CH-6 Professional Accounting in the Public Interest, Post Enron – Business and Professional Ethics for Directors, Executives and Accountants : Book Guide

Chapter 6 – Professional Accounting in the Public Interest, Post Enron Chapter Questions and Case Solutions Chapter Questions 1. Answer the seven questions in the opening section of this chapter. • Who really is my client - the company, the management, current shareholders, future shareholders, the public? SOX and IFAC have now spoken on this issue. See discussions in the chapter under Priority of Duty and related to Figure 6.1. The public interest ranks first, followed the profession, and by current and future shareholders or the employer. Management ranks last. • In the event I have to make a decision with ethical ramifications, do I owe primary loyalty to my employer, my client, my boss, my profession, the public or to myself? It depends on the significance of the decision, on who is acting ethically and who is not, but consideration should be given to the stakeholders in the reverse order to that listed in the question except that duty to yourself as a professional should usually rank last. • Am I, as a professional accountant, bound by professional standards even when acting as an employee? An employed professional accountant must follow the profession's standards or be sanctioned. Most codes now confirm this. Some professionals would argue that the rules ought to be tighter for those in the audit function, but I do not agree. The mess created by an unethical accountant in management can affect as many, if not more, stakeholders if the company is wound up. • Is professional accounting a profession or a business? Can it be both? Yes, but the problem comes when the drive for profit overtakes the need for the exercise of proper ethical values and professional practices based on those. Shaving hours/costs on a job results in poor quality and raises the risk of audit failure, misrepresentation and poor judgments. • When should I not offer a service? When the client is unethical, or the risk to reputation is too high, or there is a conflict of interest involved, or the service involves breaking the law. Guidelines are now offered by the SEC per SOX, and these are discussed in the text. As well, an extensive discussion is offered in this chapter about when services should be offered. • Can I serve two clients with competing interests at the same time? Rarely can this be done effectively because an optimal decision for one client is rarely the optimal decision for the other. It is very difficult to maintain the appearance and discharge the responsibilities of a fiduciary to two or more clients when their interests are different or may diverge in the future - see the Locker Room Talk case. Such double service should not be undertaken without informing the two parties and advising them to obtain outside counsel to verify the service offered. Safeguards are needed, as is scrupulous attention to fairness to all. There are, however, times when the interests of the clients are not highly conflicting (such as when an accountant audits a supplier and the buyer of that firm’s product, or a bank and a customer of that bank) and where the accountant is bound to follow GAAP and GAAS. These are designed to be neutral between clients in order to serve the public interest by ensuring objectivity. The auditor, however, must be independent of all clients, and be seen to be independent. • Is there any occasion when breaking the profession’s guideline against revealing a confidence is warranted? Yes. The profession's confidentiality guideline was not intended to protect those guilty of unethical acts, particularly if the harm caused by ignoring an unethical act would cause great difficulty. 2. What is meant by the term "fiduciary relationship"? A relationship where the professional is dealing with a matter of vital significance to a another party, where there is such a difference in knowledge and expertise between the two that one must place trust in the competency of the professional and that s/he will act in the other's best interests. 3. Why are most ethical decisions accountants face complex rather than straight forward? More than one stakeholder’s interests are involved and trade-offs between the interests of these stakeholders are tough to assess (management vs. shareholders vs. lenders etc.), particularly where fairness of disclosure is concerned. Outcomes of such decisions are difficult to predict, so consequences have to be weighed carefully (going concern problems can arise, etc.). Also, usually the output of accountant’s decisions is subject to far more intense scrutiny than for other professionals such as doctors or lawyers. 4. When should an accountant place his/her duty to the public ahead of his/her duty to a client or employer? Because the public (in the form of future shareholders, lenders, customers etc.) is the ultimate user of some services such as the attest function and external corporate reports, and if internal reports or systems are faulty the decisions made will ultimately affect such external stakeholders as well. Focusing just on existing internal stakeholders tends to obscure this. Also when the public hears of a bad decision/action of an accountant, whether it is internal or external doesn't matter, it darkens the reputation of the entire profession as happened in the Arthur Andersen case. 5. Which would you chose as the key idea for ethical behavior in the accounting profession: “protect the public interest” or “protect the credibility of the profession”? Why? Protecting the public interest will, in the long run, protect the credibility of the profession. Unfortunately, when professionals focused of protecting the credibility of the profession, they try to sweep problems “under the rug”. Almost always, these secrets emerge and embarrass the profession, which then has to act in the public interest to salvage the profession’s credibility. 6. Why is maintaining the confidentiality of client or employer matters essential to the effectiveness of the audit or accountant relationship? If it were known that an auditor or accountant were likely to disclose secrets related to competitive advantage, or discussions of potential liability or concern, it is extremely that accounting personnel would ever be consulted or made aware of them. This would severely limit the participation and effectiveness of accountants, who bring ethics and expertise to the discussions) and of the audit role. 7. What is the difference between exercising “due care” and “exercising professional skepticism.”? “Due care” refers to a standard of thoroughness, comprehensiveness and the exercise of judgment in a manner similar to other properly qualified professionals in the circumstances. This is often verified in court by the testimony of expert witnesses from the accounting profession indicating what they would have done. “Exercising professional skepticism”, on the other hand, refers to the constantly searching, challenging, comparing and verifying mindset a professional accountant is expected to apply so that incongruent facts and/or questionable actions are identified and explored. It is possible that expert witnesses could be called to testify whether the professional skepticism exercised by another professional exhibited “due care”. 8. Why did the SEC ban certain non-audit services from being offered to SEC-registrant audit clients even though it has been possible to effectively manage such conflict of interest situations? Faced with the inability of one of the largest and most respected firm’s (Arthur Andersen) inability to resist the lure of profit and protect the public interest, and the fact that such conflicts were common practice, SOX required the SEC to eliminate the most problematic conflicting services. The investing public and government observers would not have been satisfied with less. 9. Where, on the Kohlberg framework would you place your own usual motivation for making decisions? You may want to suggest a trial decision for the class to use to operationalize this question, such as: whether or not to engage in a barter or cash transaction to avoid paying income tax, or whether to report that the government overpaid you on your tax refund. 10. Why don’t more professional accountants report ethical wrongdoing? Consider their awareness and understanding of ethical issues, as well as their motivation and courage for doing so? Frankly, although they are able to detect ethical wrongdoing, they may have misplaced loyalty to their boss, or company/employer instead of to the public interest. They may also lack the courage necessary to oppose their boss or blow the whistle, partly because they fear loss of their job or public denigration. 11. Which type of conflict of interest should be of greater concern to a professional accountant: actual or apparent? Per the discussion related to Figure 5.6, they should both be of great concern given their potential impact on the professional’s reputation, but actual conflicts are more important given the harm that could be caused to the interests of the client involved. 12. An auditor naturally wishes his/her activity to be as profitable as possible, but when, if ever, should the drive for profit be tempered? When it interferes with the auditor’s duty to the public interest, profession, or client (shareholders). 13. If the provision of management advisory services can create conflicts of interest, why are audit firms still offering them? Because they are lucrative services that can benefit their clients without compromising the auditor’s objectivity. 14. If you were an auditor, would you buy a new car at a dealership you audited for 17% off list price? No, this appears to be a more than nominal discount, not available to all, and which could be seen to sway the auditor’s judgement toward management and contrary to the interests of stakeholders and the public. 15. If you were a management accountant, would you buy a product from a supplier for personal use at 25% off list? No, unless it could be shown that this did not adversely affect your judgement, and you received permission from your boss and the designated (ethics) officer of your company. 16. If you were a professional accountant, and you discovered your superior was inflating his/her expense reports, what would you do? Report the matter to the ethics officer or an independent official. Confronting your boss is not likely to generate a positive result. 17. Can a professional accountant serve two clients whose interest’s conflict? Explain. See the answer to the second-last bullet in question 1 above. 18. If an auditor’s fee is paid from the client company, isn’t there a conflict of interests that may lead to a lack of objectivity? Why doesn’t it? Yes, this is a normal practice that could give management an opportunity to influence the judgement of the auditor. However, corporate boards (via their audit committee) should negotiate and approve the audit fee, thus lessening the chance for undue influence to occur. This has now been mandated by SOX/SEC. 19. Why does the IFAC Code consider the appearance of a conflict of interests to be as important as a real, but non-apparent, influence that might sway the independence of mind of a professional accountant? Because of the potential impact on reputation of the professional and the profession. See the answer to question 11. 20. What is the most important contribution of a professional or corporate code of conduct? See the answer to question 1 in Chapter 3. 21. Are one or more of the fundamental principles found in codes of conduct more important than the rest? Why? I would argue that the first one listed - To, at all times maintain the good reputation of the profession - is the governing principle because it focuses attention on the goal of maintenance of the trust of the public, not on self-interest, or on the interests of the short run. For example, it could be argued that technical competence was the paramount principle, but technical competence without integrity or objectivity can lead to trouble. Also, the reputation principle covers more than accounting matters, and it reminds accountants that criminal behavior or unethical business and personal practices can also affect the reputation of themselves and the profession. 22. Was the "expectations gap" which triggered the Treadway and Macdonald Commissions, the fault of the users of financial statements, or the management who prepared them, or the auditors, or the standard setters who decided what the disclosure standards should be? All of these to some degree. But the accounting profession and its members are involved in most of these roles, and have the knowledge and expertise to close the gap. Usually, the stakeholder with the highest level of knowledge and expertise is seen to be responsible for remediation. Also, in this case, the profession is self-regulating and if it is seen not to be able to handle its responsibilities, then government will do so. There is, it seems, no point to passing the buck. 23. Why should codes focus on principles rather than specific detailed rules? Because professionals need principles and can be interpreted when specific rules don’t cover a situation. Also, principles are far easier to understand and remember than rules. 24. Is having an ethical culture important to having an effective system of internal control? Why or why not? Yes, because an effective system of internal control depends upon the integrity and ethical actions of the participants. Without integrity and ethical action, top management, directors and auditors can be lied to – at least in the short run. This was the case in many of the financial scandals. 25. What should an auditor do if he/she believes that the ethical culture of a client is unsatisfactory? The auditor should immediately bring the matter to the attention of the person in charge of the audit, so that the increase in audit risk may be assessed and extra audit tests or a qualification or resignation can be considered. Also, the problem should be brought to the attention of the client's the top management – particularly to the CEO and CFO, and to the Audit Committee of the Board, and the internal auditors so that remedial action can be undertaken and increased costs and/or tests by the internal auditors arranged. If the matter is not corrected the auditor should consider qualifying their audit report and/or resigning the audit. They should also consider making the reason for their resignation clear to the public . 26. Are the governing partners of accounting firms subject to a “due diligence” requirement similar to that for corporation executives in building an ethical culture? Can a firm and/or its governors be sanctioned for the misdeeds of its members? Yes. In some jurisdictions the firm can be disciplined and fined. Also, any lawsuit will require the resources of the firm to defend or settle and will increase liability insurance costs. Possibly, some of the partners invested capital may be paid out in a settlement, even in a limited partnership. Personal capital may be required where the firm is a traditional partnership, or where they are personally negligent. 27. An engineer employed by a large multidisciplinary accounting firm has spotted a condition in a client’s plant that is seriously jeopardising the safety of the client’s workers. The engineer believes that his/her professional engineering code requires him to report this condition to the authorities, but professional accounting codes do not. How should the head of the firm resolve this issue? After checking that the safety problem is serious and the engineer is correct in his/her interpretation of his/her code, the senior partner should make sure that the client has been advised of the problem and has been given a chance to respond with a satisfactory explanation, and/or has agreed to rectify the problem. The client should understand that the problem will have to be reported unless rectified. The remedial action must be verified. A professional engineer can be reasoned with, but not ordered not to report such a violation. A multidisciplinary firm should have a code and culture that supports professional codes in a responsible manner. See also the discussion of the Multidisciplinary Practice case in this chapter. 28. Transfer pricing can be used to shift profits to jurisdictions with low or no tax to reduce the taxes payable for multinational companies. If such profit shifting is legal, is it ethical? Was Apple well-advised to shift $30 billion in profits to its Irish subsidiary, where it paid no corporate income taxes on those profits? Why, and why not? If transfer pricing is legal, it almost certainly is not ethical. It denies tax revenue to the jurisdiction from which it is earned, even though by law, it should be paid in that jurisdiction. It shifts that income to a jurisdiction with income tax no or a lower tax rate. Apple was ill-advised to make such a transfer, as public opinion quickly demonstrated. Americans, who paid most of the monies earned by Apple, believed that Apple was not paying its fair share of tax in the U.S. Because it is a mechanism used by MNCs around the world, the Organisation for Economic Co-Operation and Development (OECD) has developed a set of guidelines to help companies determine the appropriate transfer price and avoid charges and fines for misallocations. There are three different measurement approaches identified by OECD: • Comparable uncontrolled price • Resale price method • Cost-plus method 29. Many professional accountants know of questionable transactions, but fail to speak out against them. Can this lack of moral courage be corrected? How? Acquiring moral courage is not easy. Accountants who know of questionable transactions may be reluctant to report them for fear of repercussions including loss of job or client, acquiring a reputation which means that others will be less likely to hire the accountant, and the consequences to those who have committed the questionable transactions. One way to help instill or support moral courage for such situations may be through professional accountants’ organizations; the discussion among peers about what to do in such a situation may help. 30. Why don't codes of conduct or existing jurisprudence provide sufficient guidance for accountants in ethical matters? New variations of problems are arising every day, and existing codes/jurisprudence cannot anticipate these. Codes of conduct are rarely written as exhaustive documents (people won't read them and can't remember all the rules anyway) but rather stress principles which need to be interpreted for each specific application. On complex or difficult ethical problems, such interpretation usually requires judgment that is shaped by experience, so consultation with colleagues and other experts (lawyers) is desirable. Case Solutions FAMOUS CASES 1. Parmalat – Europe’s Enron What this case has to offer Starting as an Italian milk producer in the Parma region, Parmalat grew to become a multinational company, widely regarded as one of Europe’s most successful food businesses. However, Parmalat will be remembered as one the biggest European corporate frauds ever. The company's bankruptcy caused vast losses affecting multinational banks, investors in US and European markets, and tens of thousands of employees and farmers. This case presents an interesting combination of conditions that created motives and fostered opportunities to commit fraud. The fraud involved the former CEO Calisto Tanzi and members of his family, running the company as a "family business". Rapid expansion, unprofitable acquisitions and poor management led the company to bankruptcy. Nevertheless, Tanzi and other executives manipulated the company's financial statements to mask the problem, while continued raising capital through marketable securities. Parmalat's true financial condition was uncovered when the company failed to do a scheduled bond repayment in December 2003. Further investigation revealed a vast network of fraudulent activity that involved creative tax planning, complicated off-balance sheet transactions, related-party transactions, illegal diversion of funds, and falsification of documents. This case can be also used for discussion of a wide range of governance and audit issues including: inadequacies of governance, adequacy of auditor’s risk assessment, completeness of liabilities, confirmation of receivables, transactions with related parties, and responsibility when relying on other auditor’s work. Teaching suggestions and discussion I start the case describing Parmalat’s business of the manufacture and distribution of foods and drinks worldwide – many are brands that the students have heard of or consume. Then I ask the students how it is that a food company, which operates in a stable, cash-generative sector, can develop a shortage of cash. They respond by suggesting fraud as well as financing a series of acquisitions in Asia, southern Africa and Australia, as well as adding to its North and South American holdings and moving into Eastern Europe. Many of these additions offer potential synergy gains from merging business, but some are in seemingly unrelated markets. I point this out, and ask what the chances are that a firm like Parmalat will be successful at entering unrelated business such as owning a soccer team, starting a chain of travel agencies and hotels, or sponsoring a Formula 1 racing teams. I also ask whether the use of derivatives to raise funds is advisable for Parmalat. At this point, students should start thinking that something is not quite well with this business: a dairy and drinks manufacturer, growing at a fast pace, entering unrelated markets and business, involved in unclear financing operations. Following this analysis of the business’ inherent risk, we explore how the Tanzi family kept 51% of Parmalat’s voting shares after going public in the 1990’s, and how Calisto Tanzi (CEO & Chairman) had control of the firm and undertook activities beyond the oversight of its Board of Directors. We review the activities undertaken to see how they were used to fraudulently bolster the company’s finances. I close the case by leading the discussion to the auditor’s responsibility in cases of fraud and what went wrong with their audit procedures in this case. I stress the need for independent, objective, truly challenging auditors, which are prepared to act in the best interest of the public. Discussion of ethical issues 1. What conditions appear to have allowed the Parmalat situation to get out of control? The shortcomings of the system of internal controls included: lack of supervision and control; violation of statutory provisions and provisions of the Bylaws by Directors and executives, who oversaw an organization that was inadequate for such a large and complex group; alterations of the accounting records; publication of falsified financial statements; inadequate documentation of material transactions; inadequate supervision and approval of various corporate processes; and lack of standardized administrative procedures and processes. This situation permitted unlawful behavior to continue for several years. 2. What specific audit procedures could have uncovered the Parmalat fraud earlier? The most important audit procedure in detecting fraud is adequately assessing significant risk factors. The auditor needs to exercise professional judgment when considering risk factors individually or in combination and whether there are specific controls that mitigate the risk. The size, complexity, ownership and control environment of a company have significant influence on the identification of relevant risk factors. Analytical procedures are useful tools in assessing risk, examples of these procedures are: modeling changes in financial statements, reasonability analysis, comparison to industry practices, etc. If the probability of fraud is considered high, and the effectiveness of controls low, the audit firm should apply additional procedures to ensure that common fraud types will be detected. Most common frauds are: improper revenue recognition, overstatement of inventories, capitalization of expenses, creation of discretionary cookie jar reserves, understatement of liabilities, and misappropriation of company funds by controlling executives. In this case, definitively an audit confirmation was not enough audit evidence to ensure the existence and ownership of the overly material 3.95 billion Euros ($5 billion) bank account in Cayman Islands, nor was it appropriate to send confirmations through the client’s internal mail system. 3. What audit steps should Deloitte have taken with regard to the seventeen off-shore subsidiaries that continued to be audited by Grant Thornton? Relying on a second (agent) auditor’s work is valid up to a certain extent when business reasons make a local firm more efficient than the principal auditor. It is also acceptable when the auditee is not able to provide the group auditor with sufficient access to subsidiary companies due to valid reasons (previous contracts and agreements, joint venture control, etc.). International Accounting Standards allow shared audit opinion, and the IASB recently issued guidance in this matter. However, even though auditors can split responsibility in some cases, the principal auditor is publicly seen as ultimately responsible for all audit work and opinion. This responsibility should have caused Deloitte & Touche (Parmalat’s principal auditor) to closely monitor audits performed by Grant Thornton, thus reviewing their risk assessment, audit plans, work papers, and conclusions. Probably Deloitte should have directly performed the audits deemed as high risk through the firm’s partner offices in each subsidiary’s’ country. 4.What impact will the Parmalat fraud have on Grant Thornton and on Deloitte & Touche? In 1999, Deloitte & Touche replaced Grant Thornton as auditors of Parmalat, but Grant Thornton maintained the audit of 17 Parmalat’s Subsidiaries, including Bonlat. Under the Italian Law, in case of accounting fraud the auditors are able to deny any charges where the company’s executives misled them in the course of their audits. After the company’s bankruptcy, Deloitte & Touche denied wrongdoing and Grant Thornton severed its links with its Italian arm. Eleven members of Grant Thornton were charged of fraud. However, unfortunately, it is likely that the accused auditors will be discharged or subject of short sentences, as were the Parmalat’s convicted executives. Major international auditing firms are usually organized as an international organization of national firms. This means that if the Italian firm runs into lawsuits that go against the firm, the assets of the international firm in other countries are not directly affected, nor are the assets of partners in other countries directly at risk. However, the reputation of the international firm will suffer if one of its member firms is alleged to have committed wrong-doing and convicted, and that will probably trigger a loss of clients and/or future revenue in member firms other than Italy. Therefore there will be an indirect loss to out-of-country firms and partners. In addition, if the SEC or other regulators suspect that the international firm has a weak governance and control structure, they may suspend the firm’s ability to audit new SEC-registered clients or apply some other sanctions which will have an impact on revenues and/or reputation. The executives convicted included former CEO Calisto Tanzi, chief financial officers Fausto Tonna and Alberto Ferraris, internal auditors, and Tanzi’s own brother and son. As Italian law waives jail terms for first-time offenders sentenced to no more than 2 years, eight of the 11 convicted were granted suspended sentences and will not be required to serve time in prison. Tonna was sentenced to 2 1/2 years, spent several months in detention in 2004 and was expected to work with social services instead of returning to jail. Lawyer Gian Paolo Zini, sentenced to 2 years, and former CFO Luciano Del Soldato, sentenced to a year and 10 months, were also expected to work with social services in a bid to reduce any jail sentences other criminal trials were awaiting to be resolved. 5. How did the following areas of risk in Parmalat’s control environment contribute to the fraud: integrity and ethics, commitment, audit committee participation, management philosophy, structure, and authority?  The company’s management lacked integrity, objectivity and ethics, using company’s funds to finance personal endeavors of the CEO and his family members, such as being soccer team owners and participate in Formula 1 races.  The board of directors was not independent and its members, including the audit committee, lacked sufficient financial expertise to understand off balance sheet derivatives and appropriately assess the impact of related party transactions.  The company’s structure grew too fast without consolidating authority and controls. A company with several products in multiple countries, with access to global capital markets cannot be run as a family business. 6.How did the following areas of risk in Parmalat’s strategy contribute to the fraud: changes in operating environment, new people and systems, growth, technology, new business, restructurings, and foreign operations? When businesses are growing at fast pace, management is generally concerned with constantly finding new acquisition targets and with restructuring and merging operations. However, there is little attention paid to “back office” functions including accounting, internal audit and human resources. In addition, merging information systems after an acquisition is a tremendous task that takes considerable time. Finally, the culture shock derived from change in reporting channels and authority may seriously weaken the control structure of a company right after material acquisitions. A lack of control is even more pervasive when several acquisitions are in different countries were other barriers such as language, local laws and cultural differences make the integration more difficult. All these factors contributed to increase the inherent risk of control breakdowns in Parmalat, where many changes in the operating environment were occurring without adequate planning. 7. Should the banks and other creditors be legally responsible for so-called irresponsible lending that contributes to higher than necessary losses? If so, how can they protect themselves when dealing with clients whose viability is in doubt? Banks can provide funds to a client by direct lending or by issuing market securities in their behalf acting as investment bankers. In both processes, and depending on the size of the loan, lenders have to go through a credit analysis process that involves not only looking at the company’s financial statements but also to other indicators such as managements’ competency, industry sector, market potential, cash flows, credit ratings and probability of default. It is very likely that Parmalat’s bankers were aware of problems with the company’s operating cash flows, given its difficulty to keep growing or even consolidate its acquisitions without additional cash, and its unusual appetite for derivative products. Moreover if the company’s bankers were instrumental in setting up offshore accounts and issuing Parmalat’s debt securities at the same time. In Italy, financial institutions lending money to a client prior to insolvency have to pay back interest and other fees if there is suspicion that the institutions knew the client was in financial trouble. This case points out again the importance of independence and objectivity, but now from the bankers’ perspective while lending or issuing securities. Banks can protect themselves in doubtful cases by several ways including performing appraisals and due diligence assessments of the client, demanding collateral, sharing exposure thorough syndicated loans, using external agencies’ credit ratings, or ultimately denying granting credit to certain clients. 8. Do you think that applying bankruptcy projection models should be a regular tool used by auditors, creditors and regulators to assess the reasonability of a company’s financial statements? Bankruptcy models are analytical models, often based on financial ratios, and used in assessing the likelihood of a company’s bankruptcy. For obvious reasons, creditors regularly use these models when analyzing credit applications, however auditors and regulators might benefit in applying these models, because they constitute a systematic, efficient and effective method of review and have been tested by researchers. Bankruptcy model results may provide the auditor with additional insights about the client company's financial condition that a more traditional analysis of financial statement’s ratios data might not reveal. For example, showing if the overall probability of bankruptcy diminishes over the years would assist the auditor in assessing at what point substantial doubt exists about the client's ability to fulfill its financial commitments, thus increasing the risk of accounting fraud targeted to disguise the client’s true condition. 9. Is independence important in corporate governance? What are the most recent rules on corporate governance for public firms? As evidenced in this case, independence and objectivity are fundamental in maintaining corporate governance. Recent corporate governance rules for public firms, including NYSE rules (2004), NASDAQ rules (2004) and Sarbanes-Oxley Act, require independent auditors and directors to oversee management. 10. Discuss which changes could be made to Parmalat’s control system and corporate governance structure to mitigate the risk of accounting and business fraud in future years.  Board of directors with more members  Majority of independent directors  Audit Committee made up of financially expert, independent directors elected by the board  Frequent audit committee meetings  Separation of the CEO and chairman of the board roles  Auditor and senior executive appointments by the board of directors  Internal audit functional reporting to the board’s audit committee  Companywide ethics awareness programs  Confidential whistleblower programs for accounting and ethics concerns Other Events April 18, 2006. “Deloitte Italy seeks to sue Parmalat, alleging fraud”, Bob Van Voris of Bloomberg News, National Post, April 19, 2006, page FP11. Deloitte (Italy) asked for permission to sue Parmalat in a federal court in New York. Useful Videos, Films & Links Gumbel, Peter (2004) “How it All Went So Sour” Times, Nov. 21sthttp://www.time.com/time/magazine/article/0,9171,901041129-785318,00.html “Parmalat in bankruptcy protection” BBC News, Dec. 24th 2003 http://news.bbc.co.uk/2/hi/business/3345735.stm “Parmalat on road to recovery” BBC News Video, Sept. 2008 http://news.bbc.co.uk/player/nol/newsid_6650000/newsid_6654700/6654789.stm?bw=nb&mp=wm “Italy puts 56 on trial in milk scam” Reuters, Feb 27th 2009, http://www.reuters.com/news/video?videoId=78138 PROFESSIONAL & FIDUCIARY DUTY CASES 1. KPMG Partner Shares Confidential Information with a Friend What this case has to offer This case describes what happens when a senior professional, thinking he was helping a fried in a small way, ruined his own career, damaged his firm’s reputation, and caused his firm to resign from two major audits. Teaching suggestions Ask what virtue London was acting on when he gave his friend tips. Ask what virtue he should have acted on as an audit partner for his firm on behalf of his client. Ask which should take precedence in this situation. Although loyalty may be an admirable quality, it cannot justify what was done here. Discussion of important issues 1. Should an accounting firm have to resign as the auditor of a company when the partner in charge of the audit is convicted of releasing confidential information about that audit client? Although they would not have to resign, one can see the wisdom in doing so. In essence, they are admitting that they did not provide the services they promised, confidentiality being among the priorities of first order. That acknowledgment is honorable in the circumstances. 2. How can accounting firms ensure that their partners and staff do not release confidential information? KPMG immediately took steps to improve and increase their monitoring and training of their accounting staff. Constant reminders may be required for some people. 3. Livent – When Maria… When? What this case has to offer This case illustrates the Professional Accountant’s responsibility to not be associated with misleading or false information. Maria Messina, CA and Livent’s chief financial officer delayed making public the irregularities in the company’s accounting policies. This case shows the personal and professional trade-offs that professional accountants may face between publicly disclosing accounting irregularities and pleasing upper management to keep their employment or fearing other negative repercussions. The most important aspect of this case is to determine when Maria should have spoken out inside Livent, or with the auditors, and in public once she was aware of the accounting manipulations. The case provides an opportunity for students to consider what steps a professional accountant could and should take to reveal misleading or false information. Teaching suggestions It would be useful to ask the class what responsibilities of a professional accountant are involved in the case. This should lead to a discussion of: • Service in the public interest • Applicability of professional accounting codes whether in public practice or when employed • No association with a misrepresentation • Integrity From this point, except for one issue, the questions at the end of the case present a reasonable approach for discussing the case. That issue is how Maria should have reacted when Garth Drabinski became abusive, and I would ask that at the end of the case. Discussion of important issues 1. Did Maria blow the whistle at the right time? Why or why not? The case facts seem to point out that it was too late when she blew the whistle, which caused significant harm to many stakeholders including shareholders, auditors, herself and others. It is reasonable to expect that an accountant in her situation would try to reason with her boss before going public; however, she waited too long to gather the courage to confront her boss and Drabinski. She should have tried to talk to her boss and also sought legal counsel immediately after she became aware of the fraud in July 1997. She should have acted as soon as there was any evidence that the manipulations were not being corrected. Maria’s personal circumstances – that led her to delay making an issue of the deception - while personally trying, must be set aside by professional accountants behaving professionally. 2. Was her planned response appropriate? Why or why not? No, it was not. In a situation like this, waiting is likely to make things worse for both the company and the professional accountant acting as CFO. The fraud was clear and once she became aware of it she became accomplice by not doing something right away. 3. How would you suggest she should have dealt with the problem? First, she should have tried to deal with the issue internally by talking to her boss immediately, or by reporting the issue to the chief internal auditor or compliance offices. As soon as there was evidence that her chat with Eckstein got nowhere, she should have gone to Drabinski and then on to the Audit Committee. Second, if the internal mechanisms did not work, she should have sought legal advice and could have tried to disclose the fraud to the company’s auditors –her former colleagues – or to the appropriate regulatory agencies such as the stock exchange. Confidentiality rules were not intended to hold back employees so that frauds could succeed or go undiscovered. She could also have discussed the matter with the Ethics Officer of her professional accounting body for advice. As an ultimate response, she could have resigned, thereby disassociating herself from any misleading information. She should have considered blowing the whistle publicly. 4. Should whistle-blowing be encouraged? Why or why not? Whistle-blowing should definitely be encouraged. Appropriate whistle-blower programs should be in place to protect employees who fear negative repercussions from their superiors. In several instances accounting fraud has been discovered after an employee became a whistle-blower. Most publicly listed companies, as part of their entity-level financial reporting controls, have a whistle-blower program. The existence of such programs encourages employees to come forward since they convey the expectation that whistle blowing is appropriate and useful to the Board of Directors. How should Maria have reacted to Drabinski’s abuse? There should be a company policy covering verbal or physical abuse that states clearly that it is not appropriate and will result in appropriate discipline. In some jurisdictions such behavior can result in human rights charges against the employer for failing to properly manage their work force and to provide a harassment-free workplace. Where the CEO or some other top official is the problem, the employee has to choose whether to go along or to make the abuse known to the Chief Ethics Officer and to the Governance Committee of the Board. This takes guts because the working relationship with the CEO could get worse. On the other hand, it may get better if the CEO thinks that someone will stand up to him. Many people leave the company when confronted with such choices, leaving the CEO free to do it again with someone else. Useful Videos, Films & Links “Livent co-founders found guilty of fraud, forgery” CTV News Video, Mar. 5th 2009 http://toronto.ctv.ca/servlet/an/local/CTVNews/20090325/Livent_trial_090325/20090325?hub=Toronto Acharya, Madhavi & Tom Yew (2009) “Livent looks like our WorldCom” The Star, Mar. 26thhttp://www.thestar.com/News/GTA/article/608510 Gray, John (2009) “Livent: I told you so” Canadian Business Magazine, Apr. 27thhttp://www.canadianbusiness.com/managing/strategy/article.jsp?content=20090427_16708_16708 4. The Lang Michener Affair What this case has to offer The Lang Michener Affair provides a surprisingly rich view of a self-regulating profession - the legal profession - on topics which are almost all transferable to the accounting profession. The case deals with lawyer at the partner level who is breaking the law, and the efforts of a whistleblower, junior lawyers, senior lawyers, the law firm and the legal profession to assess, come to grips with, sanction, and be fair to potentially harmed clients of the individual. Along the way, the following specific issues are raised: 1. The role of a professional with regard to: a. fiduciary responsibility, b. responsibility to self, the profession, clients, c. loyalty to the firm, d. the self-regulatory process, e. whistle blowing, f. conflicts of interest. 2. Do junior professionals have the same ethical responsibilities as their seniors, or can they be excused if seniors are involved? 3. Problems in ethical decision making, including: a. Is there a victimless crime? (i.e.. a no-impact action) b. The process of rationalization employed to downgrade theseriousness of an action. 4. Should the purpose of a self-regulating mechanism for a profession be to "add luster to the profession?" Teaching suggestions I use the Lang Michener Affair to lead off the segment on the role of a professional. It provides the student with an opportunity to think through many of the basic issues confronting professionals in a non-threatening (non-accounting) framework. After the case discussion I go on to discuss the rest of the issues in the chapter on "Roles". I set the case up with a statement covering why we are looking at a sister profession and why it is important to view accounting as a profession rather than as a mechanical exercise. This leads into the questions at the end of the case which are intended to move in focus from professions in general, to the specifics of accounting. The discussion takes up to 45 minutes, and is frequently punctuated by bouts of incredulity on the part of the students. This is a real-life case, however, and the students need to be reassured that the scenario is not far-fetched from an accounting perspective. Having lived through a few of these, I know! Discussion of ethical issues Fiduciary duty/responsibility (Question 1): The primary reason for professionals to behave more ethically than non-professionals is that their duties involve services to the public on matters of great import (health, wealth, etc.) to the public and where there is an expectation of trust by the public that the public's interests will be served properly. This is the essence of fiduciary duty or responsibility (see text pages 54, 57, and 227). If the trust inherent in the fiduciary relationship is not maintained, the profession will lose credibility and its rights ( like self-governance or a practice monopoly) will be curtailed and its ability to command premium fees will diminish. It is interesting to ask the class which professions they rank most highly and why? The features I describe usually become evident in the process. Examples of ethical wrongdoing (Question 2): Priority of duty to self, profession, client, etc.: All of the following represent some form of conflict of interest between self-interest and the interests of clients, public, profession and firm. As a result, the legal profession suffered some tarnish in the view of the public. a. Pilzmaker put himself before: i. the clients' lawful interests by providing false residency and exposing the clients to the risk of not getting citizenship, ii. the public, by smuggling, iii. his junior colleagues by involving them in the above, iv. his partners, firm and profession by exposing them to sanction and public ridicule. b. Burke Doran put his own and the firm's interests before those of the profession and the public when he gave questionable advice as a partner while he was the head of discipline for the profession. c. The junior colleagues failed to come forward and report Pilzmaker's wrongdoings to the firm or to the profession. d. The executive committee of the firm delayed action on and reporting of the wrongdoing, sidestepped, rationalized, and may have kept silent when files were given back to Pilzmaker. e. Douglas could have reported to the profession or the public earlier, but chose to handle the matter internally. Was this misplaced loyalty? f. The discipline process involved only the executive committee members at a particular point in time, and then the sanction was behind closed doors and apparently quite light. Was this an attempt to keep the profession's dirty linen out of the public's view? g. The investigating, retired judge seemed to launder or white-wash the situation. Are junior members of a firm excused from reporting an ethical wrongdoing? If a person is a full-fledged professional (has passed all the examinations), then they ought to abide by the ethical code of the profession. A student professional also ought to refer problems to more senior, fully-qualified colleagues, keep notes, and consider contacting the professional body if certain that wrongdoing is occurring. Otherwise the interests of the clients, public, profession etc. will not be served and there is a possibility that the student will be barred from becoming a professional due to ethical improprieties. This must be handled delicately, after consultation within the firm, and with a lawyer hired by the student, or with an ethics consultant provided by the profession. If a full-fledged, but junior professional, passes information on ethical malfeasance to a more senior professional in their firm, they must follow-up to ensure that the proper action has been taken to protect clients, the public and the profession. They cannot simply wash their hands of the affair. The case does not offer strong evidence on this, because of fault (f.) above, but subsequent discussions with leading lawyers has confirmed this interpretation. Self-regulation: was it effective? (Question 4) It is unlikely, in retrospect, that the legal profession, the public, or the clients involved would consider the self-regulatory process to be effective in this case. All have lost something due to its poor function. However, in the long run - if repetitions of this fiasco are not forthcoming - a case can be made for retaining the autonomous, self-regulatory framework. That argument would be based on the efficiency of having knowledgeable professionals involved in reviewing complex cases, at no cost to the public purse. At the same time, the profession would have its affairs handled expertly, discretely and with as little red tape and cost, as possible. The public and clients, however, would see no benefit to this efficiency if the process continually failed to protect their interests - that is to be effective in policing the fiduciary relationship, from their perspective. Is the purpose of self-regulation to add luster to the profession? Yes and no. Adding luster is appropriate if that luster is of the long-term variety. If it consists of hiding the profession's dirty laundry in the short term, with the result that repetitions are possible, or a bigger disillusionment is forthcoming when the truth come out, then luster is most inappropriate. Is there a victimless crime? No. Somewhere a stakeholder's interest has been worsened. In the case, the residence-passport fraud resulted in the immigration of persons who may not have otherwise been able. Presumably the residency law had utility, so a test was short-circuited and the public received an immigrant who might not have been accepted if closer observation over a defined period would have endorsed. The public - you and I - lost. The use of the concept that "No white man had been harmed" to describe this situation is particularly offensive. Rationalization of questionable acts: Professionals own all their stakeholders to investigate sufficiently to ascertain the facts about a wrongdoing. To do less offends the principles of objectivity and independence that are necessary to the maintenance of the fiduciary relationship. The delay which results when decision makers avoid the truth is usually very costly to all stakeholders involved. 5. Wanda Liczyk’s Conflicts of Interest What this case has to offer Wanda Liczyk, Toronto’s Chief Financial Officer and Treasurer at the time of this case, was involved in a scandal questioning her independence and due care at awarding and overseeing supplier contracts for the city of Toronto. This case is an example of questionable conduct in assigning government contracts and raises the issue of whether or not the accounting profession should be disciplining its own members. This is a good case to discuss the implication of professional codes of conduct and the process in place to discipline professionals that breach the professional code of conduct. Teaching suggestions I start this case explaining to students the system of professional self-regulation as well as the potential penalties that a professional faces for breaching a professional code of conduct, for example: • Formal reprimand, orally or in writing; • Fine; • Supervised practice for a specified period, with or without conditions; • Re-investigation by the Professional Conduct Committee by a specified date; • Practice inspection, with or without conditions; • Counseling or treatment; • Restriction of or conditions on practice or employment for a specified period; • Establishment and implementation of quality control procedures or professional • training programs, as specified; • Suspension of professional license or authorization to practice, for a specified period, with or without conditions; and, • Other possible sanctions. Afterwards, I discuss the facts of this case and ask students to take a vote on whether or not Wanda Liczyk appears to be guilty of breaching the ICAO professional code of conduct, and what are their recommended sanctions. Discussion of ethical issues 1. If Wanda Liczyk did not benefit financially, did she really have a conflict of interest? Should she have been disciplined by the ICAO? Why or why not? The objectivity standard from the ICAO Code of Conduct, Standards of Conduct (Section 200) says: “Members do not allow their professional or business judgment to be compromised by bias, conflict of interest or the undue influence of others. The public expects that members will bring objectivity and sound professional judgment to their professional services. It thus becomes essential that a member will not subordinate professional judgment to external influences or the will of others.” The next part of the objectivity section discusses objectivity with respect to providing assurance and other auditing services. The section concludes with the following: “With respect to both independence and conflicts of interest, the profession employs the criterion of whether a reasonable observer would conclude that a specified situation or circumstance posed an unacceptable threat to a member’s objectivity and professional judgment. Only then can public confidence in the objectivity and integrity of the member be sustained, and it is upon this public confidence that the reputation and usefulness of the profession rest. The reasonable observer should be regarded as a hypothetical individual, who has knowledge of the facts which the member knew or ought to have known, and applies judgment objectively with integrity and due care.” In this case, it seems as though Wanda Liczyk had a conflict of interest and could be subject to sanctions for her actions. In this case, arguably “a reasonable observer would conclude that a specified situation or circumstance posed an unacceptable threat to a member’s objectivity and professional judgment”. The objectivity standard does not explicitly address whether or not a member needs to benefit financially when there is a conflict of interests. Nevertheless, the ICAO Rule 7-3 on Discipline and Appeal establishes that: “In determining appropriate sanctions, the tribunal shall consider any aggravating and mitigating factors.” In this case, there could three mitigating factors: first, Wanda did not benefit financially from the transactions; second, Wanda was not acting in a direct client-professional relationship or in an assurance engagement; and third, Wanda was not criminally prosecuted for her actions. 2. Should the accounting profession be allowed to police itself, or should an independent third-party, such as the government, enforce professional codes of conduct? Professional self‐regulation is the regulation of a profession by its members. A central purpose of professional self-regulation is the protection of the public from harm. Professional self‐regulation should encourage professional conduct and competence, fairness, transparency, accountability, and public participation. Individual members are personally accountable for their practice through adherence to professional codes of conduct and standards. A fundamental problem with self-regulation is maintaining independence from the interest of individuals or firms influencing the decisions of professional standard setters and enforcers. The self-regulation of the accounting profession is moving to a self-regulation combined with oversight from government bodies. The self-regulation of the accounting profession, and particularly in regard to audit standards, was put to test after the scandals that led to the passage of the Sarbanes Oxley Act of 2002. In essence, the US government decided that self-regulation was not enough to protect the public interest and created the Public Company Accounting Oversight Board (PCAOB), this organization is: “a nonprofit corporation established by Congress to oversee the audits of public companies in order to protect the interests of investors and further the public interest in the preparation of informative, accurate and independent audit reports. The PCAOB also oversees the audits of broker-dealers, including compliance reports filed pursuant to federal securities laws, to promote investor protection.” The Canadian Public Accountability Board (CPAB) has a similar role for audits of Canadian public companies. The ICAO Rule 7-1 on Complains mentions that: “The Professional Conduct Committee shall ensure that, in every matter where the Canadian Public Accountability Board (“CPAB”) is a complainant, CPAB is given timely notice of every significant stage of the investigation and, if the matter is not referred to the Discipline Committee, prompt notification and a written explanation of that determination.” 3. Do you agree with Doug Elliott’s complaint that closed-door trials of accountants by the accounting profession is not in the public interest? Not necessarily. The objective of an ICAO investigation, trials and disciplinary actions is to maintain the reputation of the profession and enforce breaches of the ICAO’s Code of Conduct. Not all complains investigated will result in a disciplinary action, and it may be unfair to publicly disclose every time a firm has been investigated. As explained by the ICAO Rule on Discipline and Appeal 7-3: “In determining appropriate sanctions, the tribunal may consider the relevant principles, which may, but need not, include: protection of the public interest; general deterrence of the membership; specific deterrence of the Member; rehabilitation of the Member; and denunciation.” On the other side, the ICAO investigation process should be reasonably transparent and satisfy the inquiry placed by the party who filed the complaint. Moreover, the ICAO Rule 7-1 on Complains mentions that: “If the Professional Conduct Committee determines, pursuant to section 22, to take no further action or to provide guidance or to admonish, it shall also advise the complainant in writing of the right of review by the Reviewer of Complaints, as provided in Regulation 7-2.” 4. By not prosecuting Liczyk after the Bellamy Report was published, did the ICAO give the appearance that it was protecting its own, and not wanting to publicly acknowledge that some chartered accountants actually violate the rules of professional conduct? The ICAO Disciplinary Proceedings file has hundreds of cases in which the Discipline Committee enforced the ICAO’s Code of Conduct. Specifically, 30 of such proceedings found the professional accountant in a breach of the objectivity standards (Rules 201.1 to 201.4), and 37 of not maintaining the good reputation of the profession (Rule 201). Each of these proceedings contains a detailed explanation of the case and the reasons behind the decision. The ICAO does not seem to be consistently protecting its own members. On the other hand, arguably the ICAO could have done a better job at investigating this case and could have substantiated its decision. This would have indicated that it conducted a fair assessment of Wanda’s behavior. 5. Should Liczyk, as the chief financial officer of the city, have been prosecuted by the ICAO on the more serious charge of failing to provide the required financial oversight, competence and necessary due care associated with monitoring the MFP lease? Why or why not? Wanda may have been prosecuted for not exercising due care for the following reasons: • She did not controlled the costs associated with the MFP leasing contract; • She did not report the overspending to city council on a timely basis; and, • She failed to maintain a strong internal control system over the city’s procurement activities. Wanda may not be prosecuted for not exercising due care for the following reasons: • It is difficult to argue that she was the sole responsible for the swelling costs in this contract; • The contract was improperly designed in first place, allowing the vendor to increase the total leasing costs, without a project charter to set out the scope of the project, the associated risks, the resources needed, the competencies required, and the tasks to be completed within due dates; • Wanda did not assign the contract directly and she did not benefited financially from this contract; and, • The police investigation did not find enough evidence to press charges against Wanda. References Institute of Chartered Accountants of Ontario (ICAO).Decisions, Orders and Reasons in Cases involving Disciplinary Proceedings. 2011. https://ebusiness.icao.on.ca/discipline/d/RulesIndex.cfm Institute of Chartered Accountants of Ontario (ICAO).Member's handbook Web Version (Change 45). 2011.http://www.icao.on.ca/Resources/Membershandbook/1011page5011.aspx 6. Strategic Roles What this case has to offer The public expects responsible behavior from their professionals, and professional accountants are no exception. Consequently the old interpretation that professional accountants should concern themselves only with financial matters is considered to be very risky for the reputation of the professional and the profession. The mandate of some professional accounting associations is being broadened to include more areas of competence, and codes of conduct are being modified and applied more broadly than to just financial matters. There has usually been a requirement of professional accounting codes that warns not to engage in activities that will damage the reputation of the profession, and indications are that professional bodies are taking it more seriously. They are concerned not only with accounting related matters, but also acts that relate to non-accounting matters. More importantly, non-action when a professional accountant knows of something that is unethical or illegal is likely to attract negative sanctions in the near future. This leaves the Professional Accountant (PA) the problem of knowing what to do when such a problem arises. Doing nothing carries an increasing risk. Teaching suggestions Two alternatives are worth considering, with the selection depending upon the length of time available for the discussion. Either a preliminary discussion centered on the commentary above could be first, and then followed by taking up the case questions; or, if a longer time is available for discussion, the questions could be taken up first, followed by a summary of the commentary. Discussion of ethical issues 1. What is your responsibility in each of these situations? Misrepresentation of products as from environmentally friendly sources While this is unlikely to generate sanctions for the PA individually, it will erode the company’s reputation and loss of consumer and other stakeholder support. In the modern world, it is unlikely to go un-noticed, so it may also generate fines and perhaps some lawsuits. The risks and consequences will likely be strategic, legal and financial. Consequently, the PA should raise these issues with the CEO and General Counsel, and with the Audit Committee of the Board, if the response is not appropriate. Bribe foreign officials Bribery is not only unethical, it is illegal in most countries, and carries significant fines under laws like the U.S. Foreign Corrupt Practices Act that now exist in over 30 countries. U.S. subsidiaries are covered under that act. Consequently, a PA should convey this understanding to the CEO and others as noted above. Use of faulty or unethical analysis/decision techniques If the PA has or is expected to have competence in an area, then it is the PA’s responsibility to bring such faults to the attention of company authorities to prevent bad decision making and harmful actions. Depending on the nature of the problems, the reporting chain noted above should be pursued. Encourage unethical culture PAs should understand the consequences of an unethical culture – poor internal controls raise risks of inaccurate financials, lower reputation, and drive away concerned employees. A PA should enlist the support of the CFO, caution the CEO against such encouragement, and report the matter to the chief ethics officer and the chief risk officer. If the response is not appropriate, the PA should identify the problem and risks to the Audit Committee. If the encouragement continues, and the problems are serious, it may be wise for the PA to consider resignation and/or whistle blowing. Mislead the Audit Committee This would be a serious professional and perhaps legal offence to ignore or be involved with. According to most PA codes, PAs are not to be involved with misrepresentations. Don’t do it. Argue against it, indicate that you will have to report it if it happens, and report it immediately as noted above if it does happen. Ignore important internal controls This would expose the company to significant risks that could compromise the accuracy of financial reports, and permit/lead to unethical and illegal acts. It would be a breach of fiduciary duty punishable by professional, and likely legal, sanction. For the CEO and CFO who have to certify under SOX-spawned rules that an effective system of internal controls is in place and observed, the action contemplated could lead to jail and/or fines, and the ruin of the PAs reputation. Don’t do it or condone it. Argue against it. Report it using the chain noted above if you find that it has happened. 7. Locker Room Talk What this case has to offer The Locker Room Talk Case is taken from the excellent set of loose-leaf cases put together by the American Accounting Association. It presents a short, but realistic problem of an auditor who learns something while on an audit which he is wondering how or whether to apply to another assignment he has. The problem involves multiple conflicts of interest and conflicts with usual provisions in the accounting profession's code of conduct. The case provides a forum for discussing the following issues: 1. Conflicts of interest, in general, and for auditors, specifically. 2. Maintenance of confidentiality and its relation to the proper function of an auditor. 3. The role of an auditor/accountant/consultant with respect to the maintenance of a fiduciary relationship. 4. Involvement of an accountant in misrepresentation. 5. The role of audit evidence. 6. How to resolve conflicts between the accountant's code of conduct and the requirements of a fiduciary relationship. 7. Which client's interests should be given priority? 8. The importance and nature of independence. Teaching suggestions This is a terrific, short case which presents much more difficult issues than first thought. I use the questions at the foot of the case to guide the discussion. It is always interesting to me to see the split in the class along gender lines. The women tend to side with the wife and the men side with the husband even though he is probably going to leave his wife penniless in divorce proceedings. The debate between these two sides illustrates the conflict between the need to look out for the needs of a client (the wife) in a proper fiduciary relationship and the need not to break the confidence obtained by an auditor even though a client (the husband) may benefit when they shouldn't. In the end, the class can see what they would like to do (help the wife), but not how to do it. By examining the fundamental basis of and need for evidence, a creative solution may be found. In the end, the desirability of maintaining independence is seen as attractive. The instructor's opening statement on the case should provide the usual position on the maintenance of confidentiality found in accountants professional codes of conduct, as follows: "Information about client matters cannot be divulged except in a court of law or subject to a disciplinary hearing". Later on, the instructor should be prepared to interject the other wisdom usually found in codes, that: "Accountants should not be party to misrepresentation". These two statements will frame the issues and inform the discussion. Otherwise, it will wander unduly. What you want is for the class to explore and identify the audit evidence as confidential, and to realize that they can't issue a financial plan for the man and wife which they know will be based on misrepresentations of assets, etc., and therefore itself be a misrepresentation. What is the solution? I usually ask the class to vote on the alternatives they suggest. Then I ask if there is any other creative solution they might like to try. Several come forward, some of which are quite humorous. In the end, I suggest they ask for a meeting with both the husband and wife, and ask for permission to confirm the details of the assets and liabilities, if any, with the bank prior to the issuance of the planning report. If the husband refuses, the ensuing discussion will inform the wife. If the husband will not allow the confirmation procedure, then the accountant must resign, and decide what to tell the wife. Telling her anything will break the strict confidentiality guideline, but, depending on her naiveté, telling her could be ethically justified. Consultation should be sought from the professional accounting society involved, or from a legal expert. Discussion of ethical issues Much of the flavor of the classroom discussion is captured in the preceding section, but specific background references are included below. Conflicts of interest, fiduciary relationship, and confidentiality: These topics are dealt with in the text. Confidentiality and the role of an auditor: In order to perform the audit and assess audit risks, an auditor must be party to information and discussions about issues, such as are subject to settlement in a court, where the outcome is in doubt and where disclosure would harm the interest of the client. If auditors were not subject to stringent rules of confidentiality, clients would not discuss sensitive issues with them, and the audit function would be compromised. In addition, the disclosure of information in a non-audit forum to the detriment of a client could result in a lawsuit by the injured client, as well as the loss of the client. Some students think that they should avoid being placed in this situation by avoiding the scrutiny of the files of other clients when they perform an audit. This, of course, is nonsense because it would then be possible for a devious client to manipulate the accounts of other known clients of their auditor. Some students will argue about whether information overheard in a lock room is restricted by rules intended to restrict evidence gained on an audit. In this case, however, the locker room talk appears to be confirmed by an audit review of financial details, so the genesis of the concern is overtaken and audit rules are properly in question. Which client's interest should be given priority? Concern over the direct interests of the public are not a significant issue in this case, so the students should be redirected to a consideration of the interests of the profession to which the auditor belongs and those of the husband and wife, the bank loan officer, and the auditor.. Following the discussion in the text, the interests of the profession involved should take precedence. However, this does not mean that the confidentiality guideline should be followed slavishly if it is not in the interests of the profession as appears to be the case here. Because of the probable naiveté of the wife, the public may perceive that her need for protection in the fiduciary relationship expected of an auditor should take precedence over that of the husband, bank loan officer or even the auditor himself. This follows from an analysis of the interests of the stakeholders and a ranking of those interests based upon the stakeholders ability to withstand the probable impact of alternative actions. Therefore, if a stratagem like that suggested in this case (confirmation) cannot be found, the auditor might have to find a way to inform the wife directly. Resignation may not be appropriate: The foregoing analysis suggests that just resigning from the financial planning engagement, as would be called for to avoid a report which misrepresents the financial position of the couple, will not sufficiently protect the wife and will therefore be unethical. Resignation with an accompanying statement of concern would not be justified until after asking for the right to confirm the financial details as referred to above, and having been refused. Avoiding conflict of interest situations: Any resignation should be accompanied by a referral of the couple to independent advisors, that is, one for each of them. In fact, taking assignments where there is a potential for conflicts to develop is not advisable, but if the client's insist, then they should be urged to submit the finished product to review by independent experts. In this case, if it was known that a divorce was thinkable when the assignment was undertaken, then taking it reflects very poor judgment - akin to playing with a time bomb. Serving two masters well is almost impossible in the best of times. Act for one, and avoid the heart aches. The value of independence: This case illustrates the desirability of auditors not being dominated by a single large client, or by the size of a specific fee. If the auditor is not financially dominated, it is far easier for the decision to be made to forego the fee or ongoing relationship involved. Independence provides the cornerstone of the fiduciary relationship expected of accountants. 8. Advice for Sam and Ruby What this case has to offer This is a real case in which I have changed the names and situation somewhat to protect the innocent/guilty. It depicts a type of involvement that most professional accountants face many times during their careers, whether they are in public practice or not. In fact, in real life, Sam was involved in negotiating the original agreement that included the “off-book revenue” clause. Sam believed that he was using his MBA skills in doing so, not his professional accounting skills, and so (erroneously) did not see his negotiating involvement as jeopardizing his professional standing. In spite of his good intentions, Sam became involved in a scheme to evade income tax, as well as sales tax and other revenue-derived costs such as workmen’s (compensation) insurance, and rent (possibly). The scheme is almost certainly illegal, and/or involves misrepresentation, and is therefore specifically banned in most professional accounting (PA) codes of conduct whether or not the PA is in public practice. This case offers an opportunity to discuss how PAs should be alert for such situations, how they should be identified, and what should be done to avoid involvement and yet assist Ruby and his relative, if possible. Teaching suggestions I would recommend calling for a student to summarize the case and identify the potential problems. Then I would call for a student to argue that Sam’s actions were reasonable and ethical. After this, I would ask a student to argue that Sam’s actions were not ethical, and indicate why. Then the class should weigh in on both sides of the argument about Sam’s position. When this discussion is concluded, I would ask the class what, if anything can be done by Sam for Ruby. Discussion of ethical issues I have reproduced below for guidance, the comments (adjusted somewhat) from a prominent senior PA with experience with an international firm, underlined and embedded in the case write-up. Dear John: I really appreciate your willingness to give me your opinion as a fellow professional accountant on what I should do, and what I should advise the minority owner to do, given that I have found myself in the following situation. Please note that: 1. I am not (and have not) been retained, nor am I being compensated, in any manner related to the situation. I became involved through extended family contacts. Involvement should be considered as the basis for professional conduct whether or not one is formally retained or compensated 2. I have not been providing accounting services in any shape or form related to the situation. Yes, Sam has been providing accounting services if only by advising Ruby to get outside accounting advice and advising Ruby and this accountant that ‘these amounts must be tracked’ in point 6. 3. I have ensured that Ruby, the party I was advising, did seek out accounting advice from another party throughout the course of events outlined below. By ensuring Ruby did seek out accounting advice from another party, Sam presumably became aware of what this advice was – not knowing what this advice was, it is difficult to make any further comment. 4. Approximately three years ago, Jimmy, an owner of a small auto body shop, approached Ruby to give her a 10% equity stake in the shop, and to provide day-to-day management functions for the entity. 5. Jimmy wanted Ruby to allow certain cash receipts to bypass the books of the shop, and in return Ruby would directly receive a commission on these transactions. Cash receipts would likely indicate also under-reporting of sales tax and if the Workman’s (compensation) insurance reporting was thus distorted, it could also affect insurance coverage so there are more issues than just the reporting of the taxable income for income tax purposes. Similarly, banks and other creditors may have be able to argue misrepresentation if the business perishes. We do not know if these amounts were claimed as taxable income by Jimmy, but there is always the possibility of this. This requirement was incorporated into the shareholders’ agreement, signed by both parties, and witnessed. 6. I informed Ruby and her accountant, that these amounts must be tracked, and reported on her tax returns as taxable income without deduction. See note re other tax and reporting requirements 7. Ruby was lax, and followed Jimmy’s advice in completing certain paperwork, such that the incorporation documents and subsequent filings still reflect her as the sole director of the company, even though she merely set up the new company formed at the time of the initial transaction. Ruby as a director and involved party has full personal responsibility for the un-remitted amounts and reported withholdings. 8. Now Jimmy has approached her to buy her out. 9. During the course of the negotiations, which I attended, Jimmy’s accountant disclosed he was aware: o That the 'off book' revenue was occurring, but still I am unaware as to how it was treated for tax purposes by Jimmy. There is a high likelihood, especially when coupled with the other disclosures listed below, of premeditated tax evasion on Jimmy’s part. o Jimmy has had, and continues to have, various taxation "issues". o Among the previous taxation issues experienced by the majority shareholder was one for approximately $80,000 that had caused the initial transaction to occur, as Jimmy was then attempting to hide assets from the tax authorities, and used the then unaware Ruby to effectively be a shield for him. o Jimmy’s accountant indicated that he is a professional accountant. And therefore has also incriminated himself in the activity and probably put Sam in the position that he is required to report this accountant to the professional body involved. o The negotiations of the transaction for the sale of the minority shares have now been transferred to Ruby’s lawyer, and I am still providing some help through her lawyer. Many thanks for your advice. Sam Question Answers 1. Keeping in mind that no compensation, nor accounting services, were ever received or provided, has Sam stepped “out of bounds”?  Yes, as the notes from a prominent PA above indicate, the absence of compensation does not matter, and he has provided accounting services, and has become involved in an illegal matter which is contrary to professional codes. 2. What is your advice for Sam? • Consider his professional reporting obligations regarding the professional accountant and the income tax evasion. (i.e. reporting to the PA’s accounting body). • Consult with a lawyer and/or ethics advisor with his professional accounting association regarding his personal professional position. • Decline to provide further advice to Ruby as such advice is involved with a criminal activity. 3. What is your advice to Ruby? • Retain a lawyer. • Then consider resigning immediately as a director. • If possible, escrow sufficient company funds to pay the back taxes. • Have the lawyer approach tax authorities on a “no names” basis to discuss the matter and propose actions to make restitution and payment. • Forget any proceeds that may be coming from her minority shares – this thing will be worthless. 4. Given the alleged disclosures by Jimmy’s accountant, has he crossed any boundaries? If so, does Sam have to take any actions and what would these actions be? • Yes, as the notes above show, he has become involved in an illegal matter, and likely is party to a tax evasion scheme. • Sam should report the other PA to his professional accounting body, and advise Ruby and her lawyer as to his concerns. Essentially, a PA should be continually alert for red flags that reveal an illegal scheme, and/or one that involves misrepresentation. If an illegal scheme is identified, then care must be taken by the PA to immediately distance him/herself from it, by recommending legal advice be sought. In the case of a scheme involving misrepresentation, a PA should advise against the misrepresentation and then resign from any involvement if the misrepresentation is not clarified. Notes should be kept by the PA of all issues and actions, and a practice advisor should be consulted. Ruby, and all involved with the off-book arrangement were naïve and exposed themselves to legal and professional sanctions. The remedy for Ruby is to make a clean breast of it to the tax authorities through a lawyer, as soon as possible, hope the authorities accept her story of naiveté, and are in a good mood. 9. Biker Nightmare What this case has to offer Most Professional Accountants (PAs) have found themselves in the position of discovering an illegal act, and have wondered what to do about it. In this case, the company president has asked for you to summarize a number of illegal transactions, and to sign the summary. If discovered or reported to the authorities, it is likely that the $200,000 will have to be paid as well as some additional fines. The duties and fines may be considered to be contingent liabilities and will have to be disclosed. If the president does not correct this situation after being informed, then the issue should be reported to the auditor and Audit Committee of the board after informing the president. The request to sign the summary is interesting in that it will indicate when the PA came to know about the problem – a fact that will be important to assess how quickly and therefore responsibly the PA has acted. If a PA doesn’t act, the president could demand future favors such as improper accounting adjustments in return for not informing the Professional Accounting body. A PA would need to be aware of this risk. Whether or not you have signed the summary does not change your professional duty. Teaching suggestions The most expedient way to approach the case is to ask the class to recap the ethical issues presented in the case. That will lead to a discussion of the items above, and then to the end-of-case questions as noted below. Discussion of ethical issues 1. What does our professional code say about this? Most codes contain general, if not specific, provisions against acting in or covering up an illegal transaction. Such actions would contravene expected standards of integrity, behavior in the public interest, protection of the good reputation of the profession, and fiduciary duty to the company’s board. Also, there is a specific provision in most codes that a PA should not be involved in a misrepresentation, which would be the case if the practice continues. (Table 6.6) 2. If this issue is uncovered by the government regulatory authorities, will I be implicated? Potentially yes, depending on the statute or regulation, and the rigor of the professional accounting body involved. 3. Should I quit my job and then go and report this situation to the regulatory authorities? Not unless the president refuses to change the practice after you advise him/her of the problems associated with it. Even then, you should advise the Audit Committee of the Board so that the practice cannot continue without their knowledge and consent. They are relying on you for that advice. Ultimately, the PA has to decide whether to stay or resign and when, but even if the PA leaves, the PA should advise the president and the Audit Committee of the problem. 10. Budget Conflict What this case has to offer As CFO of an organization, particularly one where financial acumen may be weak, it is expected that a Professional Accountant (PA) will try to clarify any perceived misunderstanding on financial matters. Consequently, if the Board of Directors approves a “stretch budget” that assumes unreasonable revenues and/or levels of expenditures that would be dangerous to the organization’s financial health, the CFO should make his/her opinions known to the Treasurer, the President and the Board, as well as the consequences. In this case, since verbal persuasion has failed, the CFO’s comments should be put in writing and circulated to the Board. If that does not change the picture, then the CFO should approach other organization members who would be present when any recommendations from the Board are voted upon at an annual meeting so they could raise their objections. The CFO’s written comments should be circulated to the membership, or at the annual meeting as well. Teaching suggestions The discussion could start by asking if a PA’s duties were different with a charitable organization as opposed to a profit-oriented one. The answer should be no, and then the class should be asked which stakeholders (board egos, members if the organization employees are really underperforming) might benefit from a “stretch budget”, and which might lose (high performing employees, members and employees who might lose if the organization’s financial stability is jeopardized, etc.). Then the questions at the end of the case should be taken up. Discussion of ethical issues 1. What should the CFO do? The CFO should put his/her comments in writing and present a copy to the President and Board members. If they still wish to go ahead, s/he should communicate with members to apprise them of the risks, and to make the comments at the annual meeting before the vote on the budget. As a last resort, after the foregoing steps, the CFO may wish to resign. 2. Beyond resigning, how can the CFO protect him or herself? The best protection is to take the steps laid out above and to document the meetings held to try to persuade the President and others to change their unrealistic path. In addition, the CFO could consult a lawyer and/or the advisor on staff at his/her professional accounting body. 11. An Exotic Professional Accountant What this case has to offer The issues involved in this case are: • The limits of damage to the profession’s reputation • The limits of damage to the PA’s reputation • Do activities on a Professional Accountant’s (PA’s) personal time matter, and if so what kind of activities? • Does the profession’s code of conduct apply? Both the reputation of a PA and the profession can be impacted by personal time activities, for better or worse. For the professional, such activities can enhance reputation if the activities reflect high levels of the values of integrity, duty and so on, excellent judgment, or demonstrated competence in financial or organizational matters. They might diminish her/his personal reputation if the choices made were not respected. As far as the reputation of the profession is concerned, the impact of personal time activities is of little consequence unless they are so far out of normal bounds as to raise questions about the judgment and processes of the profession for allowing the member to remain a member. For example, a PA who committed murder, or fraud, could not be expected to have sound judgment or be trustworthy, and should have his/her professional designation cancelled. Exotic dancing is probably in a grey area. Some clients or employers might view it as in bad taste, thus weakening the PA’s reputation, and some may even find it grounds for dismissal but that would be an unlikely outcome. Similarly, most professional accounting bodies are unlikely to regard exotic dancing as endangering the profession’s reputation sufficiently to warrant expulsion, at least without a first warning to cease and desist. Teaching suggestions I would ask the two questions one at a time, and entertain discussion and manage it to cover the points in the commentary above. • Do activities on a Professional Accountant’s (PA’s) personal time matter, and if so what kind of activities? • Does the profession’s code of conduct apply? Students will probably take a strong view that personal time deeds shouldn’t matter, and will have to be brought to understand the implications for trust, judgment, and reputational impact, as well as the preference of employers for maintaining behavior in keeping with their version of integrity and other corporate values. Discussion of ethical issues 1. What advice would you give? A PA contemplating such a choice should consider: • Employer codes, values and guidelines • Probable impact on personal reputation • Consider the past practices of the professional body involved and seek advice for the professional body’s ethics or compliance officer (which is actually where this case came from) in advance • Personal preferences, values and the necessity involved • Hire a lawyer for advice, if necessary. 12. Freebie Services for Staff What this case has to offer The case examines the grey area of duty to employer, conflicts of interest (COI), how to combat frivolous charges related to them, and what red flags they might involve. Since the employer has no formal policy for the provision of services on personal time in regard to matters not directly affecting the town, it seems that an external lawyer has influenced the Town Manager to produce a conflict of interest complaint against a Professional Accountant (PA) on staff. Does the state or province have a COI policy that covers this type of complaint? Probably not as it could be interpreted to be in violation of the PA’s human rights as it is beyond work hours and not related to the operations of the town. As long as the PA can show that s/he has the necessary expertise, then the code of the professional accounting body involved would not be offended. The PA does not seem to be acting contrary to the interests of his/her employer. Teaching suggestions Ask the class what the ethical issues are raised by the case. This should lead to a discussion of: • what duty a PA owes his/her employer • what constitutes a conflict of interests • what standards should be applied to decide upon the proper course of action. Based on this platform, the question of advice to give can be raised. Discussion of ethical issues 1. What advice would you give to the Professional Accountant? The advice to the PA should include: • asking the Town Manager: o to clarify what conflict of interest policy he is applying, o does it seek to control activities undertaken on personal time for friends for no remuneration, o how your free services affect the Town’s interests? • Asking the town’s mayor and its lawyer for clarification • Asking the ethics adviser for your professional body for advice • Hiring a lawyer if all else fails. In addition, the PA should consider if the Town Manager might have a conflict of interest if he is representing the interest of the external lawyer in such a manner, and whether this potential conflict should be identified in discussions with the mayor and town lawyer. The PA should also consider what his/her relationship will be with the Town Manager (his/her boss) if s/he does or does not acquiesce to the request. 13. Summer Camp Holdback What this case has to offer A Professional Accountant (PA) has been asked to agree to allow his/her employer to retain monies (for General Sales Tax (GST) recoveries) belonging to customers, to issue charitable receipts to give the customers partial credit (less than 100% depending on the deductibility of the donation) and to mask the right of customers to get the monies back. Ethically, PAs should not be associated with any misrepresentation according to their codes, or they would be undermining the reputation of the profession as well as themselves. Moreover, PAs are expected to demonstrate integrity, which they would not be doing if they covered up the right of getting back the GST recovered. Unless the right to reimbursement is made clear to the customers, and they agree to leave the money with the Camp as a donation, the plan for retention and issuance of charitable donation receipts is illegal. The GST recovery is money held in trust and does not belong to the Camp. Moreover, it is likely that an audit of the GST records of the Camp would find the illegal retention. Teaching suggestions The class should be asked to clarify what the PA has been asked to do. Then ask what is wrong with the proposed action from the perspective of the company and the PA. Based on this information, the question of what advice to give should be asked. Discussion of ethical issues 1. What is your advice? The company’s officers should be told that what they propose is illegal and could subject the company and possibly the officers to fines. There is a possibility that what they propose could go unnoticed by tax authorities. However, the PA should not go along with the proposal since it would be counter to ethical expectations for a PA and most PA codes of conduct for the reasons noted above. If the Camp decides to go ahead, the PA should resign and consider whistle blowing. 14. Theft Reimbursement, Twice What this case has to offer The controller has instructed the assistant controller to deposit a second check for $16,583 into a high interest account to earn interest to defray legal and other costs of the related court case. He said that the funds would be returned to the insurance company after the court case was settled. The assistant controller wanted to return the check to the insurance company immediately since the bank had already sent a reimbursement check. The assistant controller is therefore confronted with a request to act unethically, but probably not illegally if the money is returned reasonably promptly to the insurance company. Secrets of this nature don’t often stay secret, particularly given the mindset of the assistant controller. Teaching suggestions After eliciting the facts, the class could be asked if they thought the proposed action was unethical or illegal, or both. In the ensuing discussion, the class could be led to use the ethical challenges discussed in Chapters 3 and 4, such as: 1. Consider the consequences in the short and long term. 2. Consider the duty, rights and fairness involved. 3. Does the action demonstrate the virtues expected of PAs, and not-for-profit organization? The controller’s proposal may harm the reputation of the not-for profit. If the proposal becomes publicly known, then relevant stakeholders of the organization may opt to no longer deal with the not-for-profit. They may not be pleased with the values demonstrated by the organization and its accounting staff. On balance, the risks of loss of reputation for the PAs and the not-for-profit seem to reduce the possible benefits from the proposal. The challenge then is to make this clear to the controller. There is always the risk that the controller will ultimately want to keep the money, but this would be illegal, and could result in sanctions for the PAs from their professional body. Based on this platform, the questions posed at the end of the case should be answered. Discussion of ethical issues 1. How would you answer the assistant controller? The assistant controller should be encouraged to perform the above analysis and come to the conclusions identified: that the proposal is probably not illegal, but is unethical and not worth the risks involved. Armed with this information s/he should explain the risks and rewards to the controller, and convince him/her to abandon the proposal. If the controller decides to keep the money, then the assistant controller should inform the officials of the not-for-profit. If the money is not ultimately returned, then s/he should resign and consider advising the insurance company. 2. What advice would you give to the controller? As noted above, the controller should be provided with an understandable, abbreviated version of the analysis and conclusions that are noted above. 3. What aspects of the organization’s governance process and/or internal controls were flawed? The check preparation, authorization, and distribution systems are flawed because: • One individual is responsible for the first and last stages, and can take signed checks meant for others – split the duties between two people. • Checks are easily altered – consider protective machines and paper. • Consider direct deposit that would do away with checks. 4. Should the directors be told about the fraud and/or any other matters? Yes. The directors have a right to know about the fraud and other matters related to insurance, faulty internal controls, and actions that could damage the reputation of the organization and/or generate potential loss of business or reputation. The controller should inform the directors and the assistant controller should encourage that it be done. If the controller fails to do so, then the assistant controller should inform the directors. ACCOUNTING & AUDITING DILEMMAS 1. Sino-Forest Fraud? – Audit Challenges in China What this case has to offer This case provides an example of how difficult it can be to audit in China, and how important it is to adhere to established audit standards when auditing foreign operations. The case also shows how opportunists can use a reverse takeover technique to gain easy access to establish capital markets and co-op many knowledgeable people into supporting their endeavors. Teaching Suggestions The discussion could start by asking if an auditor’s duties would be different in a foreign market and country. The answer should be yes. Then elicit from the students the many reasons why. To make the point of the volatility of public markets, ask this question: Suppose that Muddy Waters’ report is proven to be wrong. What difference would it make to Sino-Forest? Ethical Issues 1. Describe the fraud that allegedly occurred through Sino-Forest Corporation Inc. Who benefited and how? Sino-Forest came into existence through a reverse takeover, its predecessor entities (private) becoming the public entity (Sino-Forest) with access to publicly-traded corporations access to capital markets, but without going through the required securities commission review. Sino-Forest traded as TRE on the Toronto Stock Exchange. Then, according to Muddy Watters, LLC, TRE (Sino-Forest) reported successful joint ventures which never launched, sales of timber that never occurred,and purchases of trees that were overstated. TRE also moved monies to subsidiaries, many of which were related offshore companies in the British Virgin Islands. TRE also falsified its books, and forged its documents. To counter these charges, the firm hired a valuations company to provide credible valuation reports on growing trees, but denied them access to all but 0.3% of growing trees. Reportedly, Sino-Forest executives benefited from an artificially inflated stock price which allowed them to raise additional funds, and launder money from Sino-Forest, moving it to several related but offshore firms. 2. Why didn’t regulators prevent this fraud from occurring? What were they relying on? Regulators were relying on accounting & financial documents which were probably forged. 3. Why didn’t the directors of Sino-Forest prevent this fraud from occurring? What should they have done to discover the problems that were subsequently uncovered? Directors were relying on accounting & financial documents which were probably forged. 4. Why didn’t shareholders foresee this fraud? What were they relying on? Shareholders were relying on accounting & financial documents which were probably forged. 5. Why did Carson Block author the Muddy Waters Research Report? Was he altruistic or self-interested? What did his company stand to gain? Carson Block’s firm, Muddy Waters, was an investment research company. His firm stood to gain from the credibility to be gained from the revelations about Sino-Forest. It was great publicity, and a demand for his services probably followed. 6. What basic assumptions were erroneously made by Ernst & Young that contributed to the audit problems of concern to the OSC? Ernest & Young generally assumed that TRE owned the timber they claimed to own, in the amounts they claimed to own it. They also assumed that the translated documents were correct, so they did not need Chinese speaking personnel at all levels of the audit. 7. What audit risks become important when auditing in unfamiliar cultures? Underlying infrastructure may be missing or different, so that one cannot rely on the norms applicable in the U.S., and may have to exercise professional skepticismat a higher level. 8. If you had been on the audit team of Sino-Forest, how would you have avoided allegations of a lack of adequate professional skepticism? The ownership of the trees and the amount of them were the basic assets of the firm. If no Chinese property system acknowledged that ownership, then the audit committee would have to use other means to verify ownership and its extent by visiting the sites, and confirming for itself that the statements were true, or hiring someone else to do so. 9. If the Chinese system of recording property rights was known to be incomplete, how would you have performed the audit of Sino-Forest’s assets? See answer to number 8 above. Without a reliable structure for the recording of property ownership, nothing may be assumed. 10. What audit problem was caused by the Sino-Forest practice of selling timber without receiving cash payments, and how would you have resolved it? Since no cash payments were made to purchase timber, there was no way to track payments, so that the purchase cannot be verified. A visit to each site to physically verify the holdings was required. 11. What would you do if you were a company director or auditor, and you were advised that your company had incomplete or inadequate record creation and retention practices, no integrated accounting system, and that employees conducted company business from time to time using personal devices and non-corporate email addresses? All of these practices would need to be changed. Both accounting practices and audits require adequate record creation and retention, an integrated accounting system, and a way to track employees conversations, documents and other relevant company information and actions, created and stored on company facilities. 2. Massive Acquisition Write-Downs in the Mining Industry What this case has to offer This case identifies several massive write-downs of recently made investments in mining companies, and raises the questions of who is responsible, if anyone, and what is the appropriate treatment of the original valuation and investment decision makers. Teaching Suggestions Ask students whether they have ever made an incorrect judgment about a business matter. What factored into their decision? Did they do their due diligence research? Ask whether they think that Albanese and Ritchie did their due diligence. Ethical Issues 1. Should the CEOs of these mining companies be held accountable for the fact that commodity prices have dropped precipitously while operating costs have soared? They have been held accountable in the most common way executives are held accountable when they lose large sums of money for the company – they have been fired. But could they have predicted that the price of aluminum would drop so significantly? Should they have known that operating costs would soar? These are the kinds of decisions CEOs make every day, and they are not always correct. 2. Should Albanese be held responsible for the fact that the Chinese market did not open as he predicted and that the price of aluminum dropped precipitously? One wonders whether Albanese knew enough about the Chinese market to anticipate their own, cheaper production of aluminum. Certainly, he should have known if he was going to conclude that they would become an importer of aluminum. 3. Because of the $14 billion write-down, should Albanese be forced to forfeit his lucrative stock options? Students will disagree about the answer to this question, but it the majority may believe he should not be forced to do so. He lost his job in circumstances which make him less than a “catch” for another firm, and perhaps that will have to be punishment enough. 4. Alcan was purchased in 2007, and there were two subsequent write-downs reducing its value by more than half of its original purchase price. But Albanese did not resign until 2013. Was this resignation too late? When should a board of directors fire a CEO who has made a significant mistake? Albanese's resignation in 2013 may have been too late, as the board should consider firing a CEO after substantial mistakes, especially if they lead to significant financial losses or impair shareholder trust, ideally before a major decline in company value occurs. 5. The Rio Tinto executives made massive errors in judgment that cost the company billions. Were they treated too gently? Students may disagree about the answer to this question, as well, but today, our most effective way of dealing with executives who err is to fire them. 6. Since several companies have written off massive amounts paid for their acquisitions, were each of their managements wrong for specific reasons, or were there common factors affecting them all? If so, what were they? If there was a common factor, it was an overvaluation of the acquired asset, and/or perhaps an overly optimistic view of the potential income of a particular acquisition. Perhaps this is simply a consequence to be expected from the pursuit of profit in a capitalist system. 3. Accounting Rule Changes Increase Apple Computer’s Revenue What this case has to offer This case describes Apple’s objection to subscription accounting, or deferred recognition of revenue, for the sale of iPhones, iPods, and other devices bundling hardware, software and technical support. When the accounting rule was changed, Apple’s income and stock price rose. This is a good case to discuss whether revenue recognition policy matters even when cash flows are the same under different accounting policies, whether the change in accounting policies resulted in fair financial reporting, and whether stock prices should react to changes in accounting policies. This case is related to the case on the impact of international GAAP on earnings, also included in this Chapter. Teaching suggestions Before discussing this case, I ask students what is earnings management. An interesting definition of earnings management widely used in the academic accounting literature is provided by Healy and Whalen (1999): “Earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers.” An important issue for financial analysts, investors and corporate executives is how to distinguish between earnings manipulation could be fraudulent and the day-to-day struggles of managers to keep costs within budgets or to get revenues to meet desired sales targets. Not all earnings management is misleading. Investors, for example, prefer to separate persistent earnings from one-time shocks. Firms that manage earnings in order to allow investors to better distinguish between the two components do not distort earnings. On the contrary, they enhance the informational value of their reported earnings. Once the class discussion focuses on what is earnings management, I introduce the case facts and follow with the discussion of the two questions from the case. In order to discuss this case, it is important to understand the concept of multiple-deliverables revenue arrangements. A sale with multiple deliverables may include both goods and services to be rendered over time. For example, cell phone contracts are sold including a phone and a service contract, including also subsequent software updates and technical support. Ideally, revenue has to be allocated separately to the phone and the contract based on their relative fair value. In addition, the revenue from long-term contracts may be deferred and amortized over the life of the contract. This deferred treatment helps to match revenue received upfront with the costs of providing services over time. The new rules changed the allocation rules, specifically exempting hardware plus software packages from the multiple-deliverables method. Discussion of ethical issues 1. Do you think that Apple’s new accounting policy, that is consistent with the 2009 FASB statement, results in fair financial reporting? Using the accelerated revenue recognition method does not necessarily distort earnings, provided that the users of the information are aware of the existence and effect of long-term contracts on the company’s net income. Both policies should be equivalent if management is transparent about its revenue streams and if the revenue recognition rules follow the company’s business model. In a way, earning the revenue from the sale of an Apple device is typically not in question. If the customer has paid for it, the likelihood of a return is usually covered by a returns allowance. Nevertheless, if management uses the deferred revenue streams to artificially inflate sales, it seems like such action may distort earnings. Under this scenario, the accounting for the long-term contracts could give management the opportunity to mislead the users of the information. Moreover, this rule may create the incentive to recklessly push products out the door in order to recognize revenue as soon as possible, something that was not as easy when revenue was deferred over time. Finally, Apple adopted the rules change retrospectively and restated its past financials to make comparisons easier. Other similar companies like Amazon and RIM are also early adopters, but will be using the new rules on a going-forward basis. That makes comparisons more challenging and thus reduces the overall quality or fairness of the new policy. 2. Do you think that Apple’s share price should have gone up as a result of increased revenue due to a change in an accounting policy? If markets are efficient with respect to information (i.e., information about revenue and revenue recognition policies is fully available to market participants) and if earnings do not directly impact managerial compensation or other contracts, the method used to recognize revenue does not matter. Market participants can undo the effect of accounting policies. Under this view, there should not be a price impact from changing accounting, particularly because Apple disclosed net income under both policies before the change in standards in 2009. On the other side, if the market only focuses on earnings and there is incomplete information about the long-term contracts, then the method used for revenue recognition matters. Revenue recognition is one of the most important accounting policies and a large number of restatements and regulatory actions have focused on revenue recognition. References Healy, P., and J.M. Whalen. 1999. A Review of the Earnings Management Literature and its Implications for Standard Setting. Accounting Horizons 13: 365-384. 4. The Impact of International GAAP on Earnings What this case has to offer This case describes a situation where a retailer’s net income decreased after the company switched to International Financial Reporting Standards (IFRS). Shoppers Drug Mart used to recognized separately sales and the effect of discounts given through a reward program. Under IFRS, sales have to be reported net of discounts in the form of a reward program. This change caused the company’s sales to decrease by approximately one to three percent. This is a good case to discuss: why, if the cash flows of the company remain the same, does the revenue recognition policy matter? This case is related to the Apple’s revenue recognition case, also included in this Chapter. Teaching suggestions Before discussing this case, I ask students to define earnings management. An interesting definition, widely used in the academic accounting literature, is provided by Healy and Whalen (1999): “Earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers.” An important issue for financial analysts, investors and corporate executives is how to distinguish between (a) earnings manipulation that could be fraudulent and (b) the day-to-day struggles of managers to keep costs within budgets or to get revenues to meet desired sales targets. Not all earnings management is misleading. Investors, for example, prefer to separate persistent earnings from one-time shocks. Firms that manage earnings in order to allow investors to better distinguish between the two components do not distort earnings. On the contrary, they enhance the informational value of their reported earnings. Once the class discussion focuses on what is earnings management, I introduce the case facts and follow with the discussion of the two questions from the case. In order to discuss this case, it is important to understand rewards or loyalty programs. IFRS interpretation IFRIC 13 “Customer Loyalty Programmes” states: “Customer loyalty programmes are used by entities to provide customers with incentives to buy their goods or services. If a customer buys goods or services, the entity grants the customer award credits (often described as 'points'). The customer can redeem the award credits for awards such as free or discounted goods or services. The programmes operate in a variety of ways. Customers may be required to accumulate a specified minimum number or value of award credits before they are able to redeem them. Award credits may be linked to individual purchases or groups of purchases, or to continued custom over a specified period. The entity may operate the customer loyalty programme itself or participate in a programme operated by a third party. The awards offered may include goods or services supplied by the entity itself and/or rights to claim goods or services from a third party.” Discussion of ethical issues 1. Do you think that the gross value method distorts earnings because it overstates revenue? Using the gross value method does not necessarily distort earnings, provided that the users of the information are aware of the existence and magnitude of the rewards program. Both policies should be equivalent if management is transparent about the rewards program. Nevertheless, if management uses the rewards program to artificially inflate sales and at the same time buries the discounts in another line of the income statement, or even worse, defers the application of such discounts to other periods, it seems that such action distorts earnings. Under this scenario, the accounting for the rewards program could give management the opportunity to mislead the users of the information. 2. The total cash that the company receives is the same regardless of the method the company uses to report revenue. So, is one revenue recognition method just as good as any other? If markets are efficient with respect to information (i.e., information about the rewards program is fully available to market participants) and if earnings do not directly impact managerial compensation or other contracts, the method used to recognize revenue does not matter. Market participants can undo the effect of accounting policies. On the other side, if the market only focuses on earnings and there is incomplete information about the rewards program, then the method used for revenue recognition matters. Revenue recognition is one of the most important accounting policies and a large number of restatements and regulatory actions have focused on revenue recognition. The reason behind this revenue recognition standard is that before the issuance of IFRIC 13, companies lacked detailed guidance in this area and practices were different for each company. Some companies measured their obligation based on the value of the points to the customer. Others measured it at the (usually lower) cost to the entity of supplying the free or discounted goods or service. IFRIC 13 is based on a view that customers are implicitly paying for the points they receive when they buy the goods or services, and hence, some of that revenue should be allocated to the points. This standard requires companies to estimate the value of the points to the customer and defer this amount of revenue as a liability until they have fulfilled their obligations when the awards are redeemed. References Healy, P., and J.M. Whalen. 1999. A Review of the Earnings Management Literature and its Implications for Standard Setting. Accounting Horizons 13: 365-384. IFRIC 13 Customer Loyalty Programmes. IASB. 2007. 5. Auditor’s Dilemma What this case has to offer This case portrays a young auditor who under-reports his time to look good to his superior, and then wrestles with the consequences of that result. Teaching suggestions Ask students what they would do in Arturo’s shoes. Three choices are listed, but are there others? The goal of this case is to put students in as close to a real-life situation as possible, so that they can realistically imagine themselves in that situation, and then have them go through the thought process of deciding what to do. Ask if their answers would be different under deontology, utilitarianism, justice, fairness and virtue ethics. Ethical issues 1. What should Arthur do? Why? The first option is to tell Stella the truth, that he lied on last year’s time report. He can explain his thought process at that time, that he saw something that raised the issue, he checked it out, although it took an extra 10 hours, found no problem with the inventory, then felt foolish, and chalked up his mistake to being new. Stella, if she is a good manager, will understand his motivation, although Arturo takes a risk by admitting he lied. But this may be his best option. Option two is to complete the inventory audit and report only 36 hours, even though it will take him more time than that. This is not a viable option. It will repeat his first error of under-reporting his time, and perpetuate the problem. It is likely to rise again. Option three - to complain that the 10% reduction is “not fair” is not at all viable. In fact, Arturo already made that complaint, and it was dismissed. In the circumstances, the business decision is a reasonable one, and others on the audit team have not complained. Arturo’s best choice is to come clean, and face the consequences. It seems likely that Stella will understand, put it behind them, and that Arturo can continue on at the firm. 6. Management Choice What this Case has to Offer In this case the chief executive officer of a construction company wants to manage her earnings downward this year so that a steady growth pattern will continue. She has proposed two means of this management: one is to judge a lower profit percentage on expected contracts in progress, and the other is to expense some R & D costs which have apparently been buried in two jobs and are carried in inventory. This case will test the students understanding of their role, to whom they owe duties, the rationale for proper accounting choices, and what their options are if their senior management isn’t prepared to do what is right. Teaching Suggestions Since this case is quite straightforward I would ask the class the questions that are listed at the bottom of the case. Identification of the stakeholders is important so that one can understand who has interests and what those interests are. As far as the ethical issues involved in the case are concerned, these should include: • the conflicts of interests for Sue Fault between her duties as an employee and her duties as a professional accountant, • how to insure that the decisions to lower expected profits and expense the R & D costs are made in accordance with the fundamental values underlying the professional accountant's code of conduct (fairness and the preservation of the integrity fundamental to the fiduciary responsibility which professional accountants bear), • what should Sue do if her CEO doesn't want to do what Sue thinks is right. Discussion of ethical issues Conflicts of Interest: The formal discussion of conflicts of interest is in Chapter 5 on p. 234 . An important issue to clarify in this connection is that the nature of the professional accountant's role involves inherent conflicts of interest which one must always be on guard against, including: self-interest related to standing with her CEO for future pay vs. her duty to the shareholders etc., and self-interest of the CEO vs. the shareholders’ interests. Students should understand their fiduciary role as a professional. Ethical Accounting Choices: Underlying the development of accounting standards is the desire to provide disclosure which respects or is fair to the interests of shareholders and others who need to get their information for decisions from the financial statements. Standards offer guidance for the choice of accounting practice and disclosure which, if it is to support the objectives of the accounting standards, must also be fair. Fair presentation, then, must not hide or suppress information which could be harmful to one of the stakeholders of the company. Stakeholders to be considered should include current shareholders as well as future shareholders. Unfair presentation would trigger a right which would be enforceable in court for significant compensation. Correct Action in the Face of Unethical Behavior: As the students will learn in Chapter 3, their code of conduct prohibits them from involvement in disclosure which constitutes a misrepresentation. They may have to resign in order to avoid the involvement. 7. To Qualify or Not? What this case has to offer This case is intended to introduce the students to a real life auditing dilemma where they're being told to do something against their better judgement, where they believe that their senior professionals are acting out of self-interest and improperly, where the alternatives are unpalatable for herself, for the firm and for the client firm. The case involves a cut-off problem where the decision to record an understatement could put the client company, Models Inc., in a bankruptcy since it is suspected that recording the loss to show economic reality would trigger a decision of the bank as a sort of self-fulfilling prophecy. Students also have an opportunity to consider the importance of client credibility to the auditor, as well as decision making in the face of lack of audit evidence, and appropriate procedures when original audit techniques fall short, and finally loyalty to one's employer and the role of a professional accountant. Teaching suggestions and discussion By way of introducing the case I would invite a student to recap the major issues that they had seen in it. Other students will chime in, and you can develop a list of issues. I would then ask the class whether Jane Ashley, the staff accountant, had any choice except to follow the direction of the partner on the job with regard to what happened on the job. This issue usually develops a rather interesting discussion with some students pointing out that as a new recruit they lack an understanding of the situation, they haven't got as much at stake as the partner who is a fully qualified professional accountant and that they are an employee of the firm and thus owe a duty of loyalty to their employers. Some will argue that even if they participate in something which is erroneous, the fact that they're not qualified will save them from any legal fall-out. What they don't tend to understand is the opposing set of arguments which I take care to develop. First, as students in training they are owed a full explanation so that they will understand what issues they should address when they become fully qualified. Moreover, it is not in the profession's interest to have audit staff that follow the dictum of the partner on the job in all circumstances. In fact if it turns out Jane's suppositions that this was not the appropriate way to proceed turn out to be true, then the partner's ethical behavior will come into question. Most professional accounting bodies require someone to certify that students and accountants are ethically sound before admitting them to the profession, so a blemish on their record could prevent them from becoming fully qualified professional accountants. Having established the relevance of the case for the students, I ask the members of the class to outline their understanding of the cut-off problem that has developed and make sure that they appreciate the issues involved. It would appear that there is a shortage in inventory which Mrs. Hyst is attempting to cover through misrepresentation. The adding back of $150,000 to inventory would mean that profits were also increased by $150,000. This would allow the corporation to be favorably reviewed by a banker and probably avoid bankruptcy in the short run. The problem to be faced here is to whom should the auditor be loyal? Is the primary duty owed to her partner, the firm, Mrs. Hyst, or other financial statement users in the public which would include the bank. (See the discussion in the text p. on the role of the auditor.) At this stage (if I use the case at the end of Chapter 3) I ask what the fundamental principles underlying a professional accountant's code of ethics are and we begin to discuss how these principles should be applied to this particular case. As we do this it becomes clear that the principles of accuracy and integrity and objectivity are all suffering, and in turn various stakeholders may suffer. If we give the benefit of the doubt to Mrs. Hyst then the bank and other creditors potentially suffer. The auditing firm, if the company finally goes bankrupt, may also suffer. If we take a conservative approach and reflect the loss of $150,000 then we may be being unfair to Mrs. Hyst but the bank may get more than they would by liquidating now as opposed to later. In the end the students should see that the proper decision is to do the very best they can to apply the principles underlying the code. If it could be shown later that they were biased in some way and did not apply fundamental principle rigorously then they would be open to legal liability by one or the other of the stakeholders. Their only hope is to apply the principles as rigorously, fairly and accurately as they can to escape this liability. Another issue which could be developed at this stage is fairness in presentation. The students should realize that this requires that information be presented so each can form reasonable decisions. Otherwise, flawed information will result in unfair transfers of wealth between stakeholders. Having come to decisions on these issues, the class should turn to think about what if anything Miss Jane Ashley should do under the circumstances. Again a look at the stakeholders and their interests would suggest that she ought to approach Mr. Viccio for further consultation, and if not satisfied consider approaching another partner or the senior partner in the firm to protect both herself and the firm. A written note should be kept of these discussions. If the firm is not responsive to her interests, then she should consider whether she should consult an ethics officer or with the professional body to which she is attached or a lawyer for advice. This would be to protect the profession from a scandal that could be developed if an improper judgement is made. These are matters of judgement based on the conviction of the individual, which is in turn based on Jane's assessment of the situation. It is unlikely that a student would be held liable if they went to their partner again and to another partner in the firm. Going to a professional body or to a lawyer may be therefore considered idealistic, but is not far-fetched particularly in the case of a newly qualified professional accountant. Discussion of other issues Fairness to All Stakeholders: See above for discussion. Use of Case with Later Chapters: This case can be used with later chapters of the text. It is offered at the end of Chapter 2 so that students will develop an understanding of the role of professional accountants. If used after Chapter 3, they could also develop an appreciation of the ethical principles underlying the codes of conduct that have been evolved for the accounting profession. If it is used with later chapters there can be an interesting discussion of the appropriate choice of ethical decision making framework to be applied. In the consideration of the 5-question/box framework, the issue of legalities can be taken to refer to the observance of generally accepted accounting principles. 8. Team Player Problems What this case has to offer This case puts the professional accountant (PA) in the position of being on a multidisciplinary team as a player, not as the leader. This means that if any issue comes up that offends the PA’s ethical code, then the PA will have to decide what to do about it. If it were an audit scenario, there would be more agreement among the team as to the right set of ethical principles to use. In this case the PA is not even the team leader, so his/her will may not dominate the situation. Whistleblowing and resignation may be required. Teaching suggestions I start the case with a brief introduction setting the stage as noted above except for the last sentence. Also we discuss the need to apply the PA’s code more broadly than on audit engagements. I then ask the class what parts of the PA’s code of ethics could be offended during the completion of the assignment. They come up with and we discuss the following:  Misrepresentation – of facts through error or leaving out important issues  Confidentiality – release of confidential client information  Quality - of data gathering, analysis, reporting, staff supervision, expertise  Area of expertise is beyond PA  Materiality of the issue involved. We then turn to the possible actions open to the PA, including:  Consider if the issue is material, and if so:  Attempt to convince the team/team leader to do the right thing  Render a minority report  Go over the head of the team leader to his/her boss  Blow the whistle outside the firm  Discuss with superior in firm and/or lawyer and/or ethics advisor at firm or professional society  Resign. Discussion of ethical issues Applicability of code The PA’s code of ethics would have to be applied if the PA were known to be a PA and was acting in a capacity known to utilize the expertise of a PA. This is because the client and users of the report could be said to be relying on the PA to exercise his/her fiduciary responsibilities as a PA. It is possible that this expectation could be dispensed with by contract, or by specific exception in the code. Materiality The general test of materiality (affecting the judgment of a lay person) would apply unless the report clearly stipulated a higher level. Even then the PA should use his/her judgment about the nature of the impact that would be produced, and whether s/he agreed with the level of materiality stipulated in the report. Area of expertise The PA must take into consideration his/her expertise in the matters under review. If the team is on an assignment outside of the normal areas of PA subject expertise, and the PA is on the team to contribute generic skills of objective evidence gathering, analysis, report writing and disclosure, the PA may wish to defer to subject area experts on subject area issues. There can be no deferral, however, on issues related to generic PA skills. Choice of action A PA cannot be involved with a misrepresentation, or other breach of his/her code. If the team leader cannot be convinced to adopt the right practices, then the PA must act. The choice involves judgment. The discussions in the text on pages 59, 60, 118, 128 and 234 may be helpful here. This scenario is common today and will become even more common in the future as multidisciplinary teams become the norm in areas such as environmental assessment, auditing, and reporting; social impact reporting; and non-financial reporting on all levels. 9. Minimal Disclosure What this Case has to Offer In this case Ted, the manager on the audit of Smart Investments Limited, is briefing a partner on an upcoming meeting with the audit committee. In the briefing the manager raises a problem of conflict of interest wherein the CEO, CFO and some directors would not want to lessen their profits or present full information which might weaken their ability to exercise stock options profitably. The three disclosure choices are rather interesting: • should profit on trading of derivative securities qualify for segmented disclosure, • appropriate disclosure for a lawsuit, and • anticipating whether a subsidiary which you do not audit will be let go broke with a significant impact on the consolidated statements which you do audit. The case offers the student the opportunity to consider whether potential adjustments (audit choices) are simply technical or whether there is an ethical aspect inherent in the judgement process for making the audit adjustments. Teaching Suggestions and Discussion At the outset I call for a student to outline what they thought the major problem in the case was, and then I ask for students to clarify each of the three issues raised. This would be useful for some may not have a full understanding of derivative securities or the desire for segmented disclosure. Others may not appreciate why there would be a need to disclose the significant amount of profit made through the trading of derivative securities for segmented disclosure usually refers to a revenue earned by geographic area or by line of business. The principles behind segmented disclosure however should be applied to significant sources of earning and that means that the derivative securities profit of 55% of the total company profit ought to warrant disclosure. There is however the confounding factor that the profit for derivative securities may have been made in part as a result of hedging transactions to protect foreign currency positions. The argument here is that attributing 55% profit to derivative securities would be too high. Since the correct amount seems to be unknown or uncertain no disclosure ought to be offered. The issue which should determine the disclosure (I would suggest) would be that of fairness to the stakeholders. Although fairness depends on accuracy, objectivity and integrity, there is a tendency to allow a strict interpretation of these principles to override the good that can come from some disclosure of the probable magnitude of contribution of this activity. Hence the concept of overall well-offness should also be considered. The decision should be taken to disclose if the amount could be reasonably determined or the total of 55% can be disclosed by note indicating the variety of sources involved. With regard to the second issue, the disclosure of a potential lawsuit would turn also on a balance of a desire to be as accurate as possible in fairness to the shareholders who are relying upon the auditor as their information agent. The client therefore should be pressed to come up with a proper calculation, but if it was not possible or if appropriate wording could be found for the disclosure of the possibility of a lawsuit in the contingent liability note, then that disclosure might provide the best balance of fairness for current and future shareholders as well as the auditors and executives. It is very helpful in these kinds of decisions to recognize the ultimate client of the auditor is the public or the future shareholders as well as current shareholders and to some extent other stakeholders who have been identified. Disclosure should be adequate to protect the interest of future shareholders as well as the interests of current shareholders, so some judgement of the balance between shareholders is required. This is an ethical choice in line with the fiduciary duty of professional accountants. The final issue is that of reliance on another auditing firm who have given a clean opinion or on your own judgement as an auditor as to the financial viability of a subsidiary. Because the firm of Dodds & Co. is probably not one which operates within the U.S., but just in the Bahamas, it is unlikely that they could withstand a significant lawsuit. Given current US laws regarding joint and several legal liability Carl's firm would be in the position of picking up the bill, even though they were not the primary auditor for the subsidiary. Consequently it would be wise from a legal perspective for Carl to exercise his independent judgement on the financial liability of the subsidiary, which if material to the consolidation, would require disclosure at least in a note to be fair to the shareholders of the parent firm. It's a tough call because disclosing the lack of viability of the subsidiary may trigger its downfall. This could be to the detriment of the current shareholders and management but could be in the interests of future shareholders - unless, of course, the current shareholders wished to continue to own the company after the subsidiary was straighten out. This discussion of what the action will do to stakeholders interests can be quite revealing to the students, and very lively. At the end of this case discussion, students should be reminded that their deliberations involved: identification of stakeholders, and reasoning about fairness to their interests, overall and individual well-offness, legal rights, and fiduciary duty. All of these are ethical concepts and are inherent in the choices accountants make. The use of an ethical decision making framework from the outset, or reference to its important components, would ensure that each major ethical issue is given attention. Carl's decisions depend on judgement, and that is an ethical concept. 10. Opinion Shopping What this case has to offer In Opinion Shopping, the student is confronted with the prospect of an auditor who has done his job in a proper and rigorous manner who is nonetheless going to be subjected to pressure, intimidation and possible loss of the client for his troubles. There is also the issue of why this activity is being engaged in, because the relatively new president is obviously concerned that the results may come out less than he expected. This introduces the problem of conflicts of interest and the chief financial officer, who the students should take on the role of, is being put squarely in the middle. What should Bob do in order to be loyal to his chief executive officer and to the owners of the business, as well as to himself and to the incumbent auditor of the organization. These are interesting questions which the class will enjoy discussing. There is also the issue of gamesmanship between the client firm's executives and the auditor, which is quite realistic, and which the students will ultimately face when they become professional accountants. Teaching Suggestions I would invite the class to answer the questions in the order they're set out at the conclusion of the case. In the section above, I have identified most of the major stakeholders, and have indicated the ethical issues involved. The stakeholder list should also include the other auditors who are to be questioned, current and future shareholders, directors (particularly those on the Audit Committee), and the auditing profession. In addition, however, there is the issue of the proper conduct of Bill Page as the professional in charge of the audit, and the other auditors who are going to be consulted in the circumstances wither as a way of putting pressure on Bill, or as a preamble to opinion shopping to see who might get the audit in the future. What ethical considerations ought they to consider. When the class comes to consider whether the situation is unethical, the instructor may have to take the position as devil's advocate, in order to elicit the range of comment which will provide understanding that is required. This is the area in which you should invite the class to consider which ethical decision framework introduced in chapter 4 to use, flowing from an analysis of stakeholders and their interests and the impacts of the decision on these stakeholders. They should be asked to justify their choice, and to consider developing a hybrid framework. Question four presents a dilemma which John, the chief financial officer, should be alert to and should consider what to do if the problem develops. Discussion of ethical issues Conflicts of Interest: These are relatively obvious with the main one being the self-interest of the president, the chief financial officer and the auditor and the owners of the business, as well as whoever else might be led astray if unsatisfactory disclosure practices get adopted and sanctioned by a new auditor. Who would benefit and whom would be hurt by such a development. What position should the professional accountant take to maintain the integrity required of a fiduciary relationship? Opinion Shopping: There is nothing wrong with informal discussions with other auditors on how issues might be handled, provided no misrepresentations were made as to the relationship of a particular decision to the awarding of the audit, and the likelihood that the audit would be awarded to someone new, or that the awarding of the audit would be related to the guarantee of a fixed audit fee regardless of audit difficulties for the next year or years. These situations would all be questionable from an ethical perspective because they might involve misrepresentation. The quotation of an absolute fee without regard to audit experience could lead to erosion or lowering of audit standards to make an adequate profit, and the implication that Bob, the chief financial officer, is interested only in the bottom line rather than the integrity of the financial disclosures included in the financial statements. Students should understand that an auditor cannot be dislodged without a formal vote of the shareholders unless he or she chooses to resign, so informal discussions may not be regarded as disturbing by auditors who know that they will be able to appear before the board of directors and shareholders to tell their side of the story. One of the harmful aspects of carrying on informal discussions is that it may diminish the level of trust between the auditor and the chief financial officer and other executives, thus perhaps requiring the auditor to do more audit testing than would otherwise be the case. Responsibility for Fair Disclosure: The desire of the president to soften the auditor's stand on several issues including obsolete inventory, an engine warranty problem, and the cleanup costs of a waste spill does not relive the chief financial officer who is a qualified accountant from his responsibility to be satisfied with the disclosure on those three issues. It is unethical to be involved in a misrepresentation related to those or any other disclosure and accounting practice of the company. So John should be looking ahead not only at the problems that the president prescribes, but also on how he would like them disclosed. It will not be enough to hide behind the audit of an external auditor who makes a mistake. Bob will be charged with misconduct and may incur personal liability in the process. Choice of Ethical Decision Framework: Provided the list of stakeholders is accurately identified, and their interests are also clearly understood, I would be comfortable with any of the three approaches listed in Chapter 4. I would perhaps lean to the use of the five question framework or the Velasquez model because I don't see the logic, at the level of chief financial officer, in worrying about such things as ground rule ethics; you should be setting the ground rules at that stage. I would also substitute the concept of the code of ethics for the consideration of legality in the five question framework. Ultimately the consideration of the suggested action will boil down to a consideration of the well-offness, the impact on the rights and the fairness to each of the stakeholders who have been listed. What if Webster& Co. Looks Like the Choice for New Auditors? John, the chief financial officer, would have to consider in this case whether the interests of the directors and owners of the company would be adequately protected by Webster and Co. becoming the auditors. If he had serious concerns about the previous relationship between the president and Webster & Co. and about the potential for unethical action on the part of the new auditing firm, at the very least he should visit with one of the external directors on the Audit Committee who would be responsible for recommending the choice of auditor to the board of directors and ultimately to the shareholders for vote at the annual meeting. Depending on the discussion with the external director the matter might be taken to a further external director or directly to the Audit Committee for further discussion. The problem with this approach of course is that John would come in conflict with his president and thus endanger his career at the company. Sometimes, however, a professional is called upon to make such sacrifices. 11. Lowballing a Fee Quotation Note: Lowballing can occur when the fee quoted does not cover the costs of the engagement and provide a reasonable return, within a reasonable time frame. What this case has to offer The Lowballing Case offers the opportunity to explore: 1. The problem of agreeing to a fee which is too low to support usual or reasonable profit margins for the audit firm, thus usually leading to the skimping on audit procedures, the erosion of audit standards and the increase of risk that problems will escape the audit. 2. Under what conditions a lowball fee quotation may be acceptable. 3. How audit professionals should approach problems which, if not properly controlled, would undermine their fundamental fiduciary function. The class should be left with the understanding that inherent in the auditor's function are many conflicts of interest which could undermine the audit function, such as: appointment by management to serve shareholders, payment of fees by management not shareholders, the audit of information provided by management, the conflict between doing a quality audit and making a profit on the engagement. These conflicts cannot be avoided entirely. However, they can be recognized, analyzed and controlled for. Teaching suggestions I would begin discussion of this case by eliciting the chain of reasoning set out in point 1 above, so that the class understands the problem (low bid > cost cutting > skimping on audit work > erosion of audit quality > audit errors > failure to discharge duty to shareholders). Obviously, the shareholders are not the only stakeholders to be affected adversely, and I would get at this issue by asking the class to identify the stakeholders involved in this chain of events, and their interests. They should come up with: shareholders, management, other users of financial statements, the other audit partners who would lose profit and risk legal liability, the employees of the audit firm - particularly those who will be expected to work harder or not to charge all the time worked to this job, the professional in general, and the decision makers themselves. Each of these interests should be explored, but particularly those related to legal liability and the impact on audit staff. The class should be brought to understand that audit professionals cannot escape the pressures for profit and the inherent conflict this raises for adequate audit work. As a result, they should see that early recognition of such problems is essential, and proper ethical analysis is required to keep the professional on the right track, as is continued attention to control measures put in place. Having identified the stakeholders and their interests, I would select and apply one of the three ethical decision making (EDM) frameworks discussed in Chapter 4, or a hybrid of them. The choice of framework should be based on which addresses the problems most directly and efficiently. In this case, the issues of legality and sustainable development do not apply, but profitability does. As well, it would be useful to canvas the organizational culture to see if lowballing was a common practice in the firm, and that effective control practices had been developed. Consequently, I would probably use a hybrid approach, as follows: Well-offness: For the audit firm (profit) For the decision makers For the shareholders and other stakeholders (broader costs and benefits) Rights: Of the shareholders (to expected levels of service by their agent) Of the audit staff (to reasonable work conditions) Of the other audit partners (audit risk & legal liability beyondnormal and agreed levels) Fairness: To the audit staff (expectations to work too hard) To the rest of the audit profession To the decision-makers (higher personal risks for the projected return). After the analysis, I would ask whether there is any way the ethical problems surfaced in this analysis can be offset or controlled by reasonable procedures. The analysis and discussion will not yield a conclusive solution, but will provide a good basis of understanding of the questions to ask and the fine lines not to be crossed. Highlighting these would be my approach to the wrap-up of the case. Discussion of important issues Within the framework suggested above, the important issues to be addressed and their sub-components are: Balancing personal self-interest against the interests of others In the long run, personal self-interest will be affected by the interests of others. If the profitability of the firm suffers, the share of profit for each partner (including Tim) will diminish. If the audit risk is too high and legal liability is incurred, the cost to Tim and Andy will be severe because their poor judgement will be exposed. Leaving aside self-interest, a proper professional attitude would include the desire for reasonable profit, but would derive primary satisfaction from rendering good and useful service to clients. In the long run, this line of thinking maximizes the well-offness for all. Usually this conclusion is not arrived at because the participants' analysis is too narrow. Profitability is too narrowly defined The analysis of profitability of the firm should take into account the opportunity cost of using your best staff on this job to maximize efficiency, but lose on other jobs which might have led to more satisfied customers, additional assignments and higher revenues. In addition, the negative impact on staff from pressing them too far may result in the loss of staff, or the lowering of their productivity. The increase in audit risk should also be included based on a discounted projection of potential liability costs. In this regard, recent cases are attracting settlements which are XXX times the audit fee or YYY times the equity of the client company. On the other hand, there may be direct savings in the overhead, planning or management components of a multiple audit engagement if a subsidiary previously audited by another audit firm is taken on as an audit client, as well as indirect savings in a lowering of audit risk by having control of audit standards. Are there occasions when lowballing is appropriate? On the assumption that each assignment must make a reasonable return within a reasonable time frame or unfortunate consequences will result, lowballing is not appropriate. However, there are occasions when lowballing may be acceptable, such as: • when reasonable returns are made on a consolidated or co-owned group of companies taken as a whole, and staff are managed with this overall view in mind, • when the savings mentioned above outweigh the increased costs, • when the control practices in place can control the audit risk and negative consequences on staff. Unfortunately, projected benefits associated with lowballing often do not materialize. What control strategies may be advisable? In order to protect the integrity of the audit, procedures must be in place which ensure that audit standards are not reduced beyond levels which would be used in similar but non-lowballed audits. These could include: specific instructions to audit staff, reviews to insure adequate time budgets, extra reviews of audit working papers to insure quality control, etc. FUNDAMENTAL ACCOUNTING & AUDITING ISSUES CASES 1. Societal Concerns What this case has to offer This case is intended to allow students to explore the role of the accountant. As a professional the accountant has a responsibility to the public and not just to whoever they think is their immediate client such as the management of a corporation or the current shareholders. The case is also intended to get the students to assess what accountants have expertise in and thus what they might be able to comment on. Finally the issue of the impact of a financial or managerial accounting scorecard on management is an area which the students should explore. Teaching suggestions This case is very transparent as to the basic issue involved but it allows the students to develop their understanding of the issues as the discussion progresses. I would begin the discussion of the case by asking two students who would be stereotypical of the positions of Joan and Miguel in the case to speak to their respective positions. Of the two, I would ask the students who would be comfortable in arguing Miguel's case to lead off. I find that the students who would take Joan's case are usually greater in number and perhaps more involved in their position, and if you ask them to go first it truncates the discussion because the other students are less willing to take the floor. After the two students are done speaking encourage the rest of the class to comment on the positions taken. Occasionally I ask that comments be given in support of Miguel's position after the first student makes his comments, and comments in support of Joan to be made by supporters immediately after she makes her comments. Discussion of ethical issues Responsibility to the public: This issue is argued in Chapter 2 where for a variety of reasons it is shown that the accounting professional, particularly the auditor, is ultimately responsible to the public. This issue is not something that most accounting students and even professionals have thought through and this case provides a gentle way of moving into the arguments. The proposition of responsibility to the public can be supported in this case as a defensive measure to protect the mandate of the profession, to enhance the respect of the public for the professional and profession as a result of speaking out, and to develop an equivalence between the accounting profession and other professions mentioned such as medical doctors or lawyers. Credibility: Care must be taken, and this should be realized by the student, that a professional should not comment definitively on something beyond their expertise, nor should anything be promised beyond what can be delivered. This means that while we might wish companies to start disclosing their impacts on society and particularly on our environment we should recognize that we don't have all the answers with regard to how this should be done just yet. That is not to say that we shouldn't begin the debate and participate in it. Information Inductance: The students should be made aware of the principal of information inductance which, commonly stated, suggests that management will be induced to better the scorecard that they are being judged by. As a consequence, if one wishes better impacts of corporations on society and particularly our environment, then setting up a target for environmental impacts and exposing that target would be a useful first step in getting management to give proper attention to the problems. Basic and relative expertise of accountants: Accountants are trained and educated to develop an understanding and skills in the area of evaluation and measurement of economic activities. Traditionally these measurements are made in dollars, but there is no reason why the awareness of such principles as objectivity and consistency cannot be transferred to measurements made in terms of units or percentages and other factors which would be relevant in measuring environmental impacts. These basic elements of the accountant's expertise will permit the accountant to be useful in areas beyond the traditional financial statements, such as environmental impacts. While it is true that accountants made not know absolutely everything about environmental impacts, they have what could be described as relative expertise on measurement and auditing issues because of their basic expertise in a field which relies upon them. This relative expertise provides them a competitive advantage when they are asked to join environmental audit and disclosure teams. If accountants do speak out on issues the impacts of a company on the environment, then they run the risk of some other profession springing up to take over their mandate. The Societal Concerns Case is intended to develop an awareness of the proper professional perspective which is necessary to serve the public and to maintain the rights accorded the professional accountants in society by properly discharging duties to the public. To the extent that accountants are reluctant to take the opportunities provided and discharge the responsibilities they have been given as professionals, it is possible that they will lose reputation and perhaps have to share their mandate with another profession which looks more broadly at the science and application of measurement in non-financial matters. The points that Joan and Miguel have raised are worthy of comment by accountants. 2. Economic Realities or GAAP What this case has to offer This case is based on the Four Seasons Hotel's use of the cost base basis for carrying an investment which has attracted negative press in the Wall Street Journal during the winter and spring of 1994. The principal issues which the students should address are: 1) The probable response by the investing public when the rationale for a generally accepted accounting principle/practice is not intuitively obvious. 2) The logic behind the development of a generally accepted accounting principle. 3) The desirability of going beyond the specific generally accepted accounting principle to make sure that financial statements capture the economic reality of the event being measured and so avoid unfairly presenting the activity. Teaching suggestions I would start the class thinking about this class by asking about the logic of the accounting profession in creating accounting standards which are generally accepted as accounting principles. From this base I would ask the class what their understanding is of the cost basis for carrying investment, rather than incorporate their share of the investment's/subsidiaries earnings or losses into their financial statements under the equity or consolidations methods. I would discuss this issue until it was clear what the rule implies and why 20.0% was selected as a cutoff below which companies could carry investments on a cost basis. I would then ask the students whether there were circumstances under which a rule like 20% might be set aside, or augmented by additional disclosure. What I would be getting at here is that generally accepted accounting principles are intended as guides to fair presentation and may occasionally be deviated from if unfair representations of the economic transactions of an enterprise are going to result. (Rule 203) In this case the 20% might be a poor one to apply, if for example, there were no other owners of the subsidiary Far East Hotels whose interest approached the 19.9% owned by Fineline Hotels. If they had control of the Board of Directors and management, and intended to continue to operate the chain, Fine Line would therefore be the dominant owner. In this situation, if the loss were unlikely to be reversed, it should have been disclosed in the numbers or in a note to the financial statements. Having built this base I would ask the class whether in this situation they would, as Janet, state that Fineline Hotels should have used a cost basis, an equity basis or a consolidation basis or a note disclosure for carrying the investment and recording their share of the profit or loss on the variations of the subsidiary Far East Hotels. Discussion of issues General acceptance of accounting principles: The concept of fair presentation of economic transactions relies upon the use of accounting rules and conventions may apply to transactions in a consistent way that preparers and readers can understand. Since there is usually no single, right way to disclose the economic impact of a transaction accountants have traditionally sorted out which rules are best applied in certain circumstances. Since accountants were not in a position to mandate by law what accounting principles should be used they took pains to see that their deliberate determinations would be fully accepted by their colleagues. Even today judgment must be used to make choices or judgments as to when a transaction qualifies for one accounting treatment or another. The general acceptance of the methods used insures the consistency referred to. Tough choices have to be made on occasion, and it is possible that two professionals can differ on the interpretation of a particular transaction and the application of particular generally accepted accounting principles. Fairness in presentation: The ethical principle of fairness is one which is used an interesting way to control the disclosure of accounting transactions according to the financial statements of a corporation. If a transaction is unfairly presented it is thought to convey an economic advantage or disadvantage to one stakeholder or another. For example, if the transaction is recorded at too low a value then current shareholders may not find the earnings as high as they should be and the price of the corporation's stock may be undervalued. This would result in a transfer of value from current shareholders to future shareholders. It could also represent a shortchanging of the management of the corporation who would not make as much money on stock options or be prepared to exercise them. The reverse is true of an overstatement. Inherent in the concept of fairness is that the students should understand that there is more than one stakeholder who will be affected by the disclosure of economic events and financial statements. Fairness should be thought of in a relatively broad context because accountants have a duty to the public not just to current shareholders or to management. Economic realities: In this case the point being made by Stan Jones is that the presentation using a cost basis for carrying the investment in the subsidiary Far East Hotels did not reflect the losses which have been made because the companies interests of 19.9% was just a hair underneath the 20% trigger for disclosure. He felt very disadvantaged due to a technicality. He felt the economic reality was that the large losses should have been shown. Janet, on the other hand, could argue that below a certain level an investing company might not control the affairs of a subsidiary company like Far East Hotels particularly if there was another investor with a larger than 20% share that was calling the shots. The dominance of another investor would be identified by tests such as representation on the board of directors, determination of company policy and intention to hold the investment by Fineline Hotels. If, for example, the losses described were expected to be reversed soon, there would be no need to show them in the financial statements or in notes to the financial statements. If the Fineline Hotels intention was to hold the securities until the losses were made up then recognition of the dilution of value due to the losses in the short run would be unnecessary. In other words Janet could argue that the economic reality could depend on a number of factors which are not apparent from the case. She could argue that the intention behind GAAP was to provide a fair representation of reality and that was usually accommodated by a cost base disclosure of investments and subsidiaries where the ownership was less than 20%. Credibility and trust in auditors: The case implies that the auditors of Fineline Hotels decided not to qualify their audit report and therefore either found the losses in the subsidiary not to be material, or believed that the rationale behind the 20% rule should apply. Moreover, after applying the 20% rule, thus allowing a cost base carrying of the investment, they decided that they could agree with management's non-inclusion of the losses in the notes to the company's financial statements. In weighing the decisions that the auditors must have taken, and that our students must take in the future, they should be aware of the potential damage they can do to the credibility of the profession and the trust the public puts in the profession. To avoid the profession losing credibility and therefore the trust of the public, care must be taken to see that the GAAP rules applied really do represent the economic realities of the transaction involved fairly. 3. Multidisciplinary Practices – Ethical Challenges What this case has to offer Multidisciplinary practices (MDPs) are fast becoming the norm for assurance service-oriented firms, and are the vision of the future developed by Task Forces of the AICPA and CICA. This is a change from the narrower auditing, tax and consulting orientation that has prevailed for decades. The case calls for the student to assume an organizational view of ethics rather than the view of an individual professional. To solve the problems of competing professional cultures and codes, the student will realize the need for the development and maintenance of an overall ethical culture for the MDP firm, and will explore what this will entail. In the process, the accounting student will have to explore the differences between the professions of law, accounting and engineering on the ethical dimensions of confidentiality, reporting of wrongdoing, and loyalty to external standards of integrity rather than putting only the best case forward. Teaching suggestions This case offers an opportunity to discuss the emerging MDPs, and I would encourage the students to visit the websites of the Big 5 accounting firms and of the AICPA and CICA Vision Task Forces to provide a backgrounder for the students. I would then pose the questions embedded in the case and entertain discussion on each. In the process I would develop a chart of potential differences between the code of accountants, lawyers and engineers, as follows: Discussion of ethical issues Whose codes will predominate: lawyers, engineers or accountants? The codes of an individual professional cannot be obviated, so each will have to be followed. However, it is important that each professional understand the others, and that consultation/discussion takes place before one professional takes action that would breach the code of the others to forewarn them and allow judgments to be challenged. Moreover, where possible, the firm should develop a code that makes clear what the normal practices of the firm are. This code should allow engineers to report possible safety breaches even though it would not be what audit clients would like or are used to from auditors. Such practices should be explained to the client in advance if they are likely to occur. Where possible, the firm’s code should take the highest standard of practice and protection of the public interest as the norm. Do professionals report to one of their own, or a member from a different profession? The type of professional reported to is not as important as one might imagine. Each professional with a license to practice on the public is deemed to be competent, and professionals are expected to refuse work that they are not able to take on competently. Professionals differ in judgment and experience, and it is possible to find supervisory expertise for a job within a firm from a variety of personnel, so it may not be necessary for a higher level manager to be experienced and competent in all phases of all jobs. It follows that the higher level manager need not be from the same profession as the front-line consultants provided adequate alternative quality controls are available. The ability to refer knotty problems to a committee of peers or senior professionals may also help ease friction, as would adherence to an agreed upon common firm code. Who would be sued? The professional who erred could be sued, but it is more likely that the firm and other deep pocket partners would be unless a limited partnership form was used. Won’t focus be on profit rather than serving the public interest? This is a real problem as the proportion of non-professionals in MDPs also grows. It will be vital to develop a firm-wide culture that enshrines integrity and serving the public interest as hallmarks of the enterprise. Otherwise, the MDP will cease to be a professional firm, and may have to try other profiles than that of a fiduciary taking care of its clients. The culture to be developed and maintained will have to be comprehensive and integrated into reward and sanction systems of the firm (see page 107 in the text). TAX & REGULATORY CASES 1. Multinationals and Tax Planning What this case has to offer This case offers a description of why and how transfer pricing is used to shift profits to low tax rate jurisdictions, and how prevalent the practice is, as well as the results of current court cases for transfers that were not justifiable. Teaching suggestions This is a question which will be disputed. Consider dividing the class into those who agree and those who disagree, and having them hold a mini debate on the question, after consultation with their colleagues. Each team may appoint 1 or 2 people to speak for their group. Ethical issues 1. Do you consider transfer pricing to be an ethical means of reducing a businesses’ tax liability? Why, and why not? Students will have different views of this question, some holding that transfer pricing is a good business principle, and a tool in the accountant’s arsenal. If the accountant’s job is to reduce taxes, why not employ a technique that reduces taxes legally? Is it ethical? Many will believe that as long as it is legal, it is ethical. Others will believe that businesses should pay their fair share of tax in the jurisdiction where their profit is earned. There are policy reasons for this, as local governments relies on the taxes to be paid by corporations operating in their jurisdiction. They rely on payment of those taxes, especially in a deficit situation. There is also public reaction to such transfers, as Apple, Inc., well knows. 2. At what level would a transfer price cease to become reasonable, and become unethical and probably illegal? One would argue that it becomes unreasonable when no longer closely related to an arms-length transaction price, and at that point, becomes unethical and probably illegal. Some will skirt the line closely, hoping for as much advantage as the law allows, hoping they will not be prosecuted or fined. 3. Does transfer pricing impose an ethically unfair tax burden on non-multinationals that cannot engage in such a scheme because they do not have international operations? Certainly, it puts them in a less favorable position because they cannot transfer assets to avoid tax. This means they pay a disproportionate share of income tax compared to others, because they are not operating on an equal playing field. 4. Do governments have an ethical responsibility to harmonize tax rates around the world? IT would be hard to argue that they do. Each country has complete autonomy set its own tax rate within its own jurisdiction. The fact that some corporations take advantage of this, moving profits to their jurisdiction with a lower tax rate, works to their benefit. 2. Italian Tax Mores What this case has to offer The Italian Tax Mores case provides a fascinating glimpse of the pressures facing business to subscribe to local patterns of conduct, and therefore ethical behavior that differs from established norms in other parts of the world. The case was copyrighted in the same year as the Foreign Corrupt Practices Act (FCPA) of 1977 was enacted in the U.S. so that it offers a chance to discuss the real and potential impact of the Act. Moreover, the Italian government was a signatory to the OECD Anti-Bribery Convention of 1999 in which the OECD member countries agreed to enact Anti-bribery/Corruption laws covering their own corporations, thereby creating a somewhat level playing field for U.S. corporations that were governed by the FCPA and reducing the corruption of foreign government officials around the world. As of April 2006, 36 countries had ratified the Convention according to Wikipedia. Practices are slow to change, but corporations and their directors and executives should understand that past local practices are not a safe guide for current practices that seem unethical. It is no longer ethically or legally safe to automatically take the view that “When in Rome, do what the Romans do.” This case offers the opportunity to explore the differences between facilitating payments (which are nominal and are paid to speed up something you are going get anyway) and bribes (which are larger than nominal and are paid to change someone’s mind and/or actions. Using an agent, as is proposed in the case, is not a perfect solution either, since large payments to the agent are considered to include a bribe. Also the case can be used to cover the responsibility for: • Considering and making pre-action decisions about the payment of bribes and the reporting of bribes is. • Instructions to staff going on assignment in foreign countries. • Manipulation of foreign financial reports directly by using GAAP, or by using foreign accounting conventions. The case is real and the reported outcome was that the Italian bank settled unfavorably, and the Italian Branch Manager was summoned home to New York and fired. However, this outcome would in all probability have been different after the FCPA was introduced and even less likely after the OECD Anti-Bribery Convention was introduced. Teaching suggestions This case lends itself to quasi-role-playing, and after questioning the class on the details of the case, I often nominate students to the following roles: 1. Italian Bank Branch Manager – a man 2. Chief Legal Officer/General Counsel – a man or woman 3. CEO in New York – a woman 4. Chair of the Board – a woman or man. I then ask the questions presented at the end of the case – one question at a time in the order set out – to each of the 4 students in turn. After each has answered question 1, I ask for the class’ reactions and discuss the issues. We then go on to the next question in the same manner, and so on. If I don’t use role assignment, I ask for a summary of the case, and then ask each question in turn and discuss the issues raised before moving on to the next question. I end up with a summary much like that presented in the “What this case has to offer section” above. Discussion of ethical issues 1. Should the Italian bank’s general manager hire a commercialista and pay busterella? The problem at the heart of this case is whether the normal Italian bargain and bribery approach should be taken, instead of the proper financial statement and pay the computed income tax route. If a commercialista is hired, the busterella (bribe) is sure to follow unless specific instructions are given. Even then, a proper FCPA investigation should turn up any large questionable payments because the FCPA requires corporations to maintain sufficient records to allow full investigation, or face sanction. Many students will adopt the “When in Rome” model, and not recall that the FCPA exists or what its requirements are. They should be reminded that the “Paying the Computed Tax Approach” will likely now produce a win even in the Italian courts in current times given the introduction of the OECD Anti-Bribery Convention. However, I do not force or permit an overall conclusion on this question at this point because I wish to see what the answers are for the other questions and I do not want to foreclose discussion on them. 2. Should the general manager phone the bank’s American CEO in New York and ask for advice? Here the issues would include: • the bank’s code of conduct – does it cover this? • should the CLO be called first? • what if the Italian branch manager doesn’t agree with the CLO? As indicated above, I do not force or permit an overall conclusion on this question at this point because I wish to see what the answers are for the other questions and I do not want to foreclose discussion on them. 3. If you were the bank’s American CEO, would you want to receive the phone call for advice? Here I am looking for an appreciation of whether: • the CEO is interested in the bribery route, or is on an ethical path, • she understands the relevance of an ethical corporate culture and its components, and • if she understands the FCPA issues? I usually toy with the Italian branch manager and the American CEO a little bit here after I get their answers to bring out the issues, as follows: • Italian branch manager – will the CEO think him indecisive? • CLO – was the earlier advice to hire a commercialista legally sound? • CEO in New York – does she want to maintain ignorance/deniability for a FCPA offense? • Chair of the Board – what does she really want her people to do – risk cheating and damage to reputation, or play by the rules? I have used this case for years with wonderful results. The students like it a lot, and there are many opportunities for the flashbulbs of real learning to blaze. 3. Tax Return Complications What this case has to offer This case provides a scenario where a client is attempting to take inappropriate deductions from taxable income and threatens to tell another client that the service he is getting is poor. At the same time, a slip-up is discovered in the handling of the second client's tax affairs. This slip-up can be covered over with modest risk, but the penalty if it found out could result in the loss of the ability to practice. The case gives the student a perspective on the application of ethical standards in the area of tax services, in the following ways: • involvement with misrepresentations in audited and unaudited data, • confidentiality on client matters, • false statements leading to a slippery slope, • reasoning based on worst case rather than optimistic projections. Teaching suggestions I would follow the questions asked at the end of the case. The ethical issues are summarized above, and a suggested solution to the specific tax issues is set out below. Personal Expenses: Bill must inform Dr. Rim that the Firm cannot associate itself with tax returns that it knows have not been properly prepared, i.e. have deviated from the rules. If Dr. Rim refuses to cooperate in ensuring that his return is properly prepared then his information should be returned to him with a letter stating that the Firm will not be preparing his return and why. The audit disclaimer on the return does not relieve the Firm from its responsibility not to associate itself with information it knows or should know to be erroneous or misleading. To maintain his relationship with Dan, Bill should inform Dan that the Firm will not be preparing his brother's tax return for the current year. Due to confidentiality Dan should not be given any of the details. Late Notice of Objection: Bill has two options: One, inform Dan that the deadline was missed and rely on past service and the strong relationships of members of the Firm with Zentor Inc. to maintain Zentor Inc. as a client. Two, agree to the back-dating of the document. Zentor Inc. may sign the document without noticing the date and no one need know the date was missed. The risks under option number one are as follows: 1) The Firm may lose Zentor Inc. as a client; 2) The Firm may have to reimburse Zentor Inc. for the $1,200,000 in taxes; and 3) Bill may not be promoted to Partner, in fact he may be fired. The risks under option number two are as follows: 1) Zentor Inc. may notice that they are being asked to sign a back-dated document and realize the significance of the back-dating, i.e. that the deadline was missed; 2) The Firm may lose Zentor Inc. as a client and will have to pay the $1,200,000 in taxes; 3) Zentor Inc. may commence legal action against the Firm for trying to involve them in an illegal act. 4) Bill may lose his Accountant designation as well as being fired from the Firm. The Firm should not be involved in back-dating documents. Bill should inform the junior of this and reprimand him for discussing such a thing with the Tax Department. Bill should inform Dan that the deadline was missed and that steps will be taken to try to rectify the situation. Attempts should be made to convince the Tax Department that it would be just and equitable to allow an extension of the deadline in this case. 4. Marketing Aggressive Tax Shelters What this case has to offer This case allows the students to discuss marketing ethics in the context of tax practitioners who sell tax shelters. It raises issues concerning: - what is a reasonable shelter as opposed to an aggressive shelter, - the obligations when providing investment advice and investment recommendations, - that tax professionals need to always uphold the public interest, and - whether or not is possible to actually outlaw aggressive tax shelters. Teaching suggestions This is a good opportunity to review the ethical theory of justice as fairness. - Is it fair that sophisticated tax planning schemes are only available to the rich and not to the poor? - Are these tax schemes for the mutual benefit of society? Reductions in taxes for the super-rich may not lead to equitable allocation of resources throughout society. - Are these being marketed to emotionally vulnerable people? There is a high emotional content to taxes. Most do not want to pay any taxes. Is a scheme that reduces taxes a temptation that these people cannot resists because of their negative attitude towards paying taxes. - Is it fair that the poor continue to pay taxes while the super-rich pay no taxes? Is this equitable? 1. Reasonable versus aggressive tax shelters A reasonable tax shelter is a plan that has a more likely than not probability of success if challenged by the taxing authority. An aggressive tax shelter is one that does not have a more likely than not chance of being accepted by the taxing authority, provided tax auditors are assumed to audit with reasonable due diligence. However, it is not always apparent which tax shelters will be accepted, and which ones will not. This means that the tax professional must use professional judgment when estimating the likelihood of success. 2. The marketing of tax shelters Some investors are more aggressive than others. Those who are more aggressive are willing to assume greater risk in order to reap potentially higher rewards. More conservative investors desire low risk investments. It is ethically incorrect for accountants to market aggressive tax shelters when - they are sold on the basis that they are safe or of only moderate risk, and - the investor is not informed of all the risks associated with the shelter. Sales of any product, including tax shelters, become ethically questionable when the sale is based on misrepresentation or deception. That is, when pertinent information is concealed. Concealing information is unfair because it does not treat all parties to the transaction equally. Some have more information, about the potential risks, than others. Concealing information in order to make a sale is deceptive. 3. The public interest Economic theory argues that the buyer is the best judge of what is in the buyer’s best interests. The expression ‘buyers beware’ puts the onus on purchasers not on vendors to know what is in the purchasers’ best interests. However, tax is extremely complex, and the nuances of the implications of intricate tax shelters are beyond the pale of most investors. Hence, investors rely on advisers for advice and recommendations. As such, professional advisers have an additional duty to make sure that the investment is appropriate for the investor. This is more than paternalism. It is the duty of the professional tax accountant to ensure that the tax shelter is in the buyer’s best interests. Professional accountants have a legal and ethical duty to uphold the public interest. Not providing candid and straightforward advice is a violation of the public interest. 4. Should tax shelters be outlawed? An Income Tax Act is like a rule book. It defines transactions that are taxable and transactions that are allowable as a deduction for tax purposes. However, not every transaction can possibly be covered by the Act. As a result, many transactions are ‘grey’ in that the Act is not clear on whether or not the item is subject to tax, or whether or not the item is an allowable deduction. This makes it impossible for the government to outlaw aggressive tax shelters in advance of their assessment. No matter how many shelters the Act specifies as unacceptable, they are others that tax professionals dream up after the Act is written, that are not covered by the Act. However, governments do have the power of the general anti-avoidance rules (GAAR). GAAR says that any transaction that has no economic purpose other than to avoid tax is in contravention of the Income Tax Act. This rule is intended to deter or counteract transactions that are simply designed as tax avoidance ploys. Tax avoidance is defined as not paying tax, or paying less tax or paying tax later than would otherwise be the case. However, these are very broad principles that require sober judgment in the interpretation of whether or not a transaction has any economic or commercial substance. Useful Videos, Films & Links Browning, Lynnley (2008) “Prosecutors Pass on Chance to Revive Tax Shelter Case” New York Times, Dec. 1sthttp://www.nytimes.com/2008/12/02/business/02kpmg.html?_r=1&ref=business Browning, Lynnley (2007) “Four Charged in Tax Shelter Case” New York Times, May 31sthttp://www.nytimes.com/2007/05/31/business/31shelter-web.html?pagewanted=1 Gleckman, Howard, Amy Borrus & Mike McNamee (2005) “Inside the KPMG Mess” Bloomberg Businessweek, Sept. 1sthttp://www.businessweek.com/bwdaily/dnflash/sep2005/nf2005091_2144_db016.htm “KPMG to Pay $456 Million for Criminal Violations” IRS.gov, Aug. 29th 2005 http://www.irs.gov/newsroom/article/0,,id=146999,00.html 5. Providing Tax Advice What this case has to offer This case allows students to ask some fundamental questions. - What is the public interest? - Why do we have a tax system? - Is the tax system designed to harm the wealthy or to help the poor? - Do tax professionals only help the wealthy who can afford their services? I have found that some of the best classroom ethical discussions centre on tax issues. This may be, in part, because tax is so emotional to so many people. Teaching suggestions I begin this case by asking the students why there are taxes. The two normal arguments are: - so that the government can afford to provide goods and services, and - to redistribute wealth. Students who use the first reason tend to explain this in terms of social obligations to help the less fortunate. Those who use the second reason tend to explain this as an unfair government grab to take more away from the wealthy. I then ask the students the following three questions. - Do you have a legal obligation to pay taxes? - Do you have a social obligation to pay taxes? - Do you have an ethical obligation to pay taxes? See how many students have their hands up after the third questions. Then ask them to explain why they think so. The reasons will normally be linked back to one of the two reasons for taxation. Discussion of important issues 1. Public Interest and Tax Planning Professional accountants have an obligation to uphold the public interest. This means that the activities of the accountant should be for the common good or to promote the general welfare. Their activities and advice should not be just for the benefit a few select individuals. Financial statements are a common good because, although the cost of preparing them is borne by the firm, anyone, even those who are not shareholders of the firm, can read them and make financial decisions based on them. With respect to taxation, the tax plans and strategies that the accountant recommends should not be to the detriment of society. The following questions help to determine whether or not the tax plan is in the public interest. - Is the tax strategy available to all taxpayers who find themselves in similar circumstances? - Is there an economic benefit, such as an increase in the economic welfare of society as a whole, to the tax strategy beyond saving tax for the taxpayer? - Is the strategy consistent with the letter of the law? Is it consistent with the spirit of the law? If the answers to these questions are yes, then the strategy is not contrary to the public interest. 2. Tax Advice for the Wealthy The reality is that there are more tax savings strategies available for the wealthy than for the poor. Single parents can only receive the basic deductions because they normally do not receive multiple sources of revenue. Wealthy entrepreneurs normally have numerous sources of revenue with a variety of deductions available for the various sources of revenue. As such, there is normally more opportunity for providing tax advice to wealthy people than to poor people. As long as the tax advice does not advocate breaking either the letter or the spirit of the law, then the advice provided would be in the public interest. 3. Paternalism There is a huge information asymmetry problem with respect to taxation. The income tax laws are voluminous, complex and occasionally vague. It takes a high level of expertise to understand the law and provide sound tax advice. As a result of this information asymmetry, the professional accountant may be seen as an authority figure who must be obeyed. If the tax professional tells the client that is what the client should do, then that is a form of paternalism, where the client is obeying simply because of the knowledge and power imbalance between the tax professional and the client. The negative consequences of paternalism can be avoided when the tax professional provides the less informed client with sufficient detail for the client to make a rational business decision. 4. Fees for Services Contingency fees are fees that are collected only in the event of a favorable outcome, which may bias the professional accountant’s judgment to take a position that is in the accountant’s best interest, not in the client’s. The accountant may no longer be independent and objective. Therefore, professional accountants are prohibited from charging contingency fees for professional services. Instead, the accountant is to charge the regular billing rate unless the work is so complex and intricate that a higher hourly billing rate is justified. 5. Pay $35 to Save $100 in Tax Two different arguments can be provided. The System is Unfair. The purpose of taxation is to raise money so that the government can provide goods and services to all citizens. All citizens utilize the infrastructures provided by the government, but the less fortunate members of society tend to use more of the other government services than the rich. If the government’s revenue from taxation is reduced, then the government is less able to provide those goods and services, services normally used by the less fortunate. So, the poor suffer by having fewer services and the rich benefit by paying lower taxes. This is unfair and not equitable. Another argument is that only the rich can afford to hire a professional tax accountant. So, the poor are penalized further. Because of their poverty they cannot get access to the tax advice that is available to the rich person. The System is Fair. Fairness is not an absolute concept; there is often a range of outcomes that can be considered more or less fair. In that context, some may argue that it is probable that the poor use much more of the public infrastructures, than they pay for, so they are relatively well off even if the rich have opportunities to reduce taxes payable. Secondly, the middle class – who make up the majority of tax payers – and probably pay the largest part of the load, can often access tax advice, so they are not badly off. Finally, the rich can be said to take more risks and opportunities that lead to the creation of value for society (jobs, etc.), so leaving them with tax collars to spend may be good for society. An alternative argument is that, the accountant is not responsible for drafting the income tax rules. The professional accountant’s job is to understand those rules. The professional accountant works for a for-profit firm. The firm earns its revenue by charging a fair fee to provide that specialized tax knowledge to anyone who is willing to pay. Accountants pay tax on the fees they charge for providing tax advice. A third argument might be that the fairest approach would be to charge no personal income tax, just corporate tax. However, this requires a strong argument for why corporate taxes are fair and personal taxes are unfair. 6. Risk Management of Taxes Payable – Is It Ethical? What this case has to offer This case is based on real-life data. Students may have different reactions to the case, including: 1. Not understanding why this practice could be unethical, 2. Realizing it could be unethical but believing that sometimes being unethical could be good business, 3. Thinking “it is OK because everyone is doing it.” There is more than one risk to be considered when dealing with tax authorities, including at least: A. The risk that the accounting treatment to be chosen could be considered to be:  Questionable, and therefore subject to debate and reversal,  Illegal, and therefore subject to fine or worse for tax evasion. B. The risk that the offense will be caught, due to a poor tax audit or too few tax auditors. Teaching suggestions I begin this case by asking if there is any ethical problem with the aspect of risk management suggested in the case. Discussion ensues and I tease out the positions noted above as 1, 2, and 3. I promote the discussion by playing devil’s advocate on items 2 and 3. We then address the question of what risks are involved in tax practice and develop items A and B, exploring the unethical aspects of each. Discussion of ethical issues The pressure for profit and for good client relations is very strong, but the temptation for short-term gain must be considered against the longer-term potential for loss. 1. Is this new practice of risk management ethical? No. One cannot dilute one’s duty to the public, profession and clients by applying a “risk management” sliding scale. An accountant is bound to use his best knowledge and skills in the performance of his task, not gamble on the outcome. For those who believe it’s ok because “Everybody’s doing it,” this is a poor defense against an unethical or illegal act because you will probably be able to find a group of people doing almost anything. You should always think through the act for yourself based on sound ethical principles. The courts and professional discipline committees will not be impressed when you argue that you were one of many. Also, be aware that the trend may change leaving you even more exposed. Solution Manual for Business and Professional Ethics for Directors, Executives and Accountants Leonard J. Brooks, Paul Dunn 9781285182223