Financial Accounting Principles BAT4MLesson 4, Page 1

BAT4M

4

Ethics

Introduction [major]ETHICS

In the lLast lesson we discussed GAAP and the importance of GAAP in the Accounting profession. Increasingly we see companies being questioned for their interpretation of GAAP and their accounting policies. In this lesson you will look closer at ethics and use a five step approach to solving ethical issues. Finally,we will look at you will describe how technology has affected accounting and how this relatesit to ethics.

What You Will Learn [minor]

After completing this lesson, you will be able to [minor]

  • define ethics
  • describe why ethical behaviour is important to all accounting professionals
  • describe what an audit is and how it relates to ethics
  • explain and apply the Five step approach to solving ethical issues
  • describe how technology has affected accounting and relate it to ethics

Ethics defined [minor]

According to Merrimanm-Webster, the word Ethic is from the Latin word Ethice, and it gives the following meanings:

  1. The discipline of dealing with what is good and bad and with moral duty and obligation
  2. a) a set of moral principles: a theory or system of moral values

b) the principles of conduct governing an individual or a group

c) a guiding philosophy

d)a consciousness of moral importance

Source: [We will need a copyright release form for this]

As you work through this lesson you will be able to relate the lesson to the definition above. In particular, look at 2b) does that sound like GAAP?

How Does This Link to Accounting Ethics? [minor]

In Canada accountants are ethically or morally expected to follow rules or GAAP set out by the CICA, and their professional associations: the CMA, CGA and CA’s. Accounting students are being introduced early in their studies to courses that address ethics in Accounting. In WaterlooOntario, the University of Waterloo has opened a Centre for Accounting Ethics which endeavours to teach and encourage a high standard of ethics and professional standards to students and financial professionals.

Accounting Ethics [minor]

A Martian lands to plunder,pillage,and burn.The Martian goes up to the owner of the first house he sees and says,“I’m a Martian just arrived from the other side of the solar system.We’re here to destroy your civilization,pillage,and burn.What do you think of that?”The owner replies,“I cannot express an opinion based on hearsay evidence,I am a chartered accountant.”

While the above scenario is fictional,the message of how a chartered accountant would handle the situation is real.All accountants must be as objective as possible and base their opinions on objective evidence.

ALast lesson you learned that accounting is not a closed system or a fixed set of rules,but a constantly evolving body of knowledge.In Canada,the CICA,through the CICA Handbook,has developed a number of recommendations on accounting standards.These accounting standards are the ground rules with which that accountants must comply when ith in quantifying and reporting financial events.

GAAP enables accountants to consistently prepare financial statements that are comparable because they have been prepared under the same rules.Businesses,bankers,investors,and financial analysts can make fair comparisons of current financial statements with previous statements of the business and the statements of other companies because the statements are all formulated on the same set of ground rules.

Like all professionals,accountants owe duties not just to their employers and clients but also to the public.Accountants produce information on the financial situation of the business that is unbiased and accurate.Accounting practices and standards of financial reporting are there to ensure the information is relevant,reliable,understandable,and comparable.

The accounting profession’s public consists of clients,credit grantors (such as banks),governments,employers,interested businesses (such as suppliers and clients),and members of the financial community.All these parties use the financial statements prepared by the business and rely on their objectivity and integrity.This reliance forms the basis of the orderly functioning of the business world.

Failure to adhere to the professional accounting associations’ rules results in a member’s expulsion from the association,making it illegal for him or her to provide accounting services to the public.


Source: CartoonStock Ltd.

Support Questions

(do not send in for evaluation)

1.From the following description/word list,fill in the characteristics of an ethical accountant in the chart provided below.

Description/Word List
Concerned with public interest
Puts professional interest ahead of self-interest
Has professional pride
Honourable and mature
Disciplined in action
Thorough in action
Will not bow to pressure
Stands on convictions
Has integrity
Has a healthy skepticism / Dignified Magnanimous Generous Persistent Courageous Alert Resourceful Determined Diligent Objective Principled / Sensitive Far-sighted Enlightened Steadfast Honest Sincere Truthful Reliable Dependable Trustworthy Independent

There are Suggested Answers to Support Questions at the end of this unit.

The Audit [minor]

An audit is a thorough investigation of every material item on the Income Statement and Balance Sheet and all of the disclosures that appear in the note section of an annual report that relate to the financial statements.

An audit report is issued by a registered chartered accountant or a firm of public accountants,and expresses an opinion as to the fairness and accuracy of the financial statements.It also states whether the financial statements were prepared in accordance with GAAP.

An ethical auditor is one who,despite personal consequences,fulfills his or her professional obligation.For example,an auditor may face the possibility of the loss of a client due to a disagreement regarding the fair representation of the client’s financial position.If an auditor believes that material misstatements exist in the client’s financial statements,an ethical auditor will refuse to sign these financial statements—even if that means losing the client and the audit fee. Remember back to lesson three and the article about Nortel. The article talks about Deloitte (Nortel’s auditors) and the straining of their relationship with Nortel due to the “buy and hold” transactions and the resulting report of fourth-quarter revenues for 2000.

Where there exists an issue on which the auditor must reach a conclusion, tThe auditor ensures that the research has been done with a full understanding of both sides of the issue,that consultation with peers has occurred,and that the issues haves been discussed with clients.As well,the auditor takes the time to understand the context of the issue and what is going on. The ethical auditor considers all the implications of the issue at hand before reaching a decision.These steps are necessary if audit firms and the accounting profession wish to ensure that auditors exercise ethical professional judgment according to the high moral and professional standards set by the accounting profession.

The accounting associations all address the issue of ethics.The Institute of Chartered Accountants of Ontario in conjunction with the Centre for Accounting Ethics at University of Waterloosuggest a five step approach when making ethical decisions.

Five Step Approach to solving Ethical issues [sub]

  1. Identify ethical issues[subsub]

It is important to identify the main or root problem and make sure the issue is based on facts.

  1. Identify stakeholders[subsub]

Who are the main people with interest in the case.

  1. Identify alternative courses of action

[subsub]

Brainstorm for as many alternative courses of action as possible. If working alone, consult with others. Don’t discount a crazy alternative. It may lead to or give you a more workable alternative when you complete step four.

  1. Identify effects/consequences of each alternative[subsub]

Identify as many consequences as possible for each alternative. For instance: you and your friends know that a student constantly uses essays “borrowed” from other sources.You don’t think it is fair as the rest of you spend hours and hours working all night to finish assigned essays. One alternative to this dilemma may be to ignore it. What would be the consequences of this alternative?

  • You and your friends remain frustrated and fester feelings against this person
  • Probably eventually the student will get caught. If this person was in University it would probably result in expulsion. Wouldn’t it be better for that person to learn now that”borrowing” is not acceptable instead of later when the consequences are greater?
  • Your teacher finds out about this person and that you knew about it. They ask you why you didn’t report him/her?

4.Decision[subsub]

Once you have identified the consequences of each alternative, chose one of the alternatives and be prepared to explain how/why you have made the decision.

Is this the source? If so,

Source: Institute of Chartered Accountants of Ontario. Teacher Colleague Program (TCP). ICAO. 29 Bloor Street East, Toronto, ONM4W 1B3. 1-800-387-0735

Ethical Decisions, Audits and the case of Peter Gunn, Forensic Accountant

PETER GUNN, FORENSIC ACCOUNTANT

Prepared by W. Morley Lemon

Peter Gunn works in the forensic accounting department of a large national public accounting firm-Kraft, Mulhuland and Brown (KMB). Richmond Corp. is an audit client of KMB and has asked that the forensic accounting department of KMB do a review of the purchasing procurement area of Richmond. Mary Thompson, the president of Richmond, advises KMB that the audit committee suggested that the forensic accounting department be called in to do a normal review of the purchasing procurement area because several members of the audit committee believe that this particular part of the firm is a fairly high risk area.

Peter Gunn organises a team of two of his staff and sends them in to the review of the purchasing procurement area of Richmond. In the course of their review, the forensic group observes that certain red flags seem to be present relating to the tendering process.

In the review of the tendering process, the forensic group discovers that a certain contractor was given a lot of work although his company was not necessarily always the lower bidder. A review of the files indicated that the same Richmond company employee, Bob Newton, made the decisions in each of these contracts. This information suggests a red flag to the forensic group. The next step for the forensic group was to do a background check on Bob Newton. The forensic group talked to both the KMB and Richmond staff and found that Bob Newton had worked for Richmond for a long time and was very highly regarded and respected by his peers and by the audit firm.

Despite this positive information, the forensic group decided to conduct a more extensive and in-depth background check on Bob. It's important to know at this point that this information search was not public knowledge; only the forensic group and the forensic partner, Peter Gunn, were aware of the investigation. This background check included looking into Bob's lifestyle, his financial situation including mortgages, houses etc., his cars and assets, and running a credit check. As a result of this background check, it was discovered that there was no mortgage on Bob's house, his Muskoka cottage or his winter property in Florida. All of these properties had been bought with cash within the last five years. A check of the company's personnel files indicated that Bob was not receiving a significantly large salary.

Peter Gunn and the forensic group went to the audit partner, Art Went, to indicate that there could be a potential problem. Art was not very comfortable with their information. For one, Richmond was his biggest client and represented fifty percent of his billings. In fact, Richmond was large enough to represent seven and a half percent of the total billings for the office. As a result of these pressures, Art indicated that Peter Gunn and the audit group should drop their investigation and leave it up to the auditors to find the fraud during their audit. He indicated he wished to follow this route because he felt that the forensic group had found a problem that the audit group had missed and Richmond would not be very happy that KMB had to bring in experts to find this difficulty-a difficulty that the auditors should have found out in the normal course. The audit partner felt quite strongly that Richmond was at risk and that he would be the one that would be the big loser if Richmond went to another firm.

What should Peter Gunn do in this particular situation?

Livent [minor]

Businesses listed on the stock exchange are required to make public a set of signed audited financials. At the same time, management knows that the better its financial results look, the higher the share price will be and, consequently, the happier shareholders will be. However, this can lead to conflicts of interest, as was the case with Livent and their auditors.

A Toronto corporation, Livent Inc. focused on live theatrical entertainment, Usually in its own theatres but with some touring engagements. Examples were

Show Boat

Show Boat

The Phantom of the Opera

Joseph and the Amazing Technicolor Dreamcoat

Ragtime

Kiss of the Spider Woman

Sunset Boulevard

Livent owned and operated theatres in Toronto, New York, and Vancouver.

The company’s revenue was derived from performance revenue, the sale of merchandise, corporate sponsorships, gains on sale of rights and exclusivity arrangements, royalties, concession income, and other related fees.

Livent became a public company in Canada in May 1993 and its stock was traded on the Toronto Stock Exchange (TSX) in Canada and on NASDAQ (NASDAQ is an association, not a stock market) in the United States. Livent declared bankruptcy on November 18 and 19, 1998, in the United States and Canada, respectively.

The attached Offer of Settlement between the U.S. Securities and Exchange Commission (SEC) and the company lists the following allegations against the company:

1During the period 1990–1994 (prior to the time Livent became an SEC registrant) Livent was involved in a fraudulent kickback scheme whereby Drabinsky and Gottlieb (the principal executives of Livent) received directly or through a company owned by Gottlieb approximately $7 000 000. Approximately $4 000 000 was capitalized as pre-production costs. See Section C of the attached.

2Livent transferred pre-production costs for shows to fixed assets where the amortization period was significantly longer. See Section D1 of the attached.

3Livent simply removed certain expenses and corresponding liabilities from the accounting records at the end of each quarter so as to improve quarterly results.

4Livent transferred costs from a currently running show to a show that had not yet opened or that had a longer amortization period.

5The dollar effect of items 2–4 was to understate expenses in 1995 by $3 500 000; in 1996 by $18 100 000; and in 1997 by $8 500 000.

6During 1996–97, Livent entered into a series of transactions purporting to represent the sale of rights to present certain Livent shows in return for fees from the counter parties, which fees were reflected in revenues. Side agreements were signed that obligated Livent to repay the fees. As a result, Livent overstated revenues by $34 000 000 ($16 400 000 in 1996 and $17 600 000 in 1997). See Section E of the attached.

The SEC alleges that misstatements were dealt with in the accounting records in the following ways:

1The accounting records were fraudulently manipulated.

2Senior management was involved in the manipulations, including Drabinsky, Gottlieb, Topol, Eckstein, Winkfein, Malcolm, Craib, Fiorino, and Messina. They were respectively the Chairman of the Board and CEO, the President who was also a director, the Senior Executive Vice President and Chief Operating Officer, the Senior Vice President Finance & Administration, the Senior Corporate Controller, the Senior Production Controller, the Senior Controller Budgeting, the Theatre Controller, and the Chief Financial Officer (who was also the engagement partner for the 1995 audit). See Section D2 of the attached.

3Drabinsky, Gottlieb, Topol, Eckstein, and others concealed the manipulations by concealing information from the auditors, and Drabinsky and Gottlieb signed false and misleading management letters of representation to the auditors.

On the face of it, the auditors were the victims of a massive scheme to fraudulently misrepresent the financial position of the company, a scheme that involved much of the senior management (especially senior financial management).

Source:Adapted from information found in Cases in Accounting Ethics, Volume 1, fromat the Centre for Accounting Ethics,School of Accountancy,University of Waterloo,Waterloo,ONN2L 3G1

Support Questions

(do not send in for evaluation)

2.Determine the facts of the Livent situation.

  1. Iidentify the first two three of the five step approach to solving Ethical issues.

a) The primary ethical issues in the Livent case study are:

b) The stakeholders that were affected by the alleged fraud were:

c) Alternative courses of action ( at least three)

  1. Read the following case and apply the five steps approach to solving ethical issues.

You, Devon James, have recently qualified as a chartered accountant.Brewin Construction has hired you to prepare its financial statements for the past year.Brewin Construction has been a successful firm for 30 years,and is run by the owner,Miles Wilson.The previous accountant,Marcellus Kaczemarek,has left for a job in Toronto.

It becomes apparent as you complete your task that Miles feels you are doing something wrong.Miles has been questioning your judgement,saying,“Marcellus didn’t do it that way.”Finally,just as you are completing the financial statements,Miles approaches you with a stack of receipts totalling $75 000.“Here are some improvements we made on the,mmmmmmm,building over the year,”Miles says.