Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall 9-1 Chapter 9 Ethics and Financial Reporting Understanding Business Ethics Stanwick & Stanwick 1 st Edition

Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall 9-2 Ethical Thoughts “When money speaks, the truth keeps silent.” –Russian proverb “A firm’s income statement may be likened to a bikini – what it reveals is interesting, but what it conceals is vital.” –Burton G. Malkiel, author of A Random Walk Down Wall Street

Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall 9-3 When is a Doughnut Hole a Real Doughnut Hole? Krispy Kreme became a sensation whenever a new store was opened. Initial public offering in April 2000 In the mid 1990’s, their strategy changed from a slow to an aggressively fast franchise growth. From , grew from 144 stores to 357 stores Pinnacle of success was when it was called the ‘hottest brand in America’ by Fortune magazine

Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall 9-4 When is a Doughnut Hole a Real Doughnut Hole? Caught up in constantly having to increase its financial performance to satisfy the premium that investors were paying for its stock CEO Scott Livengood and form COO John Tate were blamed by the SEC – ‘managed earnings’ The company would always beat EPS targets by 1cent to say that it had exceeded Wall Street expectations Bonuses for top management were linked to surpassing the EPS forecast

Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall 9-5 When is a Doughnut Hole a Real Doughnut Hole? Manipulated revenue by shipping doughnut making equipment with high margins to franchise owners before they requested the equipment –Booked the selling of the equipment as revenue

Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall 9-6 The Role of Creative Accounting Creative Accounting: the deviation from the traditional methods used to interpret an accounting rule or standard Often walks the fine line between legal and illegal activities It is sometimes hard to see where ‘aggressive’ accounting stops and ‘fraudlent’ accounting starts

Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall 9-7 Ethical Philosophies and Accounting Issues Self-interest Utilitarian beliefs Personal virtues Religious injunctions Government requirements Universal rules Individual rights Economic efficiency Distributive justice Contributing liberty

Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall 9-8 The Role of Financial Reporting Accurate financial reporting is needed to provide investors and other interested parties with the ability to 1.Make investment, credit, and financial decisions that relate to the firm 2.Help the reader determine the level of cash flows for the firm 3.Identify the economic resources and obligations to the firm –As identified by the Financial Accounting Standards Board

Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall 9-9 Five Philosophical Presuppositions of External Financial Reporting External Realism Representational Faithfulness Conceptual Relativism of Financial Reporting Schemes Subjective Judgment Commitment to Rationalism

Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall 9-10 Where Were the Auditors? Many stakeholders are asking – “Where were the auditors?” How could firms continue to make up imaginary numbers without raising a huge red flag? Audit: an inspection of the accounting records and other information deemed necessary to express an opinion on the fairness and adequacy of the financial statements Judgment must be used by the auditors

Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall 9-11 Potential Conflicts of Interest Remember; the responsibility of the auditors is to ensure the integrity for the financial reporting by the company –Auditor-Firm conflicts of interest –Shareholder-Management conflicts of interest –Self Interest-Professional Standards conflicts of interest

Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall 9-12 Steps of An Audit Getting Started Planning Stage Field Work Stage Final Review Stage

Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall 9-13 Current Trends in Auditing Risk Based Audit Model –Differs from the traditional audit model because auditors assess the level of risk of the chance of fraud by the client SEC Goals –Responsibilities of management –Responsibilities of auditors –Responsibilities of audit committees

Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall 9-14 AICPA Code of Professional Conduct Established in 1988 Based on six principles: –Responsibilities –The public interest –Integrity –Objectivity and independence –Due care –Scope and nature of services

Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall 9-15 Role of Government Regulations Intended to protect the general public from unethical and illegal actions Established in response to decisions that corporate managers made along the path to business success

Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall 9-16 Gramm-Leach-Bliley Act Sometimes called the ‘Citigroup Relief Act’ Legal name – Financial Modernization Act of 1999 Enacted partly in response to the failed 1998 merger of Citicorp and Travelers’ Group Allows companies classified as financial holding companies to own banks, insurance companies and securities firms Eliminated the Glass Steagall Act of 1933 and the Bank Holding Company Act of 1956

Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall 9-17 Major Components of a Firm’s Financial Statements Balance sheet Income statement Statement of retained earnings Statement of cash flows Must also display comprehensive income in a conspicuous place All should be prepared in accordance with generally accepted accounting principles

Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall 9-18 Accounting Shenanigans or Tricks of the Trade Revenue recognition One time charges Raiding the reserves/cookie jar accounting Lease accounting Off balance sheet items Earnings management

Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall 9-19 Questions for Thought 1.Which stakeholders would be most concerned with –A. the income statement? –B. the balance sheet? –C. the statement of retained earnings? –D. the statement of cash flows? 2.Why is earnings management considered a trick of the trade? Explain. 3.In all of the accounting scandals of the past decade, where were the auditors. Explain.

Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall 9-20 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America.