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Eron Case Study Essay

Steven M. Mintz, DBA, CPA Professor of Accounting California Polytechnic State University,

San Luis Obispo

Roselyn E. Morris, Ph.D., CPA Professor of Accounting

Texas State University–San Marcos

Fourth Edition

Ethical Obligations and Decision Making in Accounting

ETHICAL OBLIGATIONS AND DECISION MAKING IN ACCOUNTING: TEXT AND CASES,

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FOURTH EDITION

Names: Mintz, Steven M., author. | Morris, Roselyn E., author. Title: Ethical obligations and decision making in accounting : text and cases / Steven M. Mintz, DBA, CPA, Professor of Accounting California Polytechnic State University, San Luis Obispo, Roselyn E. Morris, Ph.D., CPA, Professor of Accounting Texas State University-San Marcos. Description: Fourth Edition. | New York, NY : McGraw-Hill Education, 2016. | Revised edition of the authors' Ethical obligations and decision making in accounting, 2014. Identifiers: LCCN 2015044426 | ISBN 9781259543470 (alk. paper) Subjects: LCSH: Accountants--Professional ethics--United States--Case studies. Classification: LCC HF5616.U5 M535 2016 | DDC 174/.4--dc23 LC record available at http://lccn.loc.gov/2015044426

“Educating the mind without educating the heart is no education at all.” Aristotle

What Aristotle meant by this statement is intelligence that is not informed by our hearts--by compassion--is not really intelligent at all. We strive in this book not only to educate accounting students to be future leaders in the accounting profession but to stimulate your ethical perception and cultivate virtue thereby awakening your sense of duty and obligation to the public interest.

Dedication

Steven M. Mintz, DBA, CPA, is a professor of accounting in the Orfalea College of Business at the California Polytechnic State University–San Luis Obsipo. Dr. Mintz received his DBA from George Washington University. His first book, titled Cases in Accounting Ethics and Professionalism, was also published by McGraw-Hill. Dr. Mintz has recently been acknowledged by accounting researchers as one of the top publishers in accounting ethics and in accounting education. He was selected for the 2014 Max Block Distinguished Article Award in the “Technical Analysis” category by The CPA Journal. Dr. Mintz received the 2015 Accounting Exemplar Award of the Public Interest Section of the American Accounting Association. He also has received the Faculty Excellence Award of the California Society of CPAs. Dr. Mintz writes two popular ethics blogs under the names “ethicssage” and “workplaceethicsadvice.”

Roselyn E. Morris, Ph.D., CPA, is a professor of accounting in the Accounting Department at the McCoy College of Business, Texas State University–San Marcos. Dr. Morris received her Ph.D. in business administration from the University of Houston. She is a past president of the Accounting Education Foundation and chair of the Qualifications Committee of the Texas Board of Public Accountancy. Dr. Morris has received the Outstanding Educator Award from the Texas Society of CPAs.

Both Professors Mintz and Morris have developed and teach an accounting ethics course at their respective universities.

About the Authors

Ethical Obligations and Decision Making in Accounting was written to guide students through the minefields of ethical conflict in meeting their responsibilities under the professions’ codes of conduct. Our book is devoted to helping students cultivate the ethical commitment needed to ensure that their work meets the highest standards of integrity, independence, and objectivity. An expanded discussion of professional judgment highlights the challenges to ethical decision-making for internal accountants and auditors, and external auditors. We hope that this book and classroom instruction will work together to provide the tools to help students to make ethical judgments and carry through with ethical actions.

The fourth edition of Ethical Obligations and Decision Making in Accounting: Text and Cases incorporates a behavioral perspective into ethical decision-making that encourages students to get in touch with their values and learn how to voice them in the workplace when conflicts arise and ethical dilemmas exist. We build on traditional philosophical reasoning methods by taking the process one step further, that is, to convert ethical intent into ethical action. The “Giving Voice to Values” (GVV) approach provides this link. If accounting professionals are successful in voicing values in a way that encourages doubters and detractors to join the effort, then there may be no need for whistle-blowing. We also connect many of the issues discussed in the book with a new final chapter on “Ethical Leadership.” Several states now require their accounting students to complete an ethics course prior to being licensed as a CPA. This book has been designed to meet the guidelines for accounting ethics education including:

What’s New in the 4 Edition? In response to feedback and guidance from numerous accounting ethics faculty, the authors have made many important changes to the fourth edition of Ethical Obligations and Decision Making in Accounting: Text and Cases, including the following:

encouraging students to make decisions in accordance with prescribed values, attitudes, and behaviors providing a framework for ethical reasoning, knowledge of professional values and ethical standards prescribing attributes for exercising professional skepticism and behavior that is in the best interest of the investing and consuming public and the profession.

th

Connect is available for the first time with assignable cases, test bank assessment material, and SmartBook. SmartBook is an excellent way to ensure that students are reading and understanding the basic concepts in the book and it prepares them to learn from classroom discussions. Several of the Chapter Cases are available in an auto-graded format to facilitate grading by instructors. The purpose of using the digital format is to better prepare students ahead of class to free up instructors to discuss a broader range of topics in their lectures and in the give-and-take between teacher and student. Connect Insight Reports will also give the instructor a better view into the overall class’s understanding of core topics prior to class, to appropriately focus lectures and discussion. The Connect Library also offers materials to support the efforts of first-time and seasoned instructors of accounting ethics, including a comprehensive Instructor’s Manual, Test Bank, Additional Cases, and PowerPoint presentations. Learning Objectives have been added and linked to specific content material in each chapter. Giving Voice to Values (GVV) approach is explained in Chapter 2 and used throughout the text. GVV is an innovative pedagogical method that complements the traditional philosophical reasoning

Preface

Chapter 1

Chapter 2

approaches to ethical decision-making by emphasizing developing the capacity to express one’s values in a way that positively influences others. The technique is used post-decision-making and is based on developing and fine-tuning an action plan using scripting and rehearsal. It is ideal for role-playing exercises. International auditing and ethics issues are incorporated into existing chapters. Added five new Discussion Questions to each chapter as well as revised questions with more current topics and issues. Replaced many of the cases with more current and topical issues. Eighteen of the 76 cases have been specifically developed to enable students to practice the “Giving Voice to Values” technique in the context of the decision-making model. Expanded the discussion of whistleblowing obligations of accounting professionals in Chapter 3 including guidelines for reporting under Dodd-Frank and the AICPA rules of conduct. Added a comprehensive section on professional judgment in accounting and auditing to Chapter 4 and models for making judgments and exercising professional skepticism. Updated Chapter 4 to incorporate the Revised AICPA Code of Professional Conduct. Expanded the discussion of the PCAOB inspection process in Chapters 5 and 6 for audits of companies listing stock in the U.S., including Chinese companies and audit deficiencies noted in inspections of U.S. companies. Updated case examples used throughout the text to describe earnings management techniques with expanded coverage in Chapter 7. New Chapter 8 on “Ethical Leadership” that ties together many of the topics in the chapters in the text. Ethical leadership is explored in the context of making ethical decisions and judgments in the performance of professional accounting services. Improved and expanded the scope of major cases that can be used as an end-of-course project to enhance the experiences of upper-division undergraduates and graduate students. Revised and greatly enhanced Instructor’s Resource Materials and supplements.

New discussion of the use of social networks and social media communications, personal responsibility, and workplace ethics. Expanded discussion of moral philosophies and implications for ethical reasoning in accounting and auditing. Expanded discussion of the Principles of the AICPA Code of Professional Conduct, the public interest obligation, and regulation in the accounting profession.

New discussion of moral intensity and influence on ethical decision making. New discussion of Kidder’s Ethical Checkpoints and link to moral action. Expanded discussion of Behavioral Ethics and cognitive development. New and comprehensive discussion of the GVV technique that provides a mechanism for students to act on ethical intent. Chapter 2 discusses the foundation of the approach including examples on applying the methodology. There are five cases in the chapter to engage students in discussions of the GVV approach to ethical action. Subsequent chapters also contain cases with a GVV dimension.

vi Preface

Chapter 3

Chapter 4

Chapter 5

New section on “Organizational Ethics and Leadership.” New discussion of “Character and Leadership in the Workplace.” Updated results from the National Business Ethics Survey, Association of Certified Fraud Examiners Global Survey, and KPMG Integrity Survey. Expanded discussion of financial statement fraud schemes. New discussion of the morality of whistleblowing. Added discussion of major whistleblower case of Anthony Menendez v. Halliburton, Inc. Expanded discussion of Dodd-Frank provisions for whistleblowing by internal accountants and auditors, and external auditors including when external auditors can blow the whistle on their audit firms. Expanded discussion of subordination of judgment rules and their application to whistleblowing.

Extensive new discussion of professional judgment in accounting. Added an explanation of KPMG Professional Judgment Framework. Expanded discussion of professional skepticism. New discussion of professionalism and commercialism. Comprehensive discussion of the Revised AICPA Code of Professional Conduct including: Conceptual Framework for Members in Public Practice and Conceptual Framework for Members in Business. New discussion of ethical conflict requirements and decision-making model under the Revised Code. Expanded discussion of AICPA Conceptual Framework for Independence Standards. Expanded discussion of integrity and subordination of judgment rules. New discussion of confidentiality and disclosing fraud. Expanded discussion of ethics in tax practice. Expanded discussion of “Insider Trading” cases against CPAs. New discussion of Global Code of Ethics.

Expanded discussion of errors, illegal acts, and fraud. New discussion of Private Securities Litigation Reform Act and reporting requirements to the SEC; fraud and confidentiality issues explored. Discussion of Professional Skepticism Scale that measures traits conducive to developing a questioning mind and informed judgment. Discussion of findings of the Center for Audit Quality of audit deficiencies. Expanded discussion of PCAOB audit inspection process and high rate of deficiencies of audit firms.

Preface vii

Chapter 7

Chapter 8 – New Chapter on Ethical Leadership Chapter 8 links back to discussions in Chapters 1 through 7 by incorporating material on “Ethical Leadership.” The purpose is to leave students with a positive message of the importance of being a leader and ethical leadership in building organizational ethics. Leadership in decision-making in accounting, auditing, tax, and advisory services engagements is addressed. The chapter includes 20 discussion questions and 6 new cases. The chapter includes the following major topics:

New cases that explore in depth legal obligations of accountants and auditors. Expanded discussion of auditor legal liabilities. Expanded section on legal liabilities under Sarbanes-Oxley. New discussion of International Financial Reporting Standards and international enforcement. New discussion of principles versus rules-based standards and SEC position on objectives-oriented standards. New section on “Compliance and Management by Values.” New section on “Global Ethics, Fraud, and Bribery” and the Foreign Corrupt Practices Act. Expanded discussion on regulatory issues and PCAOB inspections.

New section on “Non-Financial Measures of Earnings.” Expanded discussion of earnings management and professional judgment. Expanded discussion of the use of accruals and earnings management. Introductory discussion of new revenue recognition standard. Detailed examples of financial statement restatements of Hertz Corporation and Cubic Corporation, and CVS-Caremark merger.

Discussion of moral decision-making and leadership. Exploring different types of leaders: authentic leaders, transformational leadership, followership and leadership, and how social learning theory influences leadership. Revisiting moral intensity in the context of ethical leadership. Ethical leadership and internal audit function. Ethical leadership and tax practice. Gender influences in leadership. Causes of leadership failures. Case studies on ethical leadership. Implications of ethical leadership for whistleblowing activities. Values-based leadership. Ethical leadership and the GVV technique. Ethical leadership competence.

Chapter 6

viii Preface

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Acknowledgments

The authors want to express their sincere gratitude to these reviewers for their comments and guidance. Their insights were invaluable in developing this edition of the book.

We also appreciate the assistance and guidance given us on this project by the staff of McGraw-Hill Education, including Tim Vertovec, managing director; Natalie King, senior brand manager; Kyle Burdette, marketing manager; Rebecca Mann, senior product developer; Daryl Horrocks, program manager; Angela Norris, content project manager; Jacob Sullivan and Melissa Homer, content licensing specialists; and Jennifer Pickel, buyer. We greatly appreciate the efforts of Deborah Pfeiffer, copyeditor of the book. Finally, we would like to acknowledge the contributions of our students, who have provided invaluable comments and suggestions on the content and use of these cases.

If you have any questions, comments, or suggestions concerning Ethical Obligations and Decision Making in Accounting, please send them to Steve Mintz at smintz@calpoly.edu.

Donald Ariail, Southern Polytechnic State University Stephanie Bacik, Wake Tech Community College Charles Bunn, Jr., Wake Tech Community College Kevin Cabe, Indiana Wesleyan University Rick Crosser, Metropolitan State University of Denver Denise Dickins, East Carolina University Dennis L. Elam, Texas A&M University–San Antonio Rafik Elias, California State University–Los Angeles Athena Jones, University of Maryland University College Patrick Kelly, Providence College Lorraine S. Lee, University of North Carolina–Wilmington Stephen McNett, Texas A&M University–Central Texas Kenneth Merchant, University of Southern California Michael Newman, University of Houston Robin Radtke, Clemson University John Sennetti, NOVA Southeastern University Edward Smith, St. John’s University Dale Wallis, University of California–Los Angeles Extension

Preface xi

Case Descriptions Case # Case Name/Description

1-1 Harvard Cheating Scandal Student cheating at Harvard raises questions about responsibilities of instructors and student personal responsibilities.

1-2 Giles and Regas Dating relationship between employees of a CPA firm jeopardizes completion of the audit.

1-3 NYC Subway Death: Bystander Effect or Moral Blindness Real-life situation where onlookers did nothing while a man was pushed to his death off a subway platform.

1-4 Lone Star School District Failure to produce documents to support travel expenditures raises questions about the justifiability of reimbursement claims.

1-5 Reneging on a Promise Ethical dilemma of a student who receives an offer of employment from a firm that he wants to work for, but only after accepting an offer from another firm.

1-6 Capitalization versus Expensing Ethical obligations of a controller when pressured by the CFO to capitalize costs that should be expensed.

1-7 Eating Time Ethical considerations of a new auditor who is asked to cut down on the amount of time that he takes to complete audit work.

1-8 Shifty Industries Depreciation calculations and cash outflow considerations in a tax engagement.

1-9 Cleveland Custom Cabinets Ethical and professional responsibilities of an accountant who is asked to “tweak” overhead to improve reported earnings.

1-10 Better Boston Beans Conflict between wanting to do the right thing and a confidentiality obligation to a coworker.

Case # Case Name/Description

2-1 A Team Player (a GVV case) Ethical dilemma for audit staff member who discovers a deficiency in inventory procedures but is unable to convince the group to report it. Application of Giving Voice to Values approach.

2-2 FDA Liability Concerns (a GVV case) Conflict between a chef and CFO over reporting bacteria found in food and FDA inspection results. Application of GVV approach.

2-3 The Tax Return (a GVV case) Tax accountant’s ethical dilemma when asked by her supervisor to ignore reportable lottery winnings. Application of GVV approach.

2-4 A Faulty Budget (a GVV case) Ethical and professional responsibilities of an accountant after discovering an error in his sales budget. Application of GVV approach.

2-5 Gateway Hospital (a GVV case) Behavioral ethics considerations in developing a position on unsubstantiated expense reimbursement claims. Application of GVV approach.

2-6 LinkedIn and Shut Out Small business owner’s inability to gain support from LinkedIn after a contact in his professional network scams him out of $30,000.

2-7 Milton Manufacturing Company Dilemma for top management on how best to deal with a plant manager who violated company policy but at the same time saved it $1.5 million.

2-8 Juggyfroot Pressure imposed by a CEO on external accountants to change financial statement classification of investments in securities to defer reporting a market loss in earnings.

2-9 Phar-Mor SEC investigation of Phar-Mor for overstating inventory and misuse of corporate funds by the COO.

2-10 WorldCom Persistence of internal auditor, Cynthia Cooper, to correct accounting fraud and implications for Betty Vinson, a midlevel accountant, who went along with the fraud.

Case # Case Name/Description

3-1 The Parable of the Sadhu Classic Harvard case about ethical dissonance and the disconnect between individual and group ethics.

3-2 Rite Aid Inventory Surplus Fraud Dilemma of director of internal auditing whether to blow the whistle under Dodd-Frank on Rite Aid’s inventory surplus sales/kickback scheme.

3-3 United Thermostatic Controls (a GVV case) Acceptability of accelerating the recording of revenue to meet financial analysts’ earnings estimates and increase bonus payments.

3-4 Franklin Industries’ Whistleblowing (a GVV case) Considerations of internal accountant how best to voice her values to convince others to act on questionable payments to a related-party entity.

3-5 Walmart Inventory Shrinkage (a GVV case) Pressure to reduce inventory shrinkage at a Walmart store amidst alleged accounting improprieties and related efforts of the protagonist to voice values.

3-6 Bennie and the Jets (a GVV case) Ethical and professional obligations in reporting accounting wrongdoing to higher-ups in the organization.

3-7 Olympus Major corporate scandal in Japan where Olympus committed a $1.7 billion fraud involving concealment of investment losses through fraudulent accounting.

3-8 Accountant takes on Halliburton and Wins! Violation of confidentiality provision in a whistleblowing case under SOX after Bob Menendez reported retaliation by Halliburton subsequent to informing the audit committee of improper revenue recognition policies using bill-and-hold transactions.

3-9 Bhopal, India: A Tragedy of Massive Proportions Evaluation of the decision-making process before, during, and after the leak of a toxic chemical that killed or injured thousands.

3-10 Accountability of Ex-HP CEO in Conflict of Interest Charges Sexual harassment charges stemming from conflict of interest between CEO/board chair and outside contractor.

Case # Case Name/Description

4-1 KBC Solutions Concerns about professional judgments made by audit senior after the review of workpaper files.

4-2 Beauda Medical Center Confidentiality obligation of an auditor to a client after discovering a defect in a product that may be purchased by a second client.

4-3 Family Games, Inc. Ethical dilemma for a controller being asked to backdate a revenue transaction to increase performance bonuses in order to cover the CEO’s personal losses.

Case Descriptions xiii

4-4 Commercialism and Professionalism (a GVV case) Ethical considerations in an alternative practice structure due to threats to independence; using GVV to resolve conflict.

4-5 Han, Kang & Lee, LLC Pressure between audit partner who wants the client to write down inventory and other partners that want to keep the client happy.

4-6 Tax Shelters Ethical dilemma of tax accountant in deciding whether to participate in tax shelter transactions targeted to top management of a client entity in light of cultural influences within the firm.

4-7 M&A Transaction Ethical issues concerning a decision to provide merger and acquisition advisory services for an audit client.

4-8 Valley View Hospital Ethical obligations of CPA in deciding whether to report a hospital/client for improper Medicare payments to the government because of a faulty Medicare accounting system.

4-9 AOL-Time Warner Fall out after CFO of AOL blows the whistle on improper round-trip accounting procedures in AOL-Time Warner merger and is investigated himself for his part in the fraud by the SEC.

4-10 Navistar International Confidentiality issues that arise when Navistar management questions the competency of Deloitte & Touche auditors by referring to PCAOB inspection reports and fraud at the company.

Case # Case Name/Description

5-1 Loyalty and Fraud Reporting (a GVV case) Employee who embezzles $50,000 seeks out the help of a friend to cover it up. Application of the fraud triangle and GVV.

5-2 ZZZZ Best Fraudster Barry Minkow uses fictitious revenue transactions from nonexistent business to falsify financial statements.

5-3 Imperial Valley Community Bank Role of professional skepticism in evaluating audit evidence on collectability of loans and going concern assessment.

5-4 Busy Season Planning Role of review partner in planning an audit.

5-5 Tax Inversion Questions about the use of IFRS in a consolidation with an Irish entity motivated by tax inversion benefits.

5-6 Rooster, Hen, Footer, and Burger Ethical obligations of a CPA following the discovery of an unreported related party transaction and push back by client entity.

5-7 Diamond Foods: Accounting for Nuts Application of the fraud triangle to assess corporate culture and analysis of fraud detection procedures.

5-8 Bill Young’s Ethical Dilemma Options of a friend of an auditor advising the auditor following his inappropriate downloading of client information that shows bribery of foreign officials.

5-9 Royal Ahold N.V. (Ahold) U.S. subsidiary of a Dutch company that used improper accounting for promotional allowances to meet or exceed budgeted earnings targets and questions about professional judgment by auditors.

5-10 Groupon Competitive pressures on social media pioneer leads to internal control weakness and financial restatements.

xiv Case Descriptions

6-1 Advanced Battery Technologies: Reverse Merger Application of legal standards to assess auditor liability following a reverse merger transaction by a Chinese company.

6-2 Heinrich Müller: Big Four Whistleblower? (a GVV case) Ethical dilemma of tax accountant after finding confidential files of a client engaged in tax avoidance transactions in Liechtenstein in view of a culture of strict loyalty to the firm.

6-3 Richards & Co: Year-end Audit Engagement Questions about audit procedures used to assess client’s improper use of a credit received from a client to prop up revenue in one year while agreeing to repay the supplier in the following year.

6-4 Anjoorian et al.: Third-Party Liability Application of the foreseeability test, near-privity, and the Restatement approach in deciding negligence claims against the auditor.

6-5 Vertical Pharmaceuticals Inc. et al. v. Deloitte & Touche LLP Fiduciary duties and audit withdrawal considerations when suspecting fraud at a client.

6-6 Kay & Lee LLP Auditor legal liability when foreseen third party relies on financial statement.

6-7 Getaway Cruise Lines: Questionable Payments to do Business Overseas (a GVV case) Ethical dilemma of Director of International Accounting in voicing her values with respect to a dispute within the company over how to report “questionable payments” made to a foreign government.

6-8 Con-way Inc. Auditor legal and audit responsibilities to assess facilitating payments and internal control requirements under the FCPA.

6-9 Satyam: India’s Enron Questions about corporate culture and fraud risk assessment surrounding CEO’s falsification of financial information and misuse of corporate funds for personal purposes.

6-10 Autonomy Investigations by U.S. SEC and UK Serious Fraud Office into accounting for an acquisition of a British software maker by Hewlett-Packard (HP).

Case # Case Name/Description

7-1 Nortel Networks Use of reserves and revenue recognition techniques to manage earnings.

7-2 Solutions Network, Inc. (a GVV case) Ethical challenges of a controller in voicing values when the company uses round-trip transactions to meet earnings targets.

7-3 GE: “Imagination at Work” Assessing whether GE used earnings management techniques to accelerate revenue and meet financial analysts’ earnings expectations.

7-4 Harrison Industries (a GVV case) Challenges faced by first-year accountant in voicing values upon questioning the appropriateness of recording an accrued expense.

7-5 Dell Computer Use of “cookie-jar” reserves to smooth net income and meet financial analysts’ earnings projections.

7-6 Tier One Bank Failure of KPMG to exercise due care and proper professional judgment in gathering supporting evidence for loan loss estimates.

7-7 Sunbeam Corporation Use of cookie-jar reserves and “channel stuffing” by a turnaround artist to manage earnings.

Case # Case Name/Description

Case Descriptions xv

7-9 The North Face, Inc. Questions about revenue recognition on barter transactions and the role of Deloitte & Touche in its audit of the client.

7-10 Beazer Homes Use of cookie jar reserves to manage earnings and meet EBIT targets.

Case # Case Name/Description

Case # Case Name/Description

8-1 Research Triangle Software Innovations (a GVV case) Advisory services staff member recommends the software package of an audit client to another client and deals with push back from her supervisor who is pushing the firm’s package; issues related to leadership and application of GVV in resolving the matter.

8-2 Cumberland Lumber Difference of opinion between chief internal auditor and aggressive CFO about recording year-end accruals.

8-3 Parmalat: Europe’s Enron Fictitious accounts at Bank of America and the use of nominee entities to transfer debt off the books by an Italian company led to one of Europe’s largest fraud cases.

8-4 KPMG Tax Shelter Scandal Major tax shelter scandal case involving KPMG that explores ethical standards in tax practice and in developing tax positions on tax shelter products in a culture that promoted making sales at all costs.

8-5 Krispy Kreme Doughnuts, Inc. Questions about ethical leadership and corporate governance at Krispy Kreme, and audit by PwC, with respect to the company’s use of round-trip transactions to inflate revenues and earnings to meet or exceed financial analysts’ EPS guidance.

8-6 Rhody Electronics: A Difficult Client (a GVV case) Conflict between audit manager and controller over audit planning and execution and implications for ethical leadership.

Major Cases

1 Adelphia Communications Corporation SEC action against Deloitte & Touche for failing to exercise the proper degree of professional skepticism in examining complex related-party transactions and contingencies that were not accounted for in accordance with GAAP.

2 Royal Ahold N.V. (Ahold) Court finding that Deloitte & Touche should not be held liable for the efforts of the client to deprive the auditors of accurate information needed for the audit and masking the true nature of other evidence.