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Ethical Obligations and Decision Making in Accounting Text and Cases Third Edition

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Ethical Obligations and Decision Making in Accounting Text and Cases Third Edition

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

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

Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright © 2014 by McGraw-Hill Education. All rights reserved. Printed in the United States of America. Previous editions © 2011 and 2008. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of McGraw-Hill Education, including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.

Some ancillaries, including electronic and print components, may not be available to customers outside the United States.

This book is printed on acid-free paper.

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ISBN 978–0–07–786221–3 MHID 0–07–786221–X

Senior Vice President, Products & Markets: Kurt L. Strand Vice President, Content Production & Technology Services: Kimberly Meriwether David Managing Director: Timoth Vertovec Brand Manager: James Heine Marketing Manager: Constantine Karampelas Development Editor: Gail Korosa Director, Content Production: Terri Schiesl Project Manager: Judi David Buyer: Jennifer Pickel Cover Image: Dynamic Graphics/Jupiterimages Compositor: S4Carlisle Publishing Services Typeface: 10/12 Times New Roman Printer: Quad/Graphics

All credits appearing on pages or at the end of the book are considered to be an extension of the copyright page.

Library of Congress Cataloging-in-Publication Data Mintz, Steven M. 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, PhD, CPA, Professor of Accounting Texas State University-San Marcos. — Third edition. pages cm ISBN 978-0-07-786221-3—ISBN 0-07-786221-X 1. Accountants—Professional ethics—United States— Case studies. I. Morris, Roselyn E. II. Title. HF5616.U5M535 2014 174'.4—dc23

2013011582

The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does not indicate an endorsement by the authors or McGraw-Hill Education, and McGraw-Hill Education does not guarantee the accuracy of the information presented at these sites.

www.mhhe.com

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“Whatever we learn to do, we learn by doing it.” — Aristotle

We hope this book inspires students to engage in the learning process, to make ethical choices in their lives, and always strive for excellence in whatever they do.

Dedication

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About the Authors 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 develops individual courses in professional accounting ethics for Bisk Education that meet each state’s board of accountancy mandatory requirements for continuing education in ethics. He also writes two popular ethics blogs under the names “ethicssage” and “work- placeethicsadvice.” Dr. Mintz has received the Faculty Excellence Award of the California Society of CPAs and Service Award from the California Board of Accountancy for his work on the Advisory Committee on Accounting Ethics Curriculum.

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 a member 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.

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Preface Why Did We Write This Book?

The first edition of Ethical Obligations and Decision Making in Accounting: Text and Cases was written in the wake of the dot.com bubble and accounting scandals at companies such as Enron and WorldCom. The second edition was written in the wake of the financial meltdown of 2007–2008 that was due to high-risk lending and borrowing practices. The result of these scandals has been an increased call by professional and regulatory bodies for ethics education of accounting students in values, ethics, and attitudes to support pro- fessional and ethical judgments and act in the public interest. We dedicate ourselves to this goal through our book.

Several states now require their accounting students to complete an ethics course prior to certification. Texas was first state to do so, and it requires accounting students in Texas and those moving into the state to complete an ethics course at a Texas uni- versity or in their home institution. California and Colorado require separate account- ing ethics courses; states such as Maryland, New York, and West Virginia also have separate ethics course requirements. This book is written to enable instructors to address the content material that state boards typically expect to be covered in qualify- ing courses.

Ethical Obligations and Decision Making in Accounting was written to guide students through the minefields of ethical conflict in meeting their responsibilities under the pro- fessions’ 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. We hope that this book and classroom instruction will work together to provide the tools to help you make ethical judgments and carry through with ethical actions.

Our book blends ethical reasoning, components of behavioral ethics, reflection, and the principles of ethical conduct that embody the values of the accounting profession. We incorporate these elements into a framework to consider the ethical obligations of accountants and auditors and how to make ethical decisions that address the following material:

• The role of moral and cognitive development in ethical reasoning, ethical judgment, and ethical orientation

• Professional codes of conduct in accounting • Ethical corporate governance systems • Fraud detection and prevention • Legal and regulatory obligations of auditors • Whistleblowing obligations of accountants and auditors • Earnings management issues and the quality of financial reporting • Ethical systems, global ethics standards, and corporate governance considerations in

doing business worldwide

Attributes of This Textbook Ethical Obligations and Decision Making in Accounting is designed to provide the instructor with comprehensive coverage of ethical and professional issues encountered by accounting professionals. Our material provides the best flexibility and pedagogical

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viii Preface

effectiveness of any book on the market. To that end, it includes numerous features designed to make both learning and teaching easier, such as:

• Ethical reflections that set the tone for each chapter • 160 discussion questions • 76 cases (10 per Chapters 1–7 and 6 in Chapter 8), about one-third of which are from the

SEC enforcement files • 6 additional major cases that can be used for comprehensive testing, a group project, a

research assignment, or a capstone to the book • Dozens of additional cases and instructional resources, which are available to enrich

student learning • Links to videos for instructors

Pedagogical approach:

• The book is comprehensive enough to serve as a stand-alone text, yet flexible enough to act as a co-text or supplementary text across the accounting curricula or within an auditing or financial accounting course.

• There is sufficient case and supplementary material to allow the instructor to vary the course over at least two to three terms.

• The writing style is pitched specifically to students, making the material easy to follow and absorb.

• Group discussions and role-play opportunities using case studies • Video links to bring case material to life

The Instructor Edition of the Online Learning Center, www.mhhe.com/mintz3e, offers materials to support the efforts of first-time and seasoned instructors of accounting ethics. A comprehensive Instructor’s Manual provides teaching notes, grading sugges- tions and rubrics, sample syllabi, extra cases and projects, and guidelines for incorporating writing into the accounting ethics course; a Test Bank that provides a variety of multiple- choice, short answer, and essay questions for building quizzes and tests; additional cases that can be assigned, including some that were not carried over from the first and second editions; links to videos to enhance the learning experience and bring case discussions to life; and PowerPoint presentations for every chapter make a convenient and powerful lecture tool.

Changes in This Edition The behavioral approach to ethics leads to understanding and explaining moral behavior in a systematic way. We have expanded our discussion of ethics beyond the traditional philosophical moral reasoning methods that teach students how they should behave when facing ethical dilemmas and now also engage them to understand their own behavior better and compare it to how they would ideally like to behave. We incorporate those discussions in addressing ethical obligations of accountants and auditors under professional codes of conduct and in areas such as whistleblowing considerations under Sarbanes-Oxley (SOX) and the Dodd-Frank Financial Reform Act.

This revision also includes:

• Emphasis on values, ethics, and behaviors in a professional setting • Expanded coverage of professional codes of conduct and failure to maintain indepen-

dence, integrity, objectivity, and professional skepticism • New audit requirements and clarified Statements on Auditing Standards effective in

2014 that collectively better address financial statement fraud and the risk of material misstatements

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Preface ix

• Broadened perspective on earnings management, including the role of earnings expec- tations, the use of accruals, income smoothing, risk assessment and materiality, and financial restatements

• Public interest and ethical considerations in developing international financial report- ing standards, cultural considerations when operating overseas, corporate governance systems, and global bribery

• Restoring public trust and confidence in the accounting profession

This edition of Ethical Obligations and Decision Making in Accounting has dozens of new discussion questions. The material that was replaced to keep the book fresh is avail- able to instructors in the Instructor’s Manual for testing purposes. For the first time, we provide video links to many of the cases in the book in the IM.

In a project of this kind, errors are bound to occur. As authors, we accept full responsi- bility for all errors and omissions. We welcome feedback on the book and suggestions for improvements. The authors have collectively had more than 30 years of experience teach- ing accounting ethics and welcome the opportunity to share our insights with you on how best to use the book and teach ethics to accounting students.

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.

Russell Calk New Mexico State University Jeffrey Cohen Boston College Dan Hubbard University of Mary Washington

Lorraine Lee University of North Carolina–Wilimington Stephen A. McNett Texas A&M University–Central Texas Barbara Porco Fordham University

We also appreciate the assistance and guidance given us on this project by the staff of Mc-Graw-Hill Education, including Tim Vertovec, Managing Director; James Heine, Executive Brand Manager; Michelle Nolte, Marketing Manager; Lori Bradshaw, develop- ment editor; Judi David, project manager; Jennifer Pickel, buyer; Studio Montage, design coordinator; and Prashanthi Nadipalli, media project manager. We greatly appreciate the role of Shyam Ramasubramony, project manager, and Susan McClung, copyeditor of the book.

Finally, we would like to acknowledge the contributions of our students, who have pro- vided 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 us at smintz@calpoly.edu and rmorris@txstate.edu.

Steve Mintz

Rosie Morris

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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 A Faulty Budget Ethical and professional responsibilities of an accountant after discovering an error in his sales budget.

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

1-10 Telecommunications, Inc. Concerns about the ethics of engineers who accept free travel and lodging from a foreign entity after establishing the criteria for a contract awarded to that entity.

Case # Case Name/Description

2-1 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

2-2 Better Boston Beans Conflict between wanting to do the right thing and a confidentiality obligation to a coworker.

2-3 The Tax Return Tax accountant’s ethical dilemma when asked by her supervisor to ignore reportable lottery winnings.

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2-4 Shifty Industries Depreciation calculations and cash outflow considerations in a tax engagement.

2-5 Blues Brothers Identifying enablers and disablers of ethical action and ways to convince others of one’s point of view.

2-6 Supreme Designs, Inc. Ethical dilemma of an accountant who uncovers questionable payments to his supervisor.

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 report a market gain in earnings.

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

2-10 Gateway Hospital Behavioral ethics considerations in developing a position on unsubstantiated expense reimbursement claims.

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 Amgen Whistleblowing Case Whistleblower’s termination after raising issues about the company’s underreporting of complaints and problems with pharmaceutical drugs.

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

3-4 Hewlett-Packard Use of false and fraudulent means to obtain confidential information from members of the board of directors.

3-5 IRS Whistleblower and Informing on Tax Cheats Ethics of gathering sensitive information about wrongdoing to qualify for whistleblower payouts.

3-6 Bennie and the Jets Ethical and professional obligations in reporting accounting wrongdoing to higher-ups in the organization.

3-7 Exxon-XTO Merger Alleged breach of fiduciary duties of the board of directors of XTO Energy that arose from ExxonMobil’s takeover of XTO.

3-8 Disclosure of Steve Jobs’s Health as Apple CEO: A Public or Private Matter? Shareholder rights to receive negative information about the health of its CEO.

Case Descriptions xi

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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 America Online (AOL) Internet-based company’s improper capitalization of advertising costs and the use of “round-trip” transactions to inflate revenue and earnings.

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.

4-4 First Community Church Misappropriation of church funds and subsequent cover-up by a member of the board of trustees.

4-5 Lee & Han, LLC Alteration of work papers and ethical obligations of auditors.

4-6 Gee Wiz Ethics of working for employer’s customer on the side and evaluating the customer’s receivable account.

4-7 Family Outreach Questions about validity of expense accounts and ethical obligations of the state auditor.

4-8 HealthSouth Corporation Manipulation of contractual allowances to overstate net revenues, and auditors’ inability to gather the evidence needed to stop the fraud.

4-9 Healthcare Fraud and Accountants’ Ethical Obligations Stakeholder considerations and ethical obligations upon discovering Medicare fraud.

4-10 Independence Violations at PwC Investigation of PwC independence procedures after self-regulatory peer review fails to identify violations.

Case # Case Name/Description

5-1 Computer Associates Audit committee’s role in identifying premature revenue recognized on software contracts.

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

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

xii Case Descriptions

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5-4 Audit Client Considerations and Risk Assessment Risk assessment procedures prior to deciding whether to submit a competitive bid for an audit engagement.

5-5 Krispy Kreme Doughnuts, Inc. “Round-trip” transactions used to inflate revenues and earnings to meet or exceed financial analysts’ EPS guidance.

5-6 Dunco Industries Role and ethical responsibilities of accounting professionals in assessing the validity of audit evidence.

5-7 First Community Bank Valuation of loan loss impairment and risk assessment.

5-8 Fannie Mae: The Government’s Enron Comprehensive case covers manipulation in four areas to project stable earnings—derivatives, loan fees, loan loss reserves, and marketable securities.

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.

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

Case # Case Name/Description

6-1 SEC v. Halliburton Company and KBR, Inc. Bribery allegations against Halliburton and the application of the Foreign Corrupt Practices Act (FCPA).

6-2 Con-way Inc. Facilitating payments and internal control requirements under the FCPA.

6-3 Insider Trading and Accounting Professionals Insider trading by accounting professionals and providing tips to friends.

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 SEC v. DHB Industries, Inc., n/k/a Point Blank Solutions, Inc. SEC action against independent directors and audit committee members in a securities fraud case.

6-7 Livingston & Haynes, P. C. Evaluation of ordinary negligence, gross negligence, and fraud in a securities violation.

6-8 Kay & Lee LLP Auditor legal liability when foreseen third party relies on financial statements

6-9 Reznor v. J. Artist Management (JAM), Inc. Legal liability of manager of lead singer of Nine Inch Nails based on allegations of mismanagement.

6-10 SEC v. Zurich Financial Services Complex accounting for reinsurance transactions and transfer of economic risk.

Case Descriptions xiii

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Case # Case Name/Description

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

7-2 Solutions Network, Inc. Use of the Fraud Triangle to evaluate management’s actions.

7-3 Cubbies Cable Differences of opinion with management over whether to capitalize or expense cable construction costs.

7-4 Solway, Inc. Use of year-end accruals to manage earnings and whistleblowing considerations.

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

7-6 Sweat Construction Company Pressure on the controller to ignore higher estimated costs on a construction contract to improve earnings and secure needed financing.

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

7-8 Diamond Foods Link between projecting financial results and earnings management.

7-9 The North Face, Inc. Questions about financial structuring and revenue recognition on barter transactions to achieve desired results.

7-10 Vivendi Universal Improper adjustments to EBITDA and operating free cash flow by a French multinational company to meet ambitious earnings targets and conceal liquidity problems.

Case # Case Name/Description

8-1 SEC v. Siemens Aktiengesellschaft Bribery committed by a German company, using slush funds, off-book accounts, and business consultants and intermediaries to facilitate illegal payments.

8-2 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.

8-3 Satyam: India’s Enron CEO’s falsification of financial information and misuse of corporate funds for personal purposes.

8-4 Royal Dutch Shell plc Overstatement of estimated recoverable proved oil and gas reserves by Dutch-U.K. company in violation of SEC regulations.

xiv Case Descriptions

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8-5 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).

8-6 Olympus Major corporate scandal in Japan where Olympus committed a $1.7 billion fraud involving concealment of investment losses through fraudulent accounting.

Major Cases

Chapter Coverage Case Name/Description

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.

3 MicroStrategy, Inc. SEC action against MicroStrategy for improper revenue recognition of accounting for multiple deliverables contracts and questions about independence of PwC.

4 Cendant Corporation SEC action against Cendant for managing earnings through merger reserve manipulations and improper accounting for membership sales, and questions about the audit of Ernst & Young.

5 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.

6 Waste Management Failure of Andersen auditors to enforce agreement with the board of directors to adopt proposed adjusting journal entries that were required in restated financial statements.

Case Descriptions xv

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xvi

1 Ethical Reasoning: Implications for Accounting 1

2 Cognitive Processes and Ethical Decision Making in Accounting 54

3 Creating an Ethical Organization Environment and Effective Corporate Governance Systems 91

4 AICPA Code of Professional Conduct 175

5 Fraud in Financial Statements and Auditor Responsibilities 246

Brief Contents 6 Legal, Regulatory, and Professional

Obligations of Auditors 335

7 Earnings Management and the Quality of Financial Reporting 410

8 International Financial Reporting: Ethics and Corporate Governance Considerations 475

MAJOR CASES 542

INDEXES 579

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Table of Contents Chapter 1 Ethical Reasoning: Implications for Accounting 1

Ethics Reflection 1 Integrity: The Basis of Accounting 3 Religious and Philosophical Foundations of Ethics 4 What Is Ethics? 5

Norms, Values, and the Law 6 Ethical Relativism 8 Situation Ethics 8 Cultural Values 10

The Six Pillars of Character 11 Trustworthiness 12 Respect 15 Responsibility 15 Fairness 15 Caring 16 Citizenship 16

Reputation 16 The Public Interest in Accounting 18

Professional Accounting Associations 18 AICPA Code of Conduct 19

Virtue, Character, and CPA Obligations 20 Modern Moral Philosophies 21

Teleology 22 Deontology 25 Justice 27 Virtue Ethics 28

Application of Ethical Reasoning in Accounting 29 DigitPrint Case Study 31

Scope and Organization of the Text 33 Concluding Thoughts 34 Discussion Questions 35 Endnotes 37 Chapter 1 Cases 41

Case 1-1: Harvard Cheating Scandal 42 Case 1-2: Giles and Regas 43 Case 1-3: NYC Subway Death: Bystander Effect or Moral Blindness 45 Case 1-4: Lone Star School District 46 Case 1-5: Reneging on a Promise 47 Case 1-6: Capitalization versus Expensing 48 Case 1-7: Eating Time 49 Case 1-8: A Faulty Budget 50 Case 1-9: Cleveland Custom Cabinets 51 Case 1-10: Telecommunications, Inc. 52

Chapter 2 Cognitive Processes and Ethical Decision Making in Accounting 54

Ethics Reflection 54 Kohlberg and the Cognitive Development Approach 55

Heinz and the Drug 56 Universal Sequence 58

The Ethical Domain in Accounting and Auditing 59 Rest’s Four-Component Model of Ethical Decision Making 59

Moral Sensitivity 60 Moral Judgment 60 Moral Motivation 60 Moral Character 60

Rest’s Model and Organizational Behavior 61 Professional Judgment in Accounting: Transitioning from Moral Intent to Moral Action 63

Diem-Thi Le and Whistleblowing at the DCCA 64 Behavioral Ethics 67

Ethical Decision-Making Model 68 Application of the Model 71 Concluding Thoughts 72 Discussion Questions 72 Endnotes 74 Chapter 2 Cases 77

Case 2-1: WorldCom 78 Case 2-2: Better Boston Beans 79 Case 2-3: The Tax Return 80 Case 2-4: Shifty Industries 81 Case 2-5: Blues Brothers 83 Case 2-6: Supreme Designs, Inc. 84 Case 2-7: Milton Manufacturing Company 85 Case 2-8: Juggyfroot 87 Case 2-9: Phar-Mor 88 Case 2-10: Gateway Hospital 90

Chapter 3 Creating an Ethical Organization Environment and Effective Corporate Governance Systems 91

Ethics Reflection 91 Seven Signs of Ethical Collapse 92

Pressure to Maintain the Numbers 93 Fear of Reprisals 93

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Loyalty to the Boss 93 Weak Board of Directors 94

A Culture of Conflicting Interests 94 Innovation and Ethics 95 Community Involvement and Ethics 95 Organizational Influence on Ethical Decision Making 95 Individual-Organization Interchange 96 Ethical Dissonance Model 96

Business Ethics 98 Guiding Principles 98 Values 99 Ethical Standards 99 Business Ethics versus Personal Ethics 100 Ends versus Means 101 Trust in Business 101 Johnson & Johnson: A Case of Dr. Jekyll and Mr. Hyde? 103 Employees Perceptions of Ethics in the Workplace 105

Stakeholder Perspective 107 The Case of the Ford Pinto 107

Fraud in Organizations 109 Fraudulent Business Practices 109 Occupational Fraud 110 Financial Statement Fraud 112

Foundations of Corporate Governance Systems 114

Defining Corporate Governance 115 Views of Corporate Governance 115 The Importance of Good Governance 116 Executive Compensation 117

Corporate Governance Mechanisms 119 The Role of the Board of Directors 119 Audit Committee 120 Internal Controls as a Monitoring Device 122 Internal Auditors 123 Audited Financial Statements 125 NYSE Listing Requirements 125 Code of Ethics for CEOs and CFOs 127 Compliance Function 128

Bernie Madoff’s Ponzi Scheme 128 Whistleblowing 131

Detection, Reporting, and Retaliation 131 Incentivizing Whistleblowing under Dodd-Frank 134 Accountants’ Obligations for Whistleblowing 134 Has the Whistleblowing Program Been Successful? 135 The Ethics of Whistleblowing 136

Concluding Thoughts 137 Discussion Questions 137 Endnotes 140

Chapter 3 Cases 149 Case 3-1: The Parable of the Sadhu 150 Case 3-2: Amgen Whistleblowing Case 154 Case 3-3: United Thermostatic Controls 156 Case 3-4: Hewlett-Packard 160 Case 3-5: IRS Whistleblower and Informing on Tax Cheats 162 Case 3-6: Bennie and the Jets 163 Case 3-7: Exxon-XTO Merger 164 Case 3-8: Disclosure of Steve Jobs’s Health as Apple CEO: A Public or Private Matter? 167 Case 3-9: Bhopal, India: A Tragedy of Massive Proportions 168 Case 3-10: Accountability of Ex-HP CEO in Conflict of Interest Charges 174

Chapter 4 AICPA Code of Professional Conduct 175

Ethics Reflection 175 The Public Interest in Accounting: An International Perspective 177 Investigations of the Profession: Where Were the Auditors? 178

Metcalf Committee and Cohen Commission: 1977–1978 179 House Subcommittee on Oversight and Investigations: 1986 180 Savings and Loan Industry Failures: Late 1980s–Early 1990s 181

Treadway Commission Report: 1985; COSO: 1992; and Enterprise Risk Management: 2004 181 The Role of the Accounting Profession in the Financial Crisis of 2007–2008 183 AICPA Code of Professional Conduct and State Board Requirements 186

National Association of State Boards of Accountancy 187 Professional Services of CPAs 188

AICPA and IFAC Principles of Professional Conduct 190 Conceptual Framework for AICPA Independence Standards 191

Threats to Independence 191 Safeguards to Counteract Threats 193 Financial Relationships That Impair Independence 193 Providing Nonattest Services to an Attest Client 194

SEC Position on Auditor Independence 195 SEC Actions Against Auditing Firms 195 The PeopleSoft Case 196

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Table of Contents xix

Insider Trading Scandals Damage the Reputation of the Accounting Profession: Former KPMG Audit Partner, Scott London 196 Former Deloitte & Touche Management Advisory Partner, Thomas Flannigan 197

SOX Provisions 198 Restrictions on Nonattest Services 198

Integrity and Objectivity 200 Principles of Professional Practice 201 Responsibilities to Clients 203 Other Responsibilities and Practices 206

Commissions and Referral Fees 206 Advertising and Solicitation 207 Form of Organization and Name 208 Acts Discreditable—Client Books and Records; CPA Workpapers 210 Acts Discreditable—Negligence in the Preparation of Financial Statements or Records 212

Ethics and Tax Services 213 Rule 101—Independence 213 Rule 102—Integrity and Objectivity 214 Rule 201—Professional Competence and Due Care 214 Rule 202—Compliance with Professional Standards 214 Tax Compliance Services 214 Statements on Standards for Tax Services (SSTS) 214 Substantial Authority 216 Realistic Possibility of Success 216 Reasonable Basis 216 Tax Shelters 218

PCAOB Rules 219 Rule 3520—Auditor Independence 219 Rule 3521—Contingent Fees 219 Rule 3522—Tax Transactions 219 Rule 3523—Tax Services for Persons in Financial Reporting Oversight Roles 220 Rule 3524—Audit Committee Pre-Approval of Certain Tax Services 220 Rule 3525—Audit Committee Pre-Approval of Nonauditing Services Related to Internal Control over Financial Reporting 221 Rule 3526—Communication with Audit Committees Concerning Independence 221

Concluding Thoughts 221 Discussion Questions 222 Endnotes 225 Chapter 4 Cases 229

Case 4-1: America Online (AOL) 230 Case 4-2: Beauda Medical Center 233 Case 4-3: Family Games, Inc. 234

Case 4-4: First Community Church 235 Case 4-5: Lee & Han, LLC 236 Case 4-6: Gee Wiz 237 Case 4-7: Family Outreach 238 Case 4-8: HealthSouth Corporation 239 Case 4-9: Healthcare Fraud and Accountants’ Ethical Obligations 242 Case 4-10: Independence Violations at PwC 243

Chapter 5 Fraud in Financial Statements and Auditor Responsibilities 246

Ethics Reflection 246 Fraud in Financial Statements and the Audit Function 247 Nature and Causes of Misstatements 249

Errors, Fraud, and Illegal Acts 249 Reporting an Illegal Act 251 Auditors’ Responsibilities for Fraud Prevention, Detection, and Reporting 252 The Fraud Triangle 252 Incentives/Pressures to Commit Fraud 253 Opportunity to Commit Fraud 254 Rationalization for the Fraud 255 Tyco Fraud 255

Fraud Considerations in the Audit 259 Fraud Risk Assessment 260 Fraud Associated with Management Override of Controls 260 Rite Aid Fraud and Failure of Internal Controls 262 Communicating About Possible Fraud to Management and Those Charged with Governance 262 Management Representations and Financial Statement Certifications 263

Contents of the Audit Report 264 Background 264 Introductory Paragraph 265 Management’s Responsibility 265 Auditor’s Responsibility 265 Opinion 267 Types of Audit Opinions 267

Generally Accepted Auditing Standards (GAAS)—Overview 269

GAAS Requirements 271 Audit Evidence 272 Limitations of the Audit Report 273 Reasonable Assurance 273 Materiality 273

What Is Meant by “Present Fairly”? 275 Audit Risk Assessment 277

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Internal Control Assessment 278 Internal Control—Integrated Framework 278

PCAOB Standards 282 AS 4: Reporting on Previously Reported Material Weakness 283 AS 5: An Audit of Internal Control over Financial Reporting That Is Integrated with an Audit of Financial Statements 283 AS 6: Evaluating Consistency of Financial Statements 284 AS 8—Audit Risk 285 AS 9—Audit Planning 285 AS 10—Supervision of the Audit Engagement 285 AS No. 11—Consideration of Materiality in Planning and Performing an Audit 286 AS No. 12—Identifying and Assessing Risks of Material Misstatement 286 AS No. 13—The Auditor’s Responses to the Risks of Material Misstatement 286 AS No. 14—Evaluating Audit Results 286 AS No. 15—Audit Evidence 287 Communications with Audit Committees 287 Auditor’s Evaluation of the Quality of the Company’s Financial Reporting 289 Financial Statements Restatements 291 PCAOB Enforcement Program 293

Concluding Thoughts 294 Discussion Questions 295 Endnotes 297 Chapter 5 Cases 303

Case 5-1: Computer Associates 304 Case 5-2: ZZZZ Best 307 Case 5-3: Imperial Valley Thrift & Loan 311 Case 5-4: Audit Client Considerations and Risk Assessment 317 Case 5-5: Krispy Kreme Doughnuts, Inc. 319 Case 5-6: Dunco Industries 321 Case 5-7: First Community Bank 322 Case 5-8: Fannie Mae: The Government’s Enron 324 Case 5-9: Royal Ahold N.V. (Ahold) 329 Case 5-10: Groupon 333

Chapter 6 Legal, Regulatory, and Professional Obligations of Auditors 335

Ethics Reflection 335 Client Confidentiality, Fraud, and Whistleblowing 337

Confidentiality Obligation and Fraud 337 Dodd-Frank and Whistleblowing 337

Ethical and Legal Responsibilities of Officers and Directors 339

Duty of Care—Managers and Directors 339 Duty of Loyalty 339 Director Duty of Good Faith 339 Business Judgment Rule 340 Caremark Opinion 340 Shareholder Derivative Suit—Citigroup Subprime Lending 340 Clawback of Incentive Compensation from Executive Officers 341 Audit Committee and Business Judgment Rule 342

Legal Liability of Auditors: An Overview 343 Common-Law Liability 343 Liability to Clients—Privity Relationship 344 Liability to Third Parties 345 Actually Foreseen Third Parties 345 Reasonably Foreseeable Third Parties 346 Auditor Liability to Third Parties 348

Statutory Liability 350 Securities Act of 1933 352 Key Court Decisions 353 Securities Exchange Act of 1934 354

Interaction of Ethics and Legal Liability 356 Court Decisions and Auditing Procedures 357 Liability for Securities Violations 359

Honest Services Assessment in Criminal Matters 359 Is There a Difference Between Lying and Stealing in Securities Fraud? 360

Insider Reporting and Trading 361 Leaking Nonpublic Information 361 Auditor Betrayal of Client Confidences and Insider Trading 363

Private Securities Litigation Reform Act (PSLRA) 365

Reporting Requirements 365 Proportionate Liability 366

Sarbanes Oxley (SOX) Legal Liabilities 367 Section 302. Corporate Responsibility for Financial Reports 367 Section 302. Liability in Private Civil Actions 368 Section 302. Liability in Civil and Criminal Government Actions 369 Perspective on Accomplishments of SOX 369

Other Laws Affecting Accountants and Auditors 370 Foreign Corrupt Practices Act (FCPA) 370 SEC Charges Pfizer with FCPA Violations 371 FCPA Violations and Tyco 375 FCPA and Whistleblowing 375

Federal Sentencing Guidelines for Organizations 375

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Concluding Thoughts 377 Discussion Questions 378 Endnotes 380 Chapter 6 Cases 385

Case 6-1: SEC v. Halliburton Company and KBR, Inc. 386 Case 6-2: Con-way Inc. 390 Case 6-3: Insider Trading and Accounting Professionals 392 Case 6-4: Anjoorian et al.: Third-Party Liability 393 Case 6-5: Vertical Pharmaceuticals Inc. et al. v. Deloitte & Touche LLP 396 Case 6-6: SEC v. DHB Industries, Inc., n/k/a Point Blank Solutions, Inc. 397 Case 6-7: Livingston & Haynes, P. C. 400 Case 6-8: Kay & Lee, LLP 405 Case 6-9: Reznor v. J. Artist Management (JAM), Inc. 406 Case 6-10: SEC v. Zurich Financial Services 407

Chapter 7 Earnings Management and the Quality of Financial Reporting 410

Ethics Reflection 410 Motivation for Earnings Management 412

Earnings Guidance 412 Income Smoothing 414

Analysis of Earnings Management from a Financial Reporting Perspective 415

Definition of Earnings Management 415 Ethics of Earnings Management 416 How Managers and Accountants Perceive Earnings Management 418 Accruals and Earnings Management 419 Acceptability of Earnings Management from a Materiality Perspective 420 Current Auditing Standards and Presumptions 424

Financial Statement Restatements 426 The Nature of Restatements 426 Restatements Due to Errors in Accounting and Reporting 427

Earnings Management Techniques 428 Financial Shenanigans 429

1. Recording Revenue Too Soon or of Questionable Quality 429 2. Recording Bogus Revenue 430 3. Boosting Income with One-Time Gains 430 4. Shifting Current Expenses to a Later or Earlier Period 430

5. Failing to Record or Improperly Reducing Liabilities 430 6. Shifting Current Revenue to a Later Period 431 7. Shifting Future Expenses to the Current Period as a Special Charge 431

Descriptions of Financial Shenanigans 431 The Case of Xerox 432 Sanctions by the SEC on KPMG 433 The Case of Lucent Technologies 433 The Story of Enron 435 FASB Rules on SPEs 441 Enron’s Role in the Creation and Passage of SOX 442 Lessons to Be Learned from Enron 442

Earnings Quality 442 Concluding Thoughts 443 Discussion Questions 444 Endnotes 447 Chapter 7 Cases 451

Case 7-1: Nortel Networks 452 Case 7-2: Solutions Network, Inc. 456 Case 7-3: Cubbies Cable 458 Case 7-4: Solway, Inc. 460 Case 7-5: Dell Computer 461 Case 7-6: Sweat Construction Company 463 Case 7-7: Sunbeam Corporation 465 Case 7-8: Diamond Foods 468 Case 7-9: The North Face, Inc. 470 Case 7-10: Vivendi Universal 473

Chapter 8 International Financial Reporting: Ethics and Corporate Governance Considerations 475

Ethics Reflection 475 The Influence of Culture on International Financial Reporting 477 Restoring the Public Trust: An International Perspective 479 International Financial Reporting Environment 480

Movement toward IFRS 480 Harmonization of Standards 480 Comparability of Financial Statements 481 Convergence of Standards 482 Condorsement 483 Auditing, Corporate Governance, and Ethics Considerations 484 True and Fair View versus Present Fairly 485

IFRS for Small and Medium-Sized Entities 485

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Principles versus Rules-based Standards 487 Ethical Considerations 487 Earnings Management Concerns 488 Examples of Rules-based versus Principles- Based Standards 489 The Problem with Provisions and Reserves 491

Global Business Ethics 492 Global Code of Ethics 495 Global Fraud, Bribery, and Suspected Illegal Acts 496

Global Fraud 496 Global Bribery 497 Responding to a Suspected Illegal Act 499

Comparative Corporate Governance 501 Legal and Cultural Considerations 501 Comply or Explain Principle 502 Corporate Governance in Germany 503 Corporate Governance in China 504 Corporate Governance in India 507

CLSA Corporate Governance Watch 2012 508 Concluding Thoughts 510

Discussion Questions 510 Endnotes 513 Chapter 8 Cases 517

Case 8-1: SEC v. Siemens Aktiengesellschaft 518 Case 8-2: Parmalat: Europe’s Enron 521 Case 8-3: Satyam: India’s Enron 526 Case 8-4: Royal Dutch Shell plc 530 Case 8-5: Autonomy 534 Case 8-6: Olympus 537

Major Cases 542 Major Case 1: Adelphia Communications Corporation 543 Major Case 2: Royal Ahold N.V. (Ahold) 551 Major Case 3: MicroStrategy, Inc. 556 Major Case 4: Cendant Corporation 561 Major Case 5: Navistar International 567 Major Case 6: Waste Management 572

Name Index 579

Subject Index 583

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1

1 Ethical Reasoning: Implications for Accounting

Chapter

PENN STATE CHILD ABUSE SCANDAL: A CULTURE OF INDIFFERENCE What motivates an otherwise ethical person to do the wrong thing when faced with an ethical dilemma? Why did Joe Paterno and administrators at Penn State University look the other way and fail to act on irrefutable evidence that former assistant football coach Jerry Sandusky had raped and molested young boys, an offense for which Sandusky currently is serving a 30- to 60-year sentence? According to the independent report by Louis Freeh that investigated the sexual abuse, four of the most powerful people at Penn State, including president Graham Spanier, athletic director Timothy Curley, senior vice president Gary Schultz, and head football coach Joe Paterno, shel- tered a child predator harming children for over a decade by concealing Sandusky’s activities from the board of trus- tees, the university community, and authorities. The Freeh report characterizes the inactions as lacking empathy for the victims by failing to inquire as to their safety and well- being. Not only that, but they exposed the first abused child to additional harm by alerting Sandusky, who was the only one who knew the child’s identity, of what assistant coach Mike McQueary saw in the shower on the night of February 9, 2001. 1 McQueary testified at the June 2012 trial of Sandusky that when he was a graduate assistant, he walked into the locker room and heard sounds of slapping

and observed Sandusky up against a boy, whose hands were up against the wall. 2 He reported the suspected child abuse to Paterno who reported the incident to his superiors but did not confront Sandusky or report the incident to the board of trustees or the police. 3

REASONS FOR UNETHICAL ACTIONS The report gives the following explanations for the failure of university leaders to take action to identify this child vic- tim and for not reporting Sandusky to the authorities:

• The desire to avoid the bad publicity that reporting the incident would bring

• The failure of the university’s board of trustees to have reporting mechanisms in place to ensure disclosure of major risks to the university

• A president who discouraged discussion and dissent • A lack of awareness of child abuse issues and the Clery

Act, which requires all colleges and universities partici- pating in federal financial aid programs to keep and dis- close information about crimes committed on and near their campuses

• A lack of whistleblower policies and protections • A culture of reverence for the football program that was

ingrained at all levels of the campus community

Ethics Reflection

(Continued)

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2

EXPLANATIONS FOR UNETHICAL ACTIONS Former Penn State president Spanier who was fired by the board of trustees in November 2011, is quoted as saying in an interview with Jeffrey Toobin of the New Yorker online after the trial of Sandusky that ended on June 22, 2012, about how the university worked that “honesty, integrity, and always doing what was in the best interests of the uni- versity [italics added] was how everyone agreed to operate and . . . we’ve always operated as a family. Our personal and social and professional lives were all very intertwined.” 4

At Penn State, a culture existed that placed the interests of the university, as perceived by its leadership, ahead of the interests of the abused children and the public trust. The tone that was set by Paterno and Spanier was to cover up any potentially damaging information about the insti- tution and its football program. This happens in other organizations as well, such as Enron and WorldCom, where acting ethically took a back seat to self-interest, including maximizing earnings and share price. The culture of an organization should be built on ethical values such as hon- esty, integrity, responsibility, and accountability. While Penn State may have claimed to follow such principles, the reality was that its actions did not match these behavioral norms.

ETHICAL BLIND SPOTS Leaders of organizations who may be successful at what they do and see themselves as ethical and moral still culti- vate a collection of what Max Bazerman and Ann Trebrunsel call blind spots . 5 Blind spots are the gaps between who you want to be and the person you actually are. In other words,

most of us want to do the right thing—to act ethically— but internal and external pressures get in the way. These authors attribute blind spots to the concept of bounded ethicality; that is, psychological processes that lead even good people to engage in ethically questionable behavior that contradicts their own preferred ethics. At Penn State, bounded ethicality came into play because individuals such as Paterno decided to keep the scandal quiet, thereby ena- bling the abuse and harm to the affected children to con- tinue even though that harm was inconsistent with their purported beliefs and preferences.

Our workday lives can create ethical challenges where there is a difference between knowing the right thing to do and doing it. One reason is organizational goals (such as what is in the best interests of Penn State), rewards, com- pliance systems, and informal pressures, all of which can contribute to ethical fading, a process by which the ethical dimensions are eliminated from a decision and replaced by “avoiding bad publicity” or making the deal at any costs. Enron had a code of conduct in place, but that didn’t stop it from rewarding officers involved in conflicts of interest such as the former chief financial officer (CFO), Andy Fastow, who managed special-purpose-entities that dealt directly with Enron at the same time he served as Enron’s CFO.

As you read this chapter, think about the following ques- tions: (1) What would you have done if you had been in Joe Paterno’s position, and why? (2) What factors might have enabled you to act in accordance with your own values and beliefs? (3) What factors might have served as disablers and made it more difficult to act on your values and beliefs?

Ethics Reflection (Concluded)

Have the courage to say no. Have the courage to face the truth. Do the right thing because it is right. These are the magic keys to living your life with integrity. W. Clement Stone (1902–2002)

This quote by William Clement Stone, a businessman, philanthropist, and self-help book author, underscores the importance of integrity in decision making. Notice that the quote addresses integrity in one’s personal life. That is because one has to act with integrity when making personal decisions in order to be best equipped to act with integrity on a professional level. Integrity, indeed all of ethics, is not a spigot that can be turned on or off depending on one’s whims or whether the matter at hand is personal or professional. As the ancient Greeks knew, we learn how to be ethical by practicing and exercising those virtues that enable us to lead a life of excellence.

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Chapter 1 Ethical Reasoning: Implications for Accounting 3

Joe Paterno and other university leaders did not act with integrity. They let external considerations of reputation and image dictate their internal actions. Ironically, the very factor—reputation—that they guarded so closely was the first to be brought down by the disclosure of a cover-up in the sex scandal case.

In accounting, internal accountants and auditors may be pressured by superiors to manipulate financial results. The external auditors may have to deal with pressures imposed on them by clients to put the best face on the financial statements regardless of whether they conform to generally accepted accounting principles (GAAP). It is the ethical value of integrity that provides the moral courage to resist the temptation to stand by silently while a company misstates its financial statement amounts.

Integrity: The Basis of Accounting

According to Mintz (1995), “Integrity is a fundamental trait of character that enables a CPA to withstand client and competitive pressures that might otherwise lead to the sub- ordination of judgment.” 6 A person of integrity will act out of moral principle and not expediency. That person will do what is right, even if it means the loss of a job or client. In accounting, the public interest (i.e., investors and creditors) always must be placed ahead of one’s own self-interest or the interests of others, including a supervisor or client.

Integrity means that a person acts on principle—a conviction that there is a right way to act when faced with an ethical dilemma. For example, assume that your tax client fails to inform you about an amount of earned income for the year, and you confront the client on this issue. The client tells you not to record it and reminds you that there is no W-2 or 1099 form to document the earnings. The client adds that you will not get to audit the company’s financial statements anymore if you do not adhere to the client’s wishes. Would you decide to “go along to get along”? If you are a person of integrity, you should not allow the client to dictate how the tax rules will be applied in the client’s situation. You are the professional and know the tax regulations best, and you have an ethical obligation to report taxes in accordance with the law. If you go along with the client and the Internal Revenue Service (IRS) investigates and sanctions you for failing to follow the IRS Tax Code, then you may suffer irreparable harm to your reputation. An important point is that a professional must never let loyalty to a client cloud good judgment and ethical decision making.

WorldCom: Cynthia Cooper: Hero and Role Model Cynthia Cooper’s experience at WorldCom illustrates how the internal audit function should work and how a person of integrity can put a stop to financial fraud. It all unraveled in April and May 2002 when Gene Morse, an auditor at WorldCom, couldn’t find any documentation to support a claim of $500 million in computer expenses. Morse approached Cooper, the company’s director of internal auditing and Morse’s boss, who instructed Morse to “keep going.” A series of obscure tips led Morse and Cooper to suspect that WorldCom was cooking the books. Cooper formed an investigation team to determine whether their hunch was right.

In its initial investigation, the team discovered $3.8 billion of misallocated expenses and phony accounting entries. 7 Cooper approached the CFO, Scott Sullivan, but was dissatisfied with his explanations. The chief executive officer (CEO) of the company, Bernie Ebbers, had already resigned under pressure from WorldCom’s board of directors, so Cooper went to the audit committee. The committee interviewed Sullivan about the accounting issues and did not get a satisfactory answer. Still, the committee was reluctant to take any action. Cooper persisted anyway. Eventually, one member of the audit committee told her to approach the outside auditors to get their take on the matter. Cooper gathered additional evidence of fraud, and ultimately KPMG, the firm that had replaced Arthur Andersen LLP—the auditors during the fraud—supported Cooper. Sullivan was asked to resign, refused to do so, and was fired. 8