Chapter 4 Ethics and Financial Reporting Understanding Business Ethics Stanwick and Stanwick 2nd Edition

When is a Doughnut Hole a Real Doughnut Hole? 1 When is a Doughnut Hole a Real Doughnut Hole? Krispy Kreme became a sensation and its initial public offering was April 2000 In the mid 1990’s, the company’s strategy changed from a slow growth to an aggressively fast franchise growth. Fortune Magazine called it the “hottest brand in America” Management would establish an earnings per share target for investors and would always best that amount by one cent

When is a Doughnut Hole a Real Doughnut Hole? 2 When is a Doughnut Hole a Real Doughnut Hole? Company manipulated revenue by shipping doughnut making equipment with high margins to franchise owners before they requested the equipment

The Role of Creative Accounting 3 The Role of Creative Accounting Creative Accounting The deviation from the traditional methods used to interpret an accounting rule or standard Examples include managers and auditors from such firms as Enron, Adelphia, Global Crossing, Rite-Air, Sunbeam, Tyco, WorldCom, and Authur Andersen

The Role of Financial Reporting 4 The Role of Financial Reporting Primary objective of financial reporting is provide interested parties with the ability to Make investment, credit, and financial decisions that relate to the firm Help the reader determine the level of cash flows for the firm Identify the economic resources and obligations to the firm

Where Were the Auditors? 5 Where Were the Auditors? How could firms continue to make up imaginary numbers year after year without auditors identifying the problems and raising a huge red flag? An audit is an inspection of the accounting records and other information deemed necessary to express an opinion on the fairness and adequacy of the financial statements Auditors are considered the “gatekeepers” for the stakeholders

Potential Conflicts of Interest 6 Potential Conflicts of Interest Three potential conflicts of interest that can take place during the auditing process Auditor-Firm conflicts of interest Shareholder-Management conflicts of interest Self Interest-Professional Standards conflicts of interest

The Use of Heuristics in Auditing 7 The Use of Heuristics in Auditing Heuristics used by auditors which would bias the evaluations of the financial statements Selective perception Plausible deniability Escalation of commitment

AICPA Code of Professional Conduct 8 AICPA Code of Professional Conduct American Institute of Certified Public Accountants established code in 1988 Based on six principles: Responsibilities The public interest Integrity Objectivity and independence Due care Scope and nature of services

The Sarbanes Oxley Act (SOX) 9 The Sarbanes Oxley Act (SOX) Passed by the U.S. Congress in 2002, in direct response to the corporate scandals of Enron and WorldCom Geared toward public companies Established to help increase transparency, integrity, and accountability of public companies The biggest reform in corporate America since the 1933 Securities Exchange Act

10 Provisions of SOX Established the Public Company Accounting Oversight Board Requires that the external auditors who review the financial statements of the firms be restricted to performing audit based functions The firm’s audit committee must preapprove all the services provided by the external auditors

11 Provisions of SOX The lead audit partner and the partner responsible for the audit must change at least once every five years CEO and CFO must certify all annual and quarterly reports sent to the SEC All board members and top executives must report all stock transactions to the SEC within two business days

12 Provisions of SOX Fiduciary duty of the firm’s lawyers to report to the BOD any violations of securities fraud Every publicly traded company must include in its annual report a description of the firm’s internal controls External auditor must review the internal control procedures of the firm

13 Provisions of SOX Each firm must develop and make a corporate code of ethics applicable to the firm’s top executives at a minimum Firms are required to hold separate director’s meetings where the CEO is not present In direct response to the events at Enron, the act requires the firm to report, in detail, all off balance sheet transactions

Section 404 – Internal Controls 14 Section 404 – Internal Controls Companies are required to test internal controls on a regular basis These tests must be done by an accounting firm different from the company’s outside auditor Requires company to document and test their financial accounting controls

Least Expensive Aspects of SOX that companies adopt 15 Least Expensive Aspects of SOX that companies adopt CEO/CFO certification of financial statements Developing an internal code of ethics Appointing independent board members and an audit committee Creating processes for reporting concerns and protecting informants from retaliation for complaints made in good faith

Least Expensive Aspects of SOX that companies adopt 16 Least Expensive Aspects of SOX that companies adopt Insisting on true independence for outside professionals More clearly defining the client as the organization as a whole Splitting audit and non audit services between separate accounting firms

A Comprehensive Model of Top Management Fraud 17 A Comprehensive Model of Top Management Fraud The antecedents of fraud are based on the following types of issues Societal-Level Issues Industry Based Issues Organizational Issues

A Framework for Examining Management Fraud 18 A Framework for Examining Management Fraud

Accounting Shenanigans or Tricks of the Trade 19 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

20 Questions for Thought What do you think was the underlying reason why Krispy Kreme started having ethical problems? How does shipping equipment manipulate Krispy Kreme’s financial statements? What is unethical about the CEO receiving perks from Krispy Kreme? Why is earnings management considered a trick of the trade? Explain. In all of the accounting scandals of the past decade, where were the auditors? Explain. Why do Ponzi schemes continue to work time after time?