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Chapter 3 Ppt. Study Set Ethics
Terms in this set (87)
process by which the ethical dimensions are eliminated from a decision and replaced by consideration such as avoiding bad publicity or making the deal at all costs.
occurs because how we think we should behave differs from how we decide to behave, so we adjust our beliefs to our behavior.
Seven signs of ethical collapse
1. Pressure to maintain numbers
2. Weak board of directors
3. Loyalty to the boss
4. Conflicts of interest overlooked or unaddressed
6. Innovation like no other company
7. Goodness in some areas atones for evil in others.
Conflict of interest between investment bankers and financial analysis arises
because the investment bank serves two client groups - the firms for which it issues securities and the investors to whom it sells those securities.
"Financial results at all costs"
ethical collapse occurs when there is an unreasonable and unrealistic obsession with meeting quantitative goals
"kill the messenger syndrome"
employees are reluctant to raise issues of ethical concern because they may be ignored, treated badly, transferred, or worse.
Loyalty to the boss
young people selected by the CEO for their position based on inexperience, possibly conflicts of interest, and unlikelihood to question the boss' actions.
Weak board of directors
characterizes virtually all the companies with major accounting frauds in the early 2000's
"Doing well by doing good"
Some CEO's believe the same rules don't apply because their company is so different and more innovative than others.
looks at the role of one's personal code of conduct in ethical behavior within an organization
-When one's personal code is insufficient to make the necessary moral decision, the individual will look at professional and organizational influences to resolve the conflict
Ethical Dissonance Model
interaction between the individual and the organization, based upon person-organization ethical fit at various stages of the contractual relationship in each potential ethical fit scenario
Four potential fits in the ethical dissonance model
1. High organizational and high individual ethics (likely to stay)
2. Low organizational ethics and low individual ethics (fits but promotes a culture of corruption)
3. High organizational ethics and low individual ethics (likely to leave)
4. Low organizational ethics, high individual ethics (increased employee turnover)
comprise the principles, values, and standards that guide behavior in the world of business
specific and pervasive boundaries for behavior that are universal and absolute
beliefs that guide behavior and support the overall organizational vision; provide a frame of reference
EEthical standards for the accounting profession
are embodied in its codes of conduct
IIA Code of Ethics
states the principles and expectations governing the behavior of individuals and organizations in the conduct of INTERNAL auditing.
-Purpose: to promote an ethical culture in the profession of internal auditing
IIA Rules of Conduct - Integrity
-1.1. Shall perform their work w/ honesty, diligence, and responsibility
-1.2. Shall observe the law and make disclosures expected by the law and the profession
-1.3. Shall not knowingly be a party to any illegal activity, or engage in acts that are discreditable to the profession of internal auditing or to the organization
-1.4. Shall respect and contribute to the legitimate and ethical objectives of the organization.
IIA Rules of Conduct - Objectivity
-2.1. Shall not participate in any activity or relationship that may impair or be presumed to impair their unbiased assessment. Includes conflicts of interest
-2.2. Shall not accept anything that may impair or be presumed to impair their professional judgment.
-2.3. Shall disclose all material facts known to them that, if not disclosed, may distort the reporting of activities under review.
IIA Rules of Conduct - Confidentiality
-3.1. Shall be prudent in the use and protection of information acquired in the course of their duties
-3.2. Shall not use information for any personal gain or in any manner that would be contrary to the law or detrimental to the legitimate and ethical objectives of the organization
IIA Rules of Conduct - Competency
-4.1. Shall engine only in those services for which they have the necessary knowledge, skills, and experience
4.2. Shall perform internal audit services in accordance with the International Standards for the Professional Practice of Internal Auditing
-4.3. Shall continually improve their proficiency and the effectiveness and quality of their services.
Business Ethics vs. Personal Ethics
John Maxwell - believes a single standard of ethics applies to both.
-Golden Rule: an integrity guideline for all situations
-Kant's notion of universality
Johnson and Johnson Case
J&J's credo emphasizes primary obligation to those who use and rely on the safety of its products
Tylenol Poisoning - J&J put customer safety first.
J&J has been withdrawing from its "trust" bank in recent years.
-Illegally promoted the antipsychotic Risperdal
-Misleading statements about the recall of Motrin
-Included methylene chloride, which is banned by the FDA, in their baby shampoo
-Ethicon vaginal mesh did not meet reasonable safety standards
*Takes a long time to build a reputation of trust, but not long at all to tear it down
an inspirational statement that encourages employees to internalize the values of the company.
Trust in business
is the cornerstone of relationships with customers, suppliers, employees, and others who have dealings with the organization.
-means to be reliable and carry through words with deeds.
-gained when an employee follows through ethical intent with ethical action.
Views of employees (2007-11)
-% of employees who witnessed wrongdoing declined by 10%
-% of employees reporting misconduct increased by 7%
-Pressure to compromise ethical standards increased
-Retaliation against whisteblowers doubled
Five most recent types of misconduct
1. misuse of company time (33%)
2. abusive behavior (21%)
3. company resource abuse (20%)
4. lying to employees (20%)
5. violating company Internet use policies (16%)
the degree to which an organization understands and addresses stakeholder demands. Comprises three sets of activities:
1. organization-wide generation of data about stakeholder groups and assessment of the firm's effects on these groups
2. the distribution of this information throughout the firms
3. the responsiveness of the organization as a whole to this information
requires tag an individual consider issues from a variety of perspectives other than one's own or that of the organization.
Ford Pinto Case
-Unsafe gas tanks could burst into flames
-Initial ethical legalism
-Risk/cost benefit analysis
-Too costly to replace the fuel tanks
-Compliance with law versus ethical behavior
1. Focusing on costs and benefits (ethical fading)
2. Ignores rights of various stakeholders
3. Omitted important factor from analysis - potential cost of plaintiff judgments
deliberate mirepresentation to gain an advantage over another party
Fraudulent business practices
occur when an organization purposefully engages in an act that harms another person, such as a customer.
-typical business loses 5% of annual revenues to fraud
-Median loss of 140,000
-lasted a median of 18 months before detection
use of one's occupation to misappropriate organization's resources or assets for personal gain.
-More likely to be detected by tip than any other way
-Asset misappropriation schemes the most common type of occupational fraud
Asset misappropriation schemes
when an employee steals or misuses resources
misusing one's position or influence in an organization for personal gain
Behavioral Indicators of Fraud
1. Living Beyond Means
2. Financial Difficulties
3. Unusual Close Association with Vendor/Client
4. Control Issues, Unwillingness to Share Duties
5. Divorce/Family Issues
6. Wheeler-Dealer Attitudes
7. Instability, Suspiciousness or Defensiveness
8. Addiction Problems
Financial statement fraud schemes
occur because an employee - typically a member of top management - causes a misstatement or omission of material information in the organization's financial reports.
Methods of Financial Statement Fraud
-Revenue Recognition Issues
(highest percentage in all cases)
-Improper asset valuations
Revenue recognition deficiencies identified by the PCAOB
1. Perform any or adequate substantive procedures to test existence, completeness and valuation of revenue
2. Review contracts or appropriately evaluate the specific terms and provisions
3. Test whether revenue was recorded in the appropriate period
4. Corroborate management representations
5. Perform adequate substantive analytical procedures on revenue
-Top management committed the fraud and overrode internal controls
-Company lacked independent members on its Board of Directors
-Salaries and bonuses often depended on Miniscribe "making the numbers"
-Inventory hole initially worth $2-4 million, then $15 million
-Miniscribe bought bricks to disguise as hard drives and conceal as inventory worth $4 million
-Repeatedly signed management letter stating financial reports were accurate and truthful
Corporate Governance Systems
establish control mechanisms to ensure that organizational values guide decision making and that ethical standards are being followed.
Characteristics of Corporate Governance Systems
-Accountability: refers to the relationship between workplace decisions, strategic direction, and compliance with legal and ethical considerations
-Oversight: provides a system of checks and balances that limit employees and managers' opportunities to deviate from established policies and strategies aimed at preventing unethical and illegal activities
-Control: the process of auditing and improving organizational decisions and actions, which relies on internal audit an internal control processes.
can be seen as a set of rules that define the relationship between stakeholders, management, and board of directors of a company and influence how that company is operating.
-emphasizes the separation of ownership and control in corporations
-Corporate managers and directors are agents
-Shareholders are the principal
-Aim: Construct rules and incentives to align the behavior of agents with the desires of the principals
-Desires and goals of agents and principals may not be in accord
-Difficult to verify the activities of the agents
-Agents likely to place personal goals ahead of corporate goals
-Results in conflict of interests between agents and principals
-Consistent with egoism
-Occurs if BOD fails to exercise due care in oversight
Managers are viewed as stewards of their companies, predominately motivated to act in the best interests of the shareholders.
-Focuses on enabling managers rather than controlling them because they can be trusted to act in the best interests of the shareholders.
Solutions to Agency Problem
1. Strong governance system
2. Executive compensation that ties managerial compensation to the financial performance of the corporation in general and the performance of the company's shares
3. Controlling management through BOD's action
4. Accounting system as a monitoring device
5. Audited financial statements
6. Stewardship theory and other theories
Importance of corporate governance
1. Better access to capital
2. Aids economic growth
3. Positive impact on stock prices
4. Ensures that business is fair and transparent
5. Ensures that companies can be held accountable
6. Leads to sustainability
7. Consequences of Weak Governance
Links managerial compensation to
-Financial performance of company in general
-Stock price performance
-Maximize stock price
recovery of money already disbursed
-SOX: allowed to recover compensation and stock profits from CEO's and CFO's of public companies in the event of financial restatements caused by misconduct.
-Dodd-Frank: requires that publicly listed companies themselves recover the compensation
"say on pay" provisions
Dodd-Frank provisions that require SEC-registered issuers to provide SHAREHOLDERS (not managers) at least once every three calendar years with a separate nonbinding say-on-pay vote regarding the compensation of the company's named executive officers, and the company's three other most highly compensated officers
Backdating Stock options
changing the grant dates of their options to coincide with a dip in thestock price, making theoptions worth more because less money would be needed to exercise then and buy stock
Problems with Executive Compensation
-Manipulation of earnings
-Excessive pay packages
-Ratio of U.S. CEO to lowest employee salary (344 to 1)
-Backdating of stock options
-Policy interventions through regulations
Internal governance mechanisms
help manage, direct, and monitor corporate governance activities to create sustainable stakeholder value
1. Independent directors
2. Audit committee
4. Internal controls
5. Internal audit
External governance mechanisms
intended to monitor the company's activities, affairs, and performance to ensure that the interests of insiders (management, directors, officers) are aligned with the interests of outsiders (shareholders and other stakeholders)
1. Financial markets
2. State and federal laws and regulations
3. Court decisions
4. Shareholder proposals
Most important mechanisms
1. independent directors enhance governance accountability
2. separate meetings between the audit committee and external auditors strengthen control mechanisms.
McKesson $ Robbins Case (Pharmaceuticals)
-Philip Musica (felon)
-Acquired McKesson and Robbins under fake identities
-20m phony assets through bogus sales documentation from fake distribution company
-Led to major corporate governance and auditing reforms.
-The SEC required that public companies have audit committees of "outside" directors and that the appointment of auditors be approved by the shareholders.
-(AICPA) adopted audit standards requiring that auditors verify accounts receivable and inventory.
Role of BOD and Officers
BOD has ultimate responsibility for success or failure of company
-Are legally responsible for the firm's resources and decisions
-Appoint its top officers
-Establish ethical culture and code of conduct
-Communicate these principles within organization:
1. Ethical and honest behavior
2. Compliance with laws and regulations
3. Effective management of resources and risks
4. Accountability of personnel
-Have fiduciary duty to safeguard assets and and make decisions that promote shareholder interests
Business judgment rule
the officers and directors of a corporation are immune from liability to the corporation for losses incurred in corporate transactions within their authority, so long as the transactions are made in good faith and with reasonable skill and prudence.
Oversight of financial reporting: internal audit function and external auditors
-SOX: mandated independence from management and financial expertise
-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
Best Practices of Audit Committees
1. Focus on financial reporting and strong internal controls
2. Review the company's whistleblower processes and compliance program
3. Understand the significance of risks to the company's operations and financial reporting
4. Consider whether the company's disclosures provide investors with the information needed to understand the state of the business
5. Set clear expectations for the internal audit function and communication with the external auditors
6. Understand the audit committee's role in information technology
Ethical systems built into corporate governance that:
-Prevent and detect errors and fraud:
1. Asset misappropriations
2. Materially false and misleading financial reports
3. Inadequate disclosures
-Ensure management policies are followed
-Can be overridden by top management
1.Do what CEO says, not what he does
2. Creates cynical attitude
Committee of Sponsoring Organizations of the Treadway Commission (COSO)
a joint initiative of five private sector organizations, dedicated to providing thought leadership to executive management and governance entities on critical aspects of organizational governance, business ethics, internal control, enterprise risk management, fraud, and financial reporting.
-COSO has established a common internal control model against which companies and organizations may assess their control systems.
COSO Internal Control
-Emphasizes roles of BOD, management and personnel
-Designed to provide reasonable assurance
1. Effectiveness and efficiency of operations
2. Reliability of financial reporting
3. Compliance with laws and regulations
COSO Integrated Framework
1. Control environment - sets the tone of an organization
2. Risk assessment - the entity's identification and evaluation of how risk might affect the achievement of objectives
3. Control activities - the strategic actions established by management to ensure that its directives are carried out
4. Monitoring - a process that assesses the efficiency and effectiveness of internal controls over time
5. Information and communication systems provide information in a form and at a time that enables people to carry out their responsibilities.
example of internal control failure: had to restate financial statements because of material weakness in internal controls; management caught internal control, not auditors
NYSE Listing Requirements
1. A majority of independent directors
2. Non-management directors must meet at regularly scheduled executive sessions without management
3. Audit committee with minimum of 3 independent members
4. Audit committee must meet separately with management, internal auditors, and independent auditors
5. Audit committee should review with the independent auditor any audit problems or difficulties and management's response
6. Audit committee should report regularly to the BOD
7. Must have internal audit function
8. CEO must certify to the NYSE each year they are not aware of any violation of NYSE standards
9. Must adopt and disclose corporate governance guidelines
10. Foreign private issuers must disclose any significant ways in which their corporate governance practices differ from those followed by domestic companies
Newly Amended Corporate Governance Listing Standards
1. Enhanced notification requirements: a company's CEO must notify NYSE after an executive officer becomes aware of any noncompliance with NYSE corporate governance listing standards, regardless of its materiality
2. Communications with directors: a company must disclose a method for all interested parties, not only shareholders, to communicate with the presiding director of the non-management or independent directors as a group.
3. Disclosure of business conduct and ethic waivers: companies must disclose any waivers of their codes of conduct and ethics granted to executive officers and directors within four business days,
4. Executive sessions: a company can hold regular executive sessions of independent directors as an alternative to executive sessions of non-management directors.
Codes of Ethics for CEO's and CFO's
-Must certify that financial statements have no material misstatements
-Have a separate code from company's code of ethics
-Disclosure of waivers on the code of ethics for senior management
-Any changes to the code of ethics
-If no code, must explain why
-Ethics and Compliance Officer Association (ECOA) has increased responsibilities resulting from SOX
-ECOA promotes ethical business practices
-Trusted member of management should be organization's ethics leader; create a positive ethical tone
-Chief compliance officer should see if new ideas pass the ethics "smell" test
an investment fraud that involves the payment of purported returns to existing investors from funds contributed by new investors.
-The setup eventually falls apart after:
(1) The operator takes the remaining investment money and runs.
(2) New investors become harder to find, meaning the flow of cash dies out.
(3) Too many current investors begin to pull out and request their returns.
- Returns to one set of investors from funds of subsequent investors; schemes require a consistent flow of new money
- $65 billion fraud
- Madoff sentenced to 150 year prison term
- $170 million to be returned to victims
- "Clawback" lawsuits to recover some of the money
- Madoff's Auditors, Friehling & Horowitz:
>Did not perform anything remotely resembling an audit
>Did not perform procedures to confirm securities
>Failed to document findings and conclusions on limited procedures, as required by GAAS
>Did not test internal controls
>Was not independent
-Blame - Madoff Fraud
Bernie Madoff used his reputation to gain favor with investors
Auditor - Friehling & Horowitz
SEC - failed to act on tips 8 years before failure from external whistleblower
>Concerns over watchdog ability
-First one to pull off a Ponzi scheme
-Attracted investors with 50-100% returns from arbitrage on international reply coupons
-Was convicted for mail fraud and larceny
-Ponzi scheme in San Diego masked as an investment company
-Promised 40-50% return on investment
-Conspired with the mayor
-Caught when investors demanded returns and the checks bounced
Common elements of Ponzi schemes
1. Conducted by Trusted Individuals
2. Investors don't truly understand how the returns are made????
3. Promise of returns way above Market
4. Appeal to Greed - "but my friend made the return he was promised"
5. Faith that one Individual knows more than the market
6. Lack of depth in Corporate structure -(Either no auditors or weak auditors, Lack of 7.Experienced Staff, Weak or no Board of Directors, Often have nepotism in key positions)
SEC Prevention Methods
-require all investment officers to hire an independent public accountant to conduct an annual "surprise exam" to verify assets.
-require all investment advisors to maintain a third-party written report assessing the safeguards that protect the clients' assets.
-advocating reward for whistle blowers and demanding no retaliation towards them
disclosure by organization members of illegal, immoral, or illegitimate practices under the control of their employers to persons or organizations that may be able to effect action.
Moral Hazards and the Financial Crisis
-Excessive risk taking and mortgage meltdown
-"Moral hazard" as contributing factor
-Corporate governance failings
-Breach of fiduciary duty
-Unjust enrichment for insurance claims
-High risk lending strategy
-Shoddy lending practices
-Steering borrowers to high risk loans
-Polluting the financial system
-Securitizing delinquency-prone and fraudulent loans
-Federal False Claims Act & Whistleblowing
an undersirable action taken against a whistleblower in direct response to his or her action.
Elements of Whistleblowing
1. The whistleblower
2. The whistleblowing act
3. The party to whom the complaint is made
4. The organization involved with the complaint
situations where passersby don't offer assistance when other parties are present
-studies have shown that the greater number of parties present, the fewer the incidents of assistance.
Protection for Whistleblowers
-Legal protection for whistleblowers
-Section 806 of SOX:
-confers legal protection upon employees of public companies that report suspected violations of a range of federal offenses, including those relating to fraud against shareholders.
-U.S. Department of Labor directly protects whistelblowers who report violations of the law and refuse to engage in any action made unlawful.
R. Allen Stanford Ponzi Scheme and Whistleblowing action
-cheated investors by selling them certificates of deposit through the bank he controlled in Antigua and telling them that the money would be invested in stocks and bonds.
-Whistleblower was ignored allowing Stanford to cheat more investors
Dodd-Frank Wall Street Reform and Consumer Protection Act
-2010 passage of this increased monetary incentives for whistleblowers who aid in recovery of $1M or more, can receive 10-30% of the amount
-Concern: Will whistleblowers go straight to external sources instead of internal?
-Protection from being fired; including reinstatement, double back pay, and special damages
-Whistleblowers who only report internally may not be protected
-Also encourages accountants and auditors to report wrong doing
-Public accounting industry worried about client confidentiality
Incentive provision ethical?
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