FR 1 Ethics

Creative Accounting

The use of legitimate choices and flexibility within IFRS to present financial results in a more favourable light. Technically within the rules, but driven by management's agenda rather than neutral representation. Does not violate any standard.

Fraudulent Financial Reporting

Intentional misstatements or omissions designed to deceive users of financial statements. Goes beyond exploiting flexibility — involves deliberately misapplying standards, fabricating transactions, or suppressing information. Key tests: the treatment clearly violates a standard AND management is aware of this.

Key distinction: creative accounting vs fraud

Creative accounting stays within the rules

fraud violates them. Creative accounting may reflect a self-interested but permitted choice

fraud requires deliberate deception. If a treatment clearly violates an IFRS standard and management knows this, it is fraudulent financial reporting.

Why might a director inflate profits? (motivations)

(1) Profit-linked bonus — remuneration tied to reported profit creates a direct financial incentive. (2) Debt covenants — avoiding breach of a financial covenant (e.g. gearing limit) that could trigger early loan repayment. (3) Planned company sale — a higher sale price may benefit the director. (4) Career protection — avoiding public embarrassment from disclosing a loss or write-down.

IFAC Code of Ethics — Integrity

A professional accountant must be straightforward and honest in all professional and business relationships. This means telling the truth, not making misleading statements, not endorsing misleading statements made by others, and acting consistently regardless of observation. Breached when an accountant complies with demands to manipulate financial statements.

IFAC Code of Ethics — Objectivity

A professional accountant must not allow bias, conflicts of interest, or undue influence of others to override professional judgements. Must approach every task with an independent mindset. Threatened by financial interests in an outcome, gifts from clients, family relationships with clients, or pressure from superiors.

IFAC Code of Ethics — Professional Competence and Due Care

A professional accountant must maintain professional knowledge and skill at the level required to ensure competent service, and act diligently and in accordance with applicable technical and professional standards. Includes keeping up to date with changes in standards.

IFAC Code of Ethics — Confidentiality

A professional accountant must respect the confidentiality of information acquired through professional and business relationships, and must not disclose it to third parties without proper authority — unless there is a legal or professional right or duty to disclose. Confidential information must not be used for personal advantage.

IFAC Code of Ethics — Professional Behaviour

A professional accountant must comply with relevant laws and regulations and avoid any action that would discredit the profession. Includes not making exaggerated claims about services and not making disparaging references to the work of others.

Self-Interest Threat (IFAC)

Arises when a financial or other personal interest will inappropriately influence the accountant's judgement. Examples: fear of losing a job or pay increase, holding a financial interest in a client, dependence on a single employer, hoping to receive a bonus linked to a particular outcome.

Self-Review Threat (IFAC)

Arises when the accountant evaluates the results of a previous judgement made by themselves or a colleague. They cannot be fully objective because they are reviewing their own prior work. Example: auditing financial statements that you or your team prepared.

Advocacy Threat (IFAC)

Arises when a professional accountant promotes a position or opinion to the point that subsequent objectivity may be compromised. Example: acting as an expert witness on behalf of a client, or aggressively promoting a client's accounting treatment publicly.

Familiarity Threat (IFAC)

Arises when a close relationship makes the accountant too sympathetic to the interests of another party. Examples: long-standing audit relationships without rotation, family members working at a client entity, personal friendships with management.

Intimidation Threat (IFAC)

Arises when the accountant is deterred from acting objectively by actual or perceived pressure — including attempts to exercise undue influence. Most commonly tested in IB233. Examples: CEO threatens dismissal if accountant does not comply.

FD offers a pay rise as an inducement to comply

director threatens to blame accountant for prior errors.

What should an accountant do when pressured to manipulate financial statements?

(1) Refuse to comply. (2) Document the demands and any threats in writing to create a contemporaneous record. (3) Escalate to the Audit Committee — bypass the CEO/FD because the pressure is coming from them;

the audit committee has independent oversight of financial statement integrity. (4) Seek advice from your professional body (e.g. ICAEW) or legal counsel if internal channels are blocked. (5) Do not resign simply because of pressure — doing so allows the misstatement to proceed unchallenged.

Why escalate to the Audit Committee specifically?

The audit committee is composed entirely of independent non-executive directors who have no financial stake in the outcome. It has specific responsibility for overseeing the integrity of the financial statements and for investigating concerns raised about management behaviour. It is the appropriate body precisely because it is independent of the management creating the pressure.

IFRS 5 — when does it NOT apply? (ethics context)

IFRS 5 (Non-Current Assets Held for Sale) requires that the asset is to be disposed of through a sale. It does not apply to assets being abandoned, shut down, or scrapped. Classifying a factory being permanently closed (no buyer sought) as held for sale is a misapplication of IFRS 5. If material and intentional, this is fraudulent financial reporting.

IAS 40 fair value gain — where does it go? (ethics context)

Under IAS 40 (fair value model), gains or losses from changes in fair value of investment property must be recognised in profit or loss — NOT in OCI or the revaluation surplus. Routing the gain through OCI (as IAS 16 requires for owner-occupied PPE) artificially suppresses reported profit. This is a common fraudulent misapplication in IB233 scenarios.

Corporate Governance — definition

The system by which companies are directed and controlled. Encompasses the processes, policies, laws, and institutions affecting how a company is directed and the relationships among its stakeholders. Good corporate governance reduces the agency problem by aligning management and shareholder interests and creating accountability and transparency.

UK Corporate Governance Code — comply or explain

Companies must either comply with each provision of the UK Corporate Governance Code, or publicly explain why they have not. This differs from a rules-based approach (where non-compliance is prohibited). Advantages: flexibility; promotes transparency; avoids box-ticking. Disadvantages: explanations may be formulaic; limited enforcement; inconsistency across companies.

Board composition under the UK Corporate Governance Code

The board must have an appropriate balance of executive directors and independent non-executive directors (NEDs), with independent NEDs forming a majority for larger companies. The roles of Chairman and CEO must be held by different people — combining them concentrates too much power and undermines accountability.

Independent Non-Executive Director (NED) — definition

A board member who has no material relationship with the company: not a former employee, not a significant customer or supplier, not a major shareholder, not closely related to anyone in the company. Independence allows NEDs to challenge management without conflicts of interest.

Role of Non-Executive Directors (NEDs)

NEDs bring independent judgement to bear on board decisions regarding strategy, performance, risk management, resource allocation, key appointments, and standards of conduct. They challenge executive proposals, scrutinise management performance, and act as a check on management power. Their value derives from their independence from day-to-day operations.

Audit Committee — composition

Composed entirely of independent non-executive directors (at least three for larger companies under the UK Corporate Governance Code). Because members are independent of management, they can exercise objective oversight of both management and the external auditors.

Audit Committee — Function 1: Financial Statement Integrity

Reviews and challenges the significant accounting judgements and estimates made by management. Management prepares the statements, so there is an inherent risk judgements will favour management's interests. The audit committee provides an independent second opinion, ensuring the overall presentation is fair and not misleading.

Audit Committee — Function 2: Internal Controls and Risk Management

Oversees the effectiveness of the company's internal control environment and risk management systems. Weak controls increase the risk of fraud and misstatement. The committee receives reports on control failures and ensures the board has an accurate picture of risks and whether they are adequately managed.

Audit Committee — Function 3: External Auditor Relationship

Manages the company's relationship with external auditors on behalf of the board — recommending appointment, agreeing the audit fee and scope, reviewing results, and assessing auditor independence. Ensures management (who are being audited) does not control the terms of their own audit.

Audit Committee — Function 4: Internal Audit Oversight

Oversees the internal audit function, which provides ongoing independent assurance on internal controls, risk management, and compliance. Approves the internal audit plan, reviews findings, and ensures management responds appropriately to recommendations.

Internal Controls — definition

Policies, procedures, practices, and organisational structures that management puts in place to provide reasonable assurance that: (a) operational objectives are achieved; (b) financial reporting is reliable; and (c) applicable laws and regulations are complied with.

Segregation of duties

An internal control requiring that no single individual controls all stages of a transaction. The person who orders goods should not be the same person who approves payment and records the entry. This prevents both error and fraud by ensuring multiple people are involved in each transaction cycle.

Prevention vs Detection controls

Prevention controls stop errors and fraud from occurring (e.g. requiring two authorisations on large payments). Detection controls identify errors and fraud after they have occurred (e.g. bank reconciliations, internal audit reviews). A robust control environment includes both types.

Bypassing internal controls — ethical significance

When management asks an accountant to use another person's login, bypass approval processes, or keep adjustments away from auditors, this is itself an ethical red flag — it represents an attempt to circumvent controls specifically to avoid detection of the misstatement. This should be identified as an additional ethical concern beyond the accounting misapplication.

External Audit — objective

To enable the auditor to express an independent opinion on whether the financial statements are prepared, in all material respects, in accordance with the applicable financial reporting framework. For UK companies: the financial statements give a true and fair view.

True and Fair View — two dimensions

True: factually accurate, free from material misstatement, figures agree to the underlying records. Fair: presented in a way that is not misleading, is impartial, and does not favour any particular party. A set of accounts can be technically true but not fair if the presentation conceals material information or creates a misleading overall impression. Both are required.

Reasonable Assurance — definition

A high level of assurance that the auditor has obtained sufficient appropriate audit evidence to reduce the risk of material misstatement to an acceptably low (but not zero) level. The auditor expresses a professional opinion, not a guarantee.

Why can audits not give Absolute Assurance? — Reason 1

Financial statements contain estimates and judgements that cannot be verified with certainty (e.g. useful economic lives, recoverable amounts, legal claim outcomes). The auditor can evaluate the reasonableness of estimates but cannot know the true future outcome. Uncertainty is inherent.

Why can audits not give Absolute Assurance? — Reason 2

Auditors use sampling — testing a representative selection of transactions rather than every item. This creates sampling risk: material misstatements may exist in the untested population. Because not every transaction is examined, absolute assurance cannot be given.

Materiality — definition and benchmarks

An item is material if its omission or misstatement could influence the economic decisions of users. Quantitative benchmark: commonly 5% of profit before tax. Qualitative factors: an item may be material by nature even if small — e.g. if it converts a profit into a loss, involves director transactions, or relates to a criminal investigation. Both dimensions should be stated in answers.

Audit opinions — four types

Unmodified (clean): statements give a true and fair view. Qualified: a specific matter causes material misstatement but it is not pervasive — "except for…". Adverse: statements are so materially and pervasively misstated they do not give a true and fair view. Disclaimer: auditor was unable to obtain sufficient evidence to form any opinion.

Agency Theory and external audit

When ownership and control are separated (shareholders as principals directors as agents), directors may act in their own interests rather than shareholders'. Financial statements prepared by management alone would not be trusted. The external auditor, as an independent third party with no financial stake in the outcome, provides credibility and reassurance that statements have been independently reviewed. This is the fundamental rationale for the existence of external audit.

IFRS 5 — five criteria for held for sale classification

(1) Available for immediate sale in its present condition. (2) Sale is highly probable. (3) Management is committed to a plan to sell. (4) Active programme to locate a buyer has been initiated. (5) Sale expected to complete within 12 months. ALL five must be met simultaneously. Crucially, the asset must be disposed of through a sale — not abandoned or shut down.

IAS 16 useful life manipulation — ethical issue

Extending an asset's useful life beyond the estimate given by technical experts (e.g. a production manager) to reduce the annual depreciation charge and inflate profits is an ethical judgement issue. If done to trigger a profit-based bonus or ahead of a company sale, it breaches the principle of integrity and gives rise to a self-interest threat.

Refusing to write down a receivable — ethical issue

If a customer has entered liquidation and recovery is unlikely, IAS 10 requires the receivable to be written down (adjusting event). Refusing to do so — e.g. by suggesting a disclosure note instead — is a misstatement. A professionally qualified accountant who accepts this breaches integrity and violates the faithful representation requirement of the Conceptual Framework.

Classifying a lease as short-term or low-value to avoid recognition — ethical issue

IFRS 16 exemptions apply only where the lease term is 12 months or less (short-term) or the underlying asset has a low value when new (approximately US$5,000). Misclassifying a 5-year, high-value lease as short-term or low-value to keep the liability off the balance sheet — e.g. to remain within a gearing covenant — is a misapplication of IFRS 16 and, if intentional, constitutes fraudulent financial reporting.