Organizational dissidence in audit firms is created when

Organizational Ethics and Corporate Governance

Chapter 3

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Organizational Ethics, Ethical Culture, and Ethical Climate

Organizational Ethics

Generally accepted principles and standards that guide behavior in organizational contexts.

Ethical Culture

Explicit statement of values, beliefs and customs from top management

Organizational ethical climate

Moral atmosphere and level of ethics practiced within a company

Determined by leaders

Shared values, beliefs, goals, and problem-solving

Focuses on issues of right and wrong

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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 business.

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.

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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

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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

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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

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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:

High-High (high organization & high individual ethics)

Low-Low (low organization & low individual ethics)

High-Low (high organization & low individual ethics)

Low-High (low organization & high individual ethics)

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Seven Signs of Ethical Collapse

“Occurs when any organization has drifted from the basic principles of right and wrong” Marianne Jennings

Pressure to maintain numbers

Fear and silence

Young ‘uns and bigger than life CEO

Weak board of directors

Conflicts of interests overlooked or unaddressed

Innovation like no other company

Goodness in some areas atones for evil in others

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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”

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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

Culture of Conflicts

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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 statutes, court decisions, and shareholder proposals

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Potential Agency Problems

Executive Compensation – compensation packages are tied to firm performance and stock option plans creating an incentive to manipulate earnings

Backdating stock options and improper disclosures

Clawbacks allow a recovery of compensation from CEOs and CFOs of public companies

“Say on pay” provisions provide shareholders a vote regarding the compensation of CEO and CFOs

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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

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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.

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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

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Best Practices of Governance

Independent directors enhance governance accountability

Separation of the duties of CEO and board chair minimizes conflicts of interest

Separate meetings between the audit committee and external auditors strengthen control mechanisms

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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

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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

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18

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

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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.

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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

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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

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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

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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

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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

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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

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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.

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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

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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

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Morality of Whistleblowing (continued)

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

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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

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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

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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 and they 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

Concern: Will whistleblowers go external rather than internal with the information in order to receive an award (“bounty hunter”)?

Employees have a loyalty obligation to their employers, but loyalty should not be used to mask one’s ethical obligation to maintain integrity and protect the public interest

Whistleblowing in conformity with Dodd-Frank rules sets aside confidentiality requirement

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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.

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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

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Integrity Considerations

It is the integrity standard that establishes the basis for moral action of auditors and avoids subordinating judgment

Reporting procedures for accountants and auditors under the AICPA Code (Exhibit 3.11)

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

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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

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