and making professional judgments?
• How does cognitive dissonance influence
professional judgment?
• What is the role of professional judgment in making
ethical decisions?
• How does the AICPA Code address issues of
professional judgment?
Public Watchdog Function
• Public responsibility transcending any employment

responsibility with the client
• Ultimate allegiance to the corporation’s creditors and
stockholders, as well as to the investing public
• Accountant must maintain total independence from the client
at all times and requires complete fidelity to the public trust
• Overriding duty to put the interests of investors first
• Need for professional skepticism in making professional
judgments
• Need for objectivity and due care in making judgments given
the increasing complexity in financial reporting
• Only profession where one’s public obligation supersedes
that to a client
Professional Judgment in Accounting
• Professional judgment is influenced by personal

behavioral traits
• Attitudes
• Ethical values
• Personal values link to ethical sensitivity and judgment
• Ethical awareness of an ethical dilemma is a mediator of
the personal factors and ethical judgment relationship
• Objectivity and due care are attitudes and behaviors
that enable professional judgment
• Professional skepticism is essential in making
professional judgments; helps frame auditors’ mindset
of independent thought
KPMG Professional Judgment Framework
• Judgment is the process of reaching a decision or drawing a

conclusion where there are a number of possible alternative
solutions
• Judgment occurs in a setting of uncertainty, risk, and often conflicts
of interest
• Components revolve around ones’ mindset
• Clarify issues and objectives
• Consider alternatives
• Gather and evaluate information
• Reach conclusion
• Articulate and document rationale
• Prescriptive framework is used but pressures, time constraints, and
limited capacity may cause deviations
• Auditor should approach matters with objectivity and
independence, with inquiring mind and critical assessment of audit
evidence
Link between KPMG Framework and
Cognitive Processes
• Auditors need to use System 2 thought process

• Ethical awareness
• Application of ethical reasoning, ethical analysis of harms and
benefits and stakeholder rights; and professional obligations
• Judgments can fall prey to cognitive traps and biases that
negatively influence judgments
• Group-think
• Rush to solve problems
• Judgment triggers
• Judgment triggers – can lead to accepting a solution before it
is properly identified and evaluated
• Availability tendency
• Confirmation tendency
• Overconfidence tendency
• Anchoring tendency
CIFiR and Role of Professional Skepticism
• CIFiR is the SEC’s Advisory Committee on Improvements to

Financial Reporting; framework for accounting judgments
• A critical and good faith thought process
• Documentation
• Greek word skeptikos, meaning “inquiring or reflective”
• Professional skepticism links to professional judgment
through the ethical standards of independent thought,
objectivity and due care, which are incorporated in AICPA
Code of Professional Conduct
• CPA firm management should set an appropriate tone that
emphasizes a questioning mind throughout the audit and the
exercise of professional skepticism in gathering and
evaluating evidence
Public Interest in Accounting
• When professional judgment is compromised by taking shortcuts or

allowing pressures and biases imposed by others to taint decision
making, the public looses trust in the accounting profession
• The profession must rebuild its reputation on its historical
foundation of ethics and integrity
• IFAC’s Policy Position Paper #4, A Public Interest Framework for the
Accounting Profession
• A distinguishing mark of the accounting profession is the acceptance of its
responsibility to act in the public interest.
• International Ethics Standards Board for Accountants (IESBA)
include integrity, objectivity, professional competence and due
care, confidentiality, and compliance with laws and regulations
• AICPA public interest includes clients, credit grantors, governments,
employers, investors, the business and financial community, and
others who rely on the objectivity and integrity of CPAs
Professionalism versus Commercialism
• In 2013 PwC acquired the consulting giant Booz & Company.

• In 2014 KPMG brought Zanett Commercial Solutions and in
2015 acquired all the assets of Beacon Partners, Inc.
• Unlike audits that are conducted primarily to satisfy the
public interest, consulting services satisfy the client’s interest
and does not require independence from the client.
• Lynn Turner, former SEC chief accountant asked, “Are the
auditors going to serve management, or are they going to
serve the best interests of the investing public?”
• As long as the appearance of independence has been tainted
by the consulting relationship, the Independence standard
would be compromised.
Investigations of the Profession
• High profile frauds in the 1970s, 1980s, 2000s

• Congressional concern of auditors’ ethical and
professional responsibilities
• Themes of investigations
• Nonaudit services impairing auditor independence
• Management to report on internal controls
• Prevention and detection of fraud
• Role of audit committee and communication between
them and auditors
• Peer reviews/inspections
Metcalf (Moss) Committee
• First investigation of profession since 1930s

• Conducted between 1975-1977
• Some recommendations
• Establish self-regulatory organization of firms
• Led to AICPA two-tier voluntary peer review program
• Public company clients (assumed by PCAOB in 2004)
• Private companies
• Limitation of management service to those directly
related to accounting
• Report didn’t lead to any new legislation at the time
Cohen Commission
• Examined issues:
• Auditor’s responsibility for detecting fraud
• Expectation gap between public expectations and profession’s
goals for the audit
• Recommendations:
• Management should report on its internal controls
• Auditors should evaluate management’s report
• Both enacted as part of Sarbanes-Oxley Act of 2002
• Importance of Cohen Commission:
• Demonstrated conflicts of providing nonauditing services for an
audit client
• Lowballing fees
• Deliberately underbidding for an audit; Less prevalent after SOX
• Opinion shopping
• Client seeks auditor who will go along with accounting treatment
Early 1980s
• Fraud failure with ESM Government Securities,

Continental Illinois National Bank and Trust, and
Penn Square Bank
• Rep. Wyden authored 1986 bill to hold auditors
responsible for fraud detection
• Rep. Shad modified bill
• Internal control reports
• Detection of material illegalities or irregularities
• Bill did not pass
• ZZZZ Best Co.
• Created fictitious revenue that amounted to 80% of total
revenue; Rep. Dingell chaired investigation; auditors did
not disclose fraud to authorities
Savings and Loan Failures
• Deloitte & Touche audits

• Beverly Hills Savings and Loan
• Sunrise Savings
• Arthur Young audit
• Western Savings Association
• Lincoln Savings and Loan
• If Arthur Young had not merged with Ernst & Whinney to form EY,
the firm may have been forced out of business
• Greatest collapse of U.S. financial institutions since the Great
Depression
• Accounting issues in failed S&Ls centered on three issues:
• Inadequate allowances for loan losses
• Non-disclosure of related party transactions
• Inadequate internal controls
Treadway Commission Report
• National Commission on Fraudulent Financial Reporting

• 1985 study and report on factors leading to fraudulent
financial reporting
• Established Committee of Sponsoring Organizations
(COSO)
• Need to change the corporate culture
• Establish systems to prevent fraudulent reporting
• Tone at the Top – sets ethical tone of organization
• Importance of strong control environment
• Internal auditors must have direct and unrestricted access to
Audit Committee of BOD
• COSO Enterprise Risk Management – Integrated
Framework
2007 – 2008 Financial Crisis
• Excessive risk taking

• Mortgage meltdown
• Moral Hazard – Incentive for risk taking -- --to put own
interests first especially when perceived sanctions for
inappropriate behavior not enforced
• Concern over independence, objectivity, and audit
quality
• Growing personal and business relationships between
auditing firms, the client, and client management
• Emphasis on marketing of professional services
• Lehman Brothers
Failure of Lehman Brothers
• Insufficient liquidity to meet its current obligations and loss

of confidence of its lenders
• CEO, CFOs, and external auditors all failed to meet
professional responsibilities
• Lehman used “Repo 105”, did not disclose its use
• Shares dropped 94% over 8 months; U.S. refused to fund a
solution for Lehman
• Auditors play a critical role in the proper functioning of public
companies and financial markets
• The public has every right to conclude that auditors who hold
themselves out as independent will stand up to management
and not succumb to pressure
• External auditors need to recommit to their
watchdog/gatekeeper function
AICPA Revised Code: Independence for
Members in Public Practice
• Conceptual framework incorporates a “threats

and safeguards” approach
• New section on “Ethical Conflicts”
• Violation of the rules for a CPA to permit others
acting on his behalf to engage in behavior that
would have been a violation for the CPA
• When differences exist between AICPA and
those of the licensing state board of
accountancy, the CPA should follow the state
board’s rules
Conceptual Framework for Independence
Standards
• Independence required for audit and other

attestation services; in fact and in appearance
• AICPA uses risk based approach for analyzing
threats using the following steps:
• Identifying and evaluating threats to independence
• Determining whether safeguards already eliminate or
sufficiently mitigate identified threats and whether
threats that have not yet been mitigated can be
eliminated or sufficiently mitigated by safeguards
• If no safeguards are available to eliminate an
unacceptable threat or reduce it to an acceptable level,
independence would be considered impaired
Threats to Independence
• Independence must be in fact and appearance

• Threats include:
• Self review threat
• Advocacy threat
• Adverse interest threat
• Familiarity threat
• Undue influence threat
• Financial self-interest threat
• Management participation threat
• Safeguards to counteract threats:
• Safeguards created by the profession, legislation, or regulation
• Safeguards implemented by the attest client
• Safeguards implemented by the firm
Threats to Independence
Exhibit 4.2
Examples of Threats to Independence
Threat Example
Self-Review Threat Preparing source documents used to generate the client’s financial
statements.
Advocacy Threat Promoting the client’s securities as part of an initial public offering or
representing a client in U.S. tax court.
Adverse Interest Threat Commencing, or the expressed intention to commence, litigation by

either the client or the CPA against the other.
Familiarity Threat A CPA on the attest engagement team whose spouse is the client’s CEO.
Undue Influence Threat A threat to replace the CPA or CPA firm because of a disagreement with
the client over the application of an accounting principle.
Financial Self-Interest Threat Having a loan from the client, from an officer or director of the client, or
from an individual who owns 10 percent or more of the client’s
outstanding equity securities.
Management Participation Threat Establishing and maintaining internal controls for the client.
Safeguards
Source of the Examples of Safeguards

Safeguard
Created by the Professional resources, such as hotlines, for consultation on ethical issues.
profession,
legislation, or
regulation
Implemented by the • The client has personnel with suitable skill, knowledge, or experience who make
client managerial decisions about the delivery of professional services and makes use of
third-party resources for consultation as needed.
• The tone at the top emphasizes the client’s commitment to fair financial reporting
and compliance with the applicable laws, rules, regulations, and corporate
governance policies.
• Policies and procedures are in place to achieve fair financial reporting and
compliance with the applicable laws, rules, regulations, and corporate governance
policies.
• Policies and procedures are in place to address ethical conduct.
• Policies are in place that bar the entity from hiring a firm to provide services that do
not serve the public interest or that would cause the firm’s independence or
objectivity to be considered impaired.
Implemented by the Policies and procedures addressing ethical conduct and compliance with laws and
firm Copyright ©2017 McGraw-Hill Education.
regulations.
All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Global Code of Ethics
• International Ethics Standards Board for

Accountants (IESBA)
• Code of Ethics for Professional Accountants
(IFAC Code)
• Principles
• Integrity
• Objectivity
• Professional Competence and Due Care
• Confidentiality
• Professional Behavior
Financial Relationships that impair
Independence
• Direct or material indirect financial interest in a

client
• Loans to or from a client
• Example: Alexander Grant and ESM: CPA accepted
loans from a financial institution client.
• Led to changes in independence rules to prohibit
such loans and
• Permitted Loans
• Automobiles loans collateralized by the car
• Loans fully collateralized by cash deposits at the same
financial institution (passbook loans)
• Credit cards and overdraft accounts of $10,000 or less
Other Relationships
• Family Relationships
• Immediate family members
• Spouse or spouse equivalent, or dependents
• Close relatives in financial sensitive position with the
client or material financial interest
• Parent, sibling, or nondependent child
• Subject to independence rule if CPA knows member
has material financial interest
• Business Relationships
• Partner or manager who provides more than 10
hours of nonattest services to the attest client
• Partnerships or joint ventures with attest client
Employment or Association with Attest
Clients
• Independence may be impaired when a partner or

professional employee leaves the firm and is
subsequently employed by the client in a key position
unless following met:
• Amounts due to the former professional are not material to
the firm
• The former professional is not in a position to influence the
accounting firm’s operations or financial policies
• The former professional employee does not participate in or
appear to participate in or is not associated with the firm once
the relationship with the client begins
• Participating in the firm may be continuing to consult for
it or have one’s name included in firm literature
Providing Nonattest Services to an Attest
Client
• Certain lucrative nonattest services create a conflict

of interests
• A CPA should not perform management functions
or make management decisions for an attest client
• Client must agree to perform the following
functions:
• Assume all management responsibilities
• Designate competent overseer of these services
• Evaluate adequacy and results of services performed
• Accept responsibility for the results of the services
Nontraditional Forms of Ownership
• A traditional CPA firm may be acquired by a public

company that will provide nonattest services to
clients while, at the same time, a spin-off of the
original firm provides the attest services.
• Only firms that are majority owned by CPAs can
perform attest services.
• Concerns whether managers of the public
companies (or alternative practice structures) may
attempt to exert pressure over those in the CPA firm
and cause ethical problems.
• The appearance may be that the audit work could
be tainted by the relationship.
SEC Position on Independence
• Emphasizes independence in fact and appearance in

3 ways:
• Proscribing certain financial interests and business
relationships with the audit client
• Restricting certain nonauditing services to audit clients
• Subjecting all auditor conduct to a general standard of
independence
• Three principles that underlie auditor
independence:
• An auditor cannot function in the role of management
• An auditor cannot audit her own work
• An auditor cannot serve in an advocacy role for her client
General Standard of Independence
• Judged by a reasonable investor with knowledge of all

relevant facts and circumstances
• Auditor must be capable of exercising objective and
impartial judgment on all issues within the engagement
• Principles
• Situations which impair independence
• Creates a mutual or conflicting interest between an accountant
and his audit client
• Places an accountant in the position of auditing his own work
• Results in an accountant acting as management or employee of
the audit client
• Places an accountant in position of being an advocate for the
audit client
SEC Independence Actions
Against Big 4
• Deloitte
• Violated independence rules when its consulting affiliate kept a business
relationship with a trustee serving on boards/audit committees of three
funds Deloitte audited
• EY
• PeopleSoft – joint sales, marketing, license fees and royalty with client
(mutuality of interests)
• KPMG
• Violated independence rules by providing certain nonaudit services to
affiliates of companies whose books KPMG was auditing
• PwC
• Avon hired PwC for IT system; terminated project; did not write down full
cost of project, approved by PwC
• Pinnacle – PwC approved improper treatment of $8.5M as capital
expenses and reserves
• Cases raise red flags about consulting services and impairment of
audit independence
Insider Trading Cases
• Deloitte
• Thomas P. Flanagan, former management advisory partner and vice chair
• Traded in the securities of multiple clients (including Best Buy, Motorola,
Sears, and Option Care) from information learned in his partner duties
• Tipped his son, Patrick so he could also trade on that information
• KPMG
• Scott London, former partner of the KPMG’s Southern California’s regional
audit practice
• Leaked confidential information to Brian Shaw, about Skechers and
Herbalife
• Shaw repaid London with $50,000 in cash and a Rolex watch
• Audit opinions signed by London on Skechers and Herbalife had to be
withdrawn
• Cases show the risk to audit independence when audit engagement
team members trade on information that is not publicly available
AICPA Code: Ethical Conflicts
• Assess whether an ethical conflict exists

• Ethical conflicts create challenges to ethical decision
making because they present barriers to meeting the
requirements of the rules of conduct
• Consider whether any departures exist to the rules,
laws, or regulations and how they will be justified in
order to ensure that conflicts are resolved in a way that
permits compliance with these requirement
• Any unresolved conflicts can lead to a violation of the
rules of conduct which should focus the CPA’s attention
on any continuing relationship with the engagement
team, specific assignment, client, firm, or employer
Integrity and Objectivity
• Conflicts of interest for public practice occur when a professional service,

relationship, or specific matter creates a situation that might impair
objective judgment
• A conflict of interest creates adverse and self-adverse threats to integrity
and objectivity
• Safeguards include
• Implementing mechanisms to prevent disclosure or violation of confidentiality
• Senior individual not involved in the engagement regularly reviewing safeguards
• Member of the firm not involved in the conflict review the work performed to
assess whether key judgments and conclusions are appropriate, and
• Consulting with third parties, such as professional body, legal counsel, or another
CPA
• The CPA should disclose the nature of the conflict to clients and obtain
their consent to perform professional services
• If consent is not received, then the CPA should either cease performing the
services or take action to eliminate or reduce the threat to an acceptable
level
Subordination of Judgment
• Integrity rule prohibits a CPA from knowingly misrepresenting

facts or subordinating one’s judgments when performing
professional services for a client or employer
• Addresses differences of opinion between a CPA
accountant/auditor and that person’s supervisor or others in the
organization including top management on material accounting
issues
• CPA should consider any threats to integrity and objectivity,
and assess their significance whenever there is a material
misrepresentation of fact
• CPA should assess if threats are at an acceptable level; if not,
evaluate significance of safeguards to prevent impairment to
independence/objectivity
• Follow prescribed process to protect against subordination of
judgment (see Exhibit 3.13)
AICPA Code: Conceptual Framework for
Members in Business
• The conceptual framework for members in

business applies to integrity and objectivity, as
well as other rules of conduct, but not
independence
• Threats
• Adverse interest threat
• Advocacy threat
• Familiarity threat
• Self-interest threat
• Self-review threat
• Undue influence threat
Safeguards to Mitigate Risk
• Safeguards include
• Tone at the top
• Policies, procedures, implementation, and monitoring
addressing ethical conduct and compliance with laws and
regulations
• Internal policies and procedures for disclosure of
interests and relationships
• Whistle-blower hotlines
• Internal auditors not allowed to audit areas where they
have operational responsibilities
• Policies for promotion, rewards and enforcement of a
culture of high ethics and integrity
• Use of third-party resources for consultation as needed.
SOX: Nonaudit Services
• Financial information systems design and implementation

• Appraisal or valuation services, fairness opinions, or
contribution-in-kind reports
• Actuarial services
• Internal audit outsourcing services
• Management functions or human resources
• Broker or dealer services, investment adviser, or investment
banking services
• Legal services and expert services unrelated to the audit
• Any other service prohibited by BOD
• Tax services must be preapproved by the audit committee
Rules of Professional Practice
• The General Standards rule establishes requirements for

competence, compliance with professional standards, and
adherence to accounting principles
• Acts Discreditable covers a broad number of actions that may bring
discredit to the profession including
• Discrimination and harassment
• Solicitation or disclosure of CPA examination questions and answers
• Failure of a CPA/CPA firm to file and pay taxes
• Negligence in preparation of financial statements or records
• Standards relating to governmental accounting and auditing
• Confidentiality of information gained through employment, except
in specified situations
• Records Request governing what is client-provided records,
member-prepared records, member’s work products, and
member’s working papers
Contingent Fees, Commissions, and Referral
Fees
• Contingent fees and commissions are permitted when

performing advisory-type services for a nonattest client
• Contingent fees are prohibited from an attest (audit) client
• Prohibits acceptance of contingent fees if CPA or firm performs any of
the following:
1. an audit or review of a financial statement
2. compilation of financial statement that third party may use
3. examination of prospective financial information
4. prepares original/amended tax return
• Permits acceptance of contingent fee based upon initiation by and
findings of governmental agencies (i.e., IRS-initiated investigation of
income taxes paid)
• Commissions and Referral Fees
• Rule is similar to that for contingent fees; cannot accept commissions
or referral fees from audit client
• Commissions and referral fees require disclosures by CPAs when
recommending or referring a service or product to which the
commission relates
Advertising and Solicitation
• Advertising and solicitation permitted

• Requires that advertising not be false, deceptive or
misleading
• Imply ability to influence official bodies
• Contain a representation that specific services will
be performed for a stated fee, when such fees would
be substantially increased
• Prohibits solicitation by use of coercion, over-
reaching, or harassing conduct
• Contain any representation that would be likely to
cause a reasonable person to misunderstand or be
deceived
Confidentiality
• Confidential information
• CPA should not disclose confidential client
information without specific consent of the client
• Internal whistle blowing allowed; external may
violate confidentiality; consult legal counsel
• Permitted disclosure of confidential client
information
• Response to validly issued subpoena or summons
• Adherence to applicable laws and regulations (i.e., Dodd-
Frank whistle-blowing provisions)
• Compliance with peer review of CPA practice under
PCAOB, AICPA, state CPA society, or board of accountancy
authorization
• Defense in an investigation of the CPA
Ethics and Tax Services
• Tax services include tax compliance, where much of the service is

derived from audited financial records, tax consulting, tax planning,
and tax shelters
• AICPA explicitly recognizes the tax professional’s dual obligations to
the client to act as advocate and to foster integrity in the tax system
by honesty and fairly administering the tax laws
• The tax accountant remains obligated to act objectively, with
integrity, exercise due care, and follow the Statements on
Standards for Tax Services (SSTS)
• The CPA must place the public interest ahead of client and self-
interests
• When auditing tax client’s financial statements: The tax CPA is
expected to consider whether any threats to independence exist
that cannot be reduced or eliminated by safeguards and how such
matters will be handled to avoid a violation of audit independence
SSTS
• 7 statements explain CPAs’ responsibilities to their clients and the tax

systems
• SSTS No.1, Tax Return Positions
• A tax return position is a position reflected on a tax return on which a CPA has
specifically advised a taxpayer, or a position about which a CPA has knowledge of all
material facts and, based on those facts, has concluded whether the position is
appropriate
• A taxpayer is a client, a CPA’s employer, or any other third-party recipient of tax
services
• CPA’s obligation to advise a taxpayer of relevant tax return disclosure responsibilities
and potential penalties
• CPA should not recommend a tax return position or sign a tax return unless she has a
good-faith belief that the position has at least a “realistic possibility of success”
• CPA cannot recommend a tax return position that he knows exploits the audit
selection process of a taxing authority
• SSTS Interpretation No. 1-1 - Realistic Possibility Standard
• Includes establishing the relevant facts, consider the reasonableness of the
assumptions and representations, apply the pertinent authorities to the facts,
consider the business purpose and economic substance of the transaction, and
arrive at a conclusion supported by the authorities
Tax Shelters
• Sometimes called tax avoidance transactions

• “Prohibited tax shelter transaction" means listed
transactions, transactions with contractual protection, or
confidential transactions
• Investments to help wealthy clients avoid paying taxes
• In KPMG case, the firm prepared false documents to deceive
regulators (fraud)
• KPMG shelters broke the law: no economic risk and designed
solely to minimize taxes
• KPMG shelters generated $11 billion in fraudulent losses and $2.5
billion in tax evaded
• KPMG settled criminal tax case for $456 million
• More recent tax shelter scandal: BDO failed to register
various tax shelters as required by law
PCAOB Rules
• Variety of standards that pertain to ethics and independence:

• Rule 3520: Auditor Independence
• Rule 3521: Contingent Fees; mirrors rules of AICPA code
• Rule 3522: Tax Transactions; “aggressive tax position” transaction
• Rule 3523: Tax Services for Persons in Financial Reporting Oversight
Roles; not independent if firm provides tax services to persons who
serve in financial reporting oversight roles at an audit client unless:
• Person only serves as member of BOD
• If member serves in an affiliate of audit company and has non material financial
statements
• Person was not in role when audit began
• Rule 3524: Audit Committee Pre-Approval of Certain Tax Services
• Rule 3525: Audit Committee Pre-Approval of Nonaudit Services Related
to Internal Control Over Financial Reporting
• Rule 3526: Communication With Audit Committees Concerning
Independence
Concluding Thoughts
• Technical skills are important in accounting but so are ethical

reasoning abilities
• Virtue-based decision making is an important component
because it depends on “practical wisdom,” or the ability to
see the right thing to do in circumstances
• The process in the Code is a conceptual framework to assess
whether independence, integrity and objectivity may be
compromised as a result of threats that exist
• Safeguards can be put into place to reduce or eliminate such
threats, although nothing can substitute for ethical intent and
ethical action
• The accounting profession is in danger of losing sight of its
mandate to protect the public interest because of increased
commercial tendencies
Fraud in Financial
Statements
and Auditor Responsibilities
Chapter 5
Questions for Consideration
• What are the red flags that are indicators of

fraud may exist?
• What are the auditor’s responsibilities to detect
and report fraud?
• What is the role of internal controls and risk
assessment in preventing and detecting fraud?
• Will the revised audit report provide any
tangible benefits with respect to increasing its
informational value, usefulness, and relevance
to the investing public?
Fraud in Financial Statements
• The primary responsibility for the prevention and detection

of fraud rests with both those charged with governance of
the entity and management.
• An auditor conducting an audit in accordance with generally
accepted auditing standards is responsible for obtaining
reasonable assurance that the financial statements as a
whole are free from material misstatements, whether by
fraud or error.
• An unavoidable risk exists that some material misstatements of
the financial statements may not be detected, even though the
audit was conducted in accordance with GAAS.
• When the financial statements are materially misstated, the
auditor should not give an unmodified or unqualified opinion
but should modify the opinion as either qualified or adverse
opinion.
Fraudulent Financial Reporting
• Involves either intentional misstatements or

omissions of amounts or disclosures in order to
deceive financial statement users
• Deception – manipulation, falsification or
alteration of accounting records or supporting
documents
• Misrepresentation in, or intentional omission
from, events, transactions, or other significant
information
• Intentional misapplication of accounting
principles
Nature and Causes of Misstatements
• An inaccuracy in gathering or processing data from which financial

statements are prepared
• A difference between the amount, classification, or presentation of
a reported financial statement element, account, or item in
accordance with GAAP
• The omission of a financial statement element, account, or item
• A financial statement disclosure that is not presented in conformity
with GAAP
• The omission of information required to be disclosed in conformity
with GAAP
• An incorrect accounting estimate due to oversight,
misrepresentation of facts, or fraud
• Management’s judgments concerning an estimate or the selection
or application of accounting policies that the auditor may consider
unreasonable or inappropriate
Error, Fraud and Illegal Acts
• Error
• Innocent mistake in math or application of GAAP
• Innocent mistake in omission of information
• Fraud
• Deliberate decision made to deceive others through
• Fraudulent financial reporting
• Misappropriation of assets
• Illegal Acts
• Violations of laws or regulations
• Bribery
Illegal Acts
• Assess the impact and materiality of the acts on the

financial statements
• Consult with legal counsel and other specialists
• Report the acts to audit committee
• Consider client’s remedial actions
• Disciplinary actions
• Controls to safeguard against recurrence
• Reporting effects of the acts
• If client does not take remedial actions necessary,
the auditor should consider withdrawing from
engagement
Private Securities Litigation
Reform Act (PSLRA)
• Additional requirements upon public companies and their auditors

when
• The illegal act has a material effect on financial statements
• Senior management and the board have not taken appropriate
remedial action
• Failure to take remedial action may warrant departure from a
standard audit report (or resignation of auditors)
• When illegal act has material effect on the financial statements
• Auditors must report act to the client
• Client must inform Board of Directors which has one day to inform the SEC
• If client does not inform the SEC
• Auditors must furnish the report to the SEC within one day
• Or resign from the engagement within one day
• Ethical obligation of confidentiality is waived
The Fraud Triangle
• Incentives/Pressures to Commit • Rationalization

Fraud • Explain away actions as
• Self-serving acceptable
• Pressures to meet financial • Perpetrators are often in denial
numbers • A good person may get caught up
• Financial distress in the fraud
• Home Problems • Other Rationalizations
• Opportunity • Company had to make numbers
• Fear losing job
• Employees who have access to • I’m entitled since I’m underpaid
assets such as cash and inventory
• Link to GVV
• Internal controls to help safeguard
assets • One-time event
• Loyalty
• Segregation of duties
• Expected/standard practice
• Reconciliations
• Not your responsibility
• Backdating stock options
• Override internal controls by
management
Tyco Fraud
• Tyco board members did business with the

company
• Directors and officers had loans from the company
• Related party disclosures were not made
• Other Red Flags
• Acquired personal assets with company funds
• Lavish parties using company funds
• Decorating NY apartment with company funds
• PwC partner on Tyco was issued a cease and desist
order
• Failed to follow GAAS
• Violated antifraud provisions of securities law
Fraud Risk Assessment
• AU-C240 requires the auditor to evaluate risk assessment during

the audit
• Evaluation of evidence about the potential client before accepting
engagement
• Communication with predecessor auditor
• Reasons for firing or the reasons for no longer servicing client
• Management’s and key accounting personnel’s integrity
• Disagreement with management over accounting principles
• Make inquiries about the risks of fraud and how they are addressed
• Consider any unusual or unexpected relationships
• Consider whether one or more fraud risk factors exist
• Consider other information
• Approach each engagement with a healthy dose of skepticism
Internal Control Assessment
• The risk that internal controls will not help prevent or

detect a material misstatement is a critical evaluation to
provide reasonable assurance
• Components of internal control under the COSO
framework
• Control environment
• Risk assessment
• Control activities
• Monitoring
• Information and communication
• Attention should be focused on areas of highest risk that
a material weakness could exist in a particular area of
the company’s internal control over financial reporting
COSO Findings in Fraudulent Financial
Reporting: 1998 -2007
• 347 alleged cases of public company fraudulent

financial reporting
• CEO and/or CFO had some level involvement in
89% of the fraud cases
• Most common fraud techniques
• Improper revenue recognition
• Overstatement of existing assets
• Capitalization of expenses
• 26% of fraud firms changed auditors during
fraud period, over double the rate of non-fraud
firms
Enterprise Risk Management – Integrated
Framework
• Internal control enhanced with corporate

governance and risk management
• Aligning risk appetite and strategy
• Enhancing risk response decisions
• Reducing operational surprises and losses
• Identifying and managing multiple and cross-
enterprise risks
• Seizing opportunities
• Improving deployment of capital
COSO Guidance on Monitoring Internal
Control Systems
• Management should monitor controls to determine whether they

are operating effectively and the need for redesign when risks
change
• Effective monitoring involves
• Establishing a baseline for control effectiveness
• Designing and executing monitoring procedures that are based on the
significance of business risks relative to the entity’s objectives
• Assessing and reporting results, including follow-up on corrective actions
• Framework adopts the position that management should
determine its risk appetite and align it with strategic objectives
• ERM seems to place emphasis in the wrong areas by focusing on
risk appetite
• Emphasis needed on the ethical dimensions of making strategic
decisions
Audit Committee Responsibilities for
Fraud Risk Assessment
• Audit Committee should

• Evaluate management’s identification of fraud risks
• Implementation of antifraud measures
• Creation of the appropriate tone at the top
• Active oversight by the audit committee can help
reinforce management’s commitment to create a
culture with “zero tolerance” for fraud
• Audit committee’s evaluation and oversight can serve as
a deterrent to senior management engaging in
fraudulent activity
• Audit committee should encourage management to
provide a mechanism for employees to report concerns
about unethical behavior, suspected fraud, or violations
of ethical codes or policies
Auditor’s Communication with Those
Charged with Governance
• AU-C 240 requires communication by auditors of evidence of fraud

to appropriate level of management, even inconsequential or
minor misappropriation
• Fraud that causes a material misstatement should be reported
directly to those charged with governance
• Good governance principles suggest that
• The auditor has access to the audit committee as necessary
• The chair of the audit committee meet with the auditor periodically
• The audit committee meets with the auditor without management at least
annually
• Auditors should communicate about accounting estimates
• Nature of significant assumptions/degree of subjectivity/relative
materiality
• Communicate to management/those charged with governance risks
due to fraud that have continuing control implications
Management Representations and Financial
Statement Certifications
• Management responsible for preventing and detecting

fraud
• Management can override internal controls and create
deceptive accounting
• Management representation letters from CEO, CFO, and
other appropriate officers (Section 302 of SOX)
• Provides access to all known information bearing on fair
presentation of financial statements
• Confirms that management has performed an assessment of
effectiveness of internal control over financial reporting
• Concludes that effective internal controls have been
maintained
• Discloses any deficiencies in the design or operation of internal
controls
Audit Reports and Auditing Standards
• Since 1926, the New York Stock Exchange has

required an auditor’s report
• The Securities Exchange Act of 1934 requires all
public companies to have an independent auditor’s
report in annual financial statements
• The PCAOB oversees public companies audits since
SOX in 2002
• The AICPA Auditing Standards Board (ASB) oversees
the audits of nonpublic companies
• Independent auditors express or disclaim an
opinion on whether an entity’s financial statements
and related disclosures are presented in accordance
with GAAP
Audit Reports
• Exhibit 5.5 (ASB) Unmodified Opinion for Non-Public

Companies
• Exhibit 5.6 (PCAOB)Unmodified or Unqualified Report
for Public Companies
• International Requirements
• Section ISA 700 of the International Standards on
Auditing allows the signature of the audit firm, the
personal name of the auditor who directed the audit, or
both
• After December 15, 2016, the personal name of the auditor
who directed the audit will ordinarily be required
• Also, after December 15, 2016, the audit reports of public
companies will include a “key audit matter” section
Differences between ASB and PCAOB
Unmodified Reports
• Title of Audit Report

• ASB – Independent Auditor’s Report
• PCAOB – Report of Independent Registered Audit Firm
• Headings
• ASB – Section headings
• PCAOB – No headings
• Management’s and Auditor’s Responsibilities
• ASB – Detailed descriptions
• PCAOB – Less detailed descriptions
• Auditing Standards
• ASB – GAAS
• PCAOB – Standards of PCAOB
• Internal Control over Financial Reporting
• ASB – Not included in auditor’s report
• PCAOB – Report on internal control included in an additional paragraph in
the report
Unmodified or Unqualified Audit Opinions
• Financial statements “present fairly”

• Financial position
• Results of operations
• Cash flows
• Stockholders’ Equity
• Optional additional paragraph
• Emphasis-of-matter
• Going concern
• Consistent application of accounting principles
• Litigation uncertainty
• Other-matter
• Supplemental information
Modified or Qualified Audit Opinions
• Modifies the audit when

• Based upon evidence financial statements are materially misstated, or
• Unable to obtain sufficient appropriate evidence
• Qualified
• Concludes misstatements, individually or in the aggregate, are material
but not pervasive to the financial statements, or
• Unable to obtain sufficient appropriate audit evidence; possible effect on
financial statements could be material but not pervasive
• Adverse
• Concludes that misstatements, individually or in the aggregate, are
material and pervasive
• Basis for Modifications
• Separate paragraph describes matter giving rise to modification
• Placed immediately before the opinion paragraph
• Titled “Basis for (Qualified, Adverse, Disclaimer) Opinion
Disclaimer/Withdrawal from the
Engagement
• Disclaimer
• Unable to gather sufficient evidence to warrant the expression
of an opinion on the statements as a whole
• Withdrawal
• If significant conflict exists with management or the
auditor decides that management cannot be trusted,
then a withdrawal may be justified
• Trust issues are a matter of ethics
• The auditor must consider whether the breakdown
between management and the auditor has advanced to
the point that any and all information provided by the
client is suspect
• Withdrawal triggers the filing of the SEC’s 8-K form by
management
Limitations of the Audit Report
Reasonable Assurance
• Reasonable Assurance
• Due care
• Relation of independence and client relationships
• Not an absolute guarantee
• Followed GAAS, gathering sufficient competent
evidential matter
• Failure to follow GAAS: allegation of negligence
Materiality
• Magnitude of an omission or misstatement of accounting

information that the judgment of reasonable person
relying on the information would have been changed or
influenced by the omission or misstatement
• Judging Materiality
• May not rely solely on a quantitative threshold as a “rule of
thumb”
• 5% is a common materiality test
• SEC wants qualitative matters to be considered as well
• Unintended consequence of materiality is that it is subject to
manipulation
• An item may not be material and ignored even though it
is wrong to produce financials with mistakes from an
ethical (Rights Theory) perspective
Present Fairly
• Present Fairly
• Auditor’s assessment of fair presentation depends
on whether
• Accounting principles used have general acceptance
• Accounting principles are appropriate
• Financial statements are informative
• Information presented is classified and summarized
in a reasonable manner
• Financial statements reflect the underlying
transactions and events in a manner that is
consistent with materiality and reflects economic
substance
Generally Accepted Auditing Standards
(GAAS)
• Auditing standards provide a measure of audit quality

and the objectives to be achieved in an audit
• Auditing standards differ from auditing procedures
because the procedures are steps taken by the auditor
during the course of the audit to comply with GAAS
• The application of auditing standards entails making
judgments with regard to the nature of audit evidence,
sufficiency, competency, and reliability
• Materiality considerations are important to assess
whether the audit opinion should be modified
GAAS
• General Standards
• Adequate technical training and proficiency
• Independence in mental attitude
• Due care in the performance of the audit and preparation of the report
• Standards of Field Work
• Adequately plan the audit work and supervise assistants
• Obtain a sufficient understanding of internal control to adequately plan the audit and
determine the nature, timing, and extent of tests to be performed
• Gather sufficient competent evidential matter to provide a basis for an opinion
• Standards of Reporting
• The statements have been in conformity with GAAP
• Accounting principles have been consistently applied
• Adequate informative disclosures have been made
• Expression of an opinion on statements taken as a whole, or indication that an opinion
cannot be expressed
Auditing Evidence
• Consideration of the competency and sufficiency of

evidence
• Management representations are not a substitute for
application of proper audit procedures
• Audit risk and materiality considered together
• Determination of nature, timing and extent of procedures
• Evaluation of results of procedures
• Assess risks of material misstatements due to fraud
• Application of professional skepticism
• Audit procedures – specific acts performed to gather
evidence about specific assertions
Professional Skepticism
• An important role in gathering audit evidence and evaluating usefulness

• Auditor should exercise professional judgment and skepticism
• Determining the nature, timing, and extent of audit procedures
• Determining the sufficiency, competency, and relevancy of evidence
• Evaluating management’s judgments and estimates
• Considering fraud in the audit
• Determining the conclusions based on the audit evidence obtained
• A state of mind and requires documentation to provide evidence that the
audit was planned and performed in accordance with GAAS
• Document the thought process, alternative views considered, judgments made,
audit evidence gathered, and support for final conclusion
• Document challenges to management’s views and assumptions
• Document the basis for unusual, one-time transactions and related business
rationale
• Include a complete and comprehensive record of discussions with management
• Document assessments of the reliability of the source of documents
• Document professional skepticism in significant matters
Challenges to Professional Skepticism
• Motivated Blindness: Auditors may see what they want

to see and easily miss contradictory information when
it’s in their best interest to remain ignorant
• Results over Efficiency: Link between skeptical judgment
and action and how it relates to reward structure in
auditing: rewarding results rather than high-quality
decisions
• Personality Traits: Diligence, thoroughness, objectivity
and reliability are traits that influence level of
professional skepticism
• Levers: Accountability to reviewers and regulators serve
as a lever that impacts skeptical judgment and skeptical
action(PCAOB inspections)
PCAOB Standards
• Auditing Std No. 5 – audit of assessment of effectiveness

of internal control over financial reporting
• Auditing Std No. 7 – engagement quality review
• Auditing Std No. 14 – requirements regarding the
auditor’s evaluation of audit results and determination
of whether the auditor has obtained sufficient
appropriate audit evidence
• Auditing Std No. 15 – requirements for designing and
performing audit procedures to obtain sufficient
appropriate audit evidence to support the opinion
expressed in the auditor’s report
• Auditing Std No. 16 – communications with audit
committees on significant issues
Audit Committee Communications
• Significant accounting policies and practices

• Critical accounting policies and practices
• Critical accounting estimates
• Significant unusual transactions
• Quality of financial reporting information
• Contentious issues with
management/disagreements
• Modifications to audit report
Specific Items to Communicate:
Quality of Financial
Reporting
• Qualitative aspects of accounting policies and
procedures
• Assessment of reasonableness of estimates in
• Assessment of management’s disclosures re: critical
policies/procedures
• Whether presentation and disclosures are in
conformity with applicable financial reporting
framework
• Management’s response to issues raised
• Possibility of alternative treatments in financial
statements
Audit Deficiencies - SEC Actions
• Findings of a study of audit deficiencies for the Center for

Audit Quality that resulted in sanctions from the SEC include
• Failure to gather sufficient competent evidence
• Failure to exercise due care
• Insufficient level of professional skepticism
• Failure to obtain adequate evidence related to management
representations
• Failure to express an appropriate audit opinion
• Satyam Case resulted in PwC being sanctioned due to a lack
of due care and exercise of professional skepticism by
accepting evidence provided by management that was less
than persuasive.
• PwC also failed to perform the necessary procedures and
report likely illegal acts that had a material effect on the
PCAOB Inspection Program
• SOX authorized the PCAOB to inspect and set

professional standards for public accounting firms
• PCAOB enforcement proceedings are non-public
unless
• The parties consent to a public hearing
• The board has imposed sanctions and the time to file an
appeal with the SEC has expired
• The SEC, on appeal, issues an order regarding the
sanctions imposed
• The process, including appeals, can take years to
complete and the enforcement actions may not yet
nor never be known to the public
Inspections and Audit Deficiencies
• A significant issue addressed in many enforcement

actions against audit firms is a lack of professional
skepticism and due care
• Examples that can inhibit professional skepticism
• Incentives and pressures to build or maintain a long-term audit
engagement
• Incentives and pressures to avoid significant conflicts with
management
• Desire to achieve high client satisfaction ratings
• Desire to keep audit costs low
• Desire to cross-sell services to clients
• Deficiency rates of the Big-4 CPA firms range from 28 to
50 percent
• In 2014, PCAOB said that the firms have shown real
improvements in its internal control audits
PCAOB Inspections of Chinese Firms
• Reluctance of foreign-based entities operating under the

banner of a Big-4 CPA firm to cooperate with the PCAOB
inspections of audits conducted by the foreign entities that
list stocks on the U.S. exchanges
• Chinese authorities find the disclosure about Chinese
companies to non-Chinese regulators to be unacceptable
• The dilemma for U.S. regulators is the growing number of
Chinese companies listing stock in the U.S. that are found to
have engaged in financial fraud
• The contentious nature of relationship between PCAOB and
Chinese audit firms raises questions about the quality,
reliability, and trustworthiness of the audits and brings into
question whether the best interests of U.S. investors are
being adequately protected
Concluding Thoughts
• Financial statement fraud threatens the foundation

of the financial reporting process and jeopardizes
the integrity of the auditing function
• The audit and evaluation of audit evidence must be
controlled through an ethical approach that
emphasizes objectivity, due care, and the exercise
of professional skepticism
• “Trust but verify” should be the mantra of a sound
audit
• Audit firms and auditors should recommit to the
public interest ideal that is the foundation for the
accounting profession

Chapter 1 Thru 5 UPDATED

Caricato da

Informazioni sul documento

Copyright

Formati disponibili

Condividi questo documento

Condividi o incorpora il documento

Opzioni di condivisione

Hai trovato utile questo documento?

Questo contenuto è inappropriato?

Copyright:

Formati disponibili

Chapter 1 Thru 5 UPDATED

Caricato da

Copyright:

Formati disponibili

Ethical Reasoning:

Aristotole’s Virtues Ethical Standards for CPAs

• Cognitive development refers to the thought

• Heinz’s wife has a rare cancer

• Egoism: Steal the drug, depending on how much

• Lawrence Kohlberg’s six stages of moral

• Rules are seen as something external imposed

• Individual becomes aware of the interests of

• Individual recognizes there must be a society

• Care-and-response orientation that

• Kohlberg maintains that his stage sequence is universal

• Four key constituent groups of accountants and

• Accounting profession has professional

• Studies have shown that:

• Moral judgment is the single most influential

James Rest’s model of ethical action is based

• Moral Sensitivity – ability to identify what is

• Critical component of ethical decision making

• All processes must take place for moral behavior

• Developed by Thomas Jones

• Intellectual virtues: indirectly influence

Prescriptive Ethical Judgment

Moral Virtue Ethical Ethical Intention

Ethical Character Ethical Behavior

• Consciously thinking about and analyzing what

• Recognize that there is a moral issue.

1. Identify the ethical and professional issues

• Three stockholders: Smith, Williams, & Jones

• Identify the ethical and professional issues (ethical sensitivity)

• Considers how individuals make decisions in the

• Recognized the limitation of philosophical

• Inconsistency between our thoughts, beliefs, or

• Behavioral ethics approach with an emphasis on

• How you get it done effectively and efficiently?

• Expected or Standard Practice – “Everyone does

• What are the main arguments you are trying to

• Matt and Becca head up Accounting Club

• What are the main arguments to counter or reasons and

• What are the main arguments to counter or reasons and

• “The road to success is littered with failures, but the

• Leaders of Good Character

• Ethical Issue Intensity

• The Jones-Hiltebeitel model looks at the role of

• Interaction between the individual and the

“Occurs when any organization has drifted from the

• Ethical collapse occurs when there is an

• Young people selected by the CEO for their

• Corporate culture is the shared beliefs of top managers

• Trust means to be reliable and carry through words

• J&J’s credo emphasizes primary obligation to those who use

• A code of conduct goes beyond what is legal for an organization and

• Characteristics of ethical behavior in leaders

• People of integrity are self-driven to do the right thing.

• Views of Employees from 2011-2013:

• Fraud can be defined as a deliberate

Frequency of Anti-Fraud Controls

• Living Beyond Means

• Internal control includes all of the processes and

Fraud schemes occur because an employee – usually top

• Top management committed the fraud and

• Corporate governance is shaped by internal and

• Independent directors enhance governance

• Directors and officers are deemed fiduciaries of the corporation as

• Independent directors with one having financial expertise