Chapter 1 Law & Ethics

Accounting Ethics Chapter 1: The Nature of Accounting and the Chief Ethical Difficulty: True Disclosure

Compiled by Dr. Jake Brock BACC 410 Accounting Law & Ethics

Introduction to Enron

  • Founded in 1985

  • Characteristics:

    • Energy, commodities, and services company.

    • Based in Houston, TX.

    • Became one of the largest, wealthiest, and most successful public companies in the world.

    • Publicly traded and listed on the NYSE (ENE).

    • Market value reached $68 billion at its peak.

Enron's Downfall

  • Collapse: In October 2001, Enron began to collapse.

  • Key Events:

    • October 16, 2001: Announced a $1.01 billion write-down of investments.

    • $35 million attributable to Special Purpose Entities (SPEs) and partnerships managed by CFO Andrew Fastow.

    • Fraudulently reduced shareholder equity by more than $1.2 billion.

Consequences of the Enron Collapse

  • Bankruptcy: Filed for Chapter 11 bankruptcy on December 2, 2001.

  • Defunct as of March 1, 2007.

  • Employment impact:

    • Nearly 25,000 employees lost jobs.

    • $2 billion in pension savings lost.

    • $1.2 billion in retirement funds lost.

    • Approximately $70 billion of investment erased from the market.

Key Figures in Enron's Downfall

  • Ken Lay:

    • Chairman of the Board.

    • Convicted on six counts of conspiracy and fraud, as well as four counts of making false statements.

    • Died of a heart attack while awaiting sentencing.

  • Jeffrey Skilling:

    • CEO & COO.

    • Convicted on multiple charges including fraud, insider trading, and making false statements to auditors.

    • Sentenced to 24 years in prison.

  • Andrew Fastow:

    • CFO.

    • Indicted on 78 counts including fraud and money laundering.

    • Forfeited $29 million in assets and sentenced to 10 years in prison.

Arthur Andersen: Enron's Auditor

  • Background of Firm:

    • Was the auditor for multiple companies, including WorldCom, Sunbeam, Waste Management, and others implicated in financial fraud.

    • Initially held a great reputation.

  • Collapse:

    • June 15, 2002: Convicted of obstruction of justice for shredding documents related to the Enron audit.

    • August 31, 2002: Ordered to surrender CPA licenses and practice rights before the SEC.

The Ethical Question: How Did This Happen?

  • Key Inquiry: How did instances of ethical breaches occur in firms like Enron?

Understanding Ethics

  • Definition:

    • Ethics can be defined in numerous ways, but best understood as "the normative standards of behavior in society."

  • Legal vs. Ethical:

    • Inquiry: Is asking "is it ethical?" the same as asking "is it legal?"

    • Ethics encompasses legal standards but is not confined to them.

The Conceptual Framework of FASB

  • Definition:

    • The conceptual framework is described as: "a coherent system of interrelated objectives and fundamentals expected to lead to consistent standards."

    • Its purpose is to serve public interest by guiding financial accounting and reporting practices.

The Craft of Accounting

  • Specialization: Developing financial statements requires a blend of skill, judgment, and application of appropriate techniques.

  • Challenges: General principles may not always fit specific situations requiring individual judgment (Duska et al., 2018, p. 12).

Accounting Principles and Asset Valuation

  • Example Explained:

    • Writing down assets affects perceived profitability.

    • Example: Reducing a plant's value leads to a one-time expense; subsequent years see reduced depreciation, resulting in inflated earnings.

    • Implications: Lower equity can yield higher return on equity via less dilution of earnings (Duska et al., 2018, p. 12).

Ethical Obligations in Accounting

  • Ethics of Disclosure:

    • Complexities of truth telling and transparency.

    • Questions:

    • To what extent must accountants disclose the true financial status?

    • Is there an absolute standard of 'truth' in accounting?

    • Key Components Framing These Principles:

    1. Accounting's involvement in market exchanges.

    2. The nature of these exchanges as market transactions.

    3. The alignment of nondisclosure with deceit (Duska et al., 2018, p. 13-16).

Roles of Accountants

  • Auditing: Ensuring organizational disclosures and financial data are accurate and reasonable.

  • Managerial Accounting: Providing internal managers with accurate data for informed decision-making.

  • Tax Accounting: Determining tax liabilities for individuals and corporations.

  • Financial Planning: Utilizing knowledge of tax laws and financial markets to enhance client financial positions.

  • Consulting: Advising on money management and financial practices (Duska et al., 2018, p. 19).

Historical Context of Accounting Standards

  • Initial Development:

    • In the 1920s, driven by industrial growth and stock price surges, accounting standards developed piecemeal and lacked coherence.

    • Led to manipulation of accounting practices to meet investor expectations and maintain appearances.

  • The “Roaring 20s”:

    • Accountants shifted from protecting public interest to maximizing corporate success.

  • Economic Impact:

    • Black Tuesday, October 29, 1929: Wall Street crash initiating the Great Depression (1929-1941).

Regulatory Response**

  • Securities Act of 1933 and Securities Exchange Acts of 1934:

    • Introduced by Congress to promote ethical behavior in response to the Great Depression.

    • Established the SEC, enforced securities trading regulations, mandated standardized accounting practices, and required audits by CPA firms (Duska et al., 2018, p. 21).

Auditor Independence Rules

  • FTC Rule (1933):

    • Emphasized auditor independence, stating that accountants cannot be considered independent under certain conditions, including personal interests.

  • Principles Behind Independence:

    • Independence is seen as foundational to the public accounting profession (Duska et al., 2018, p. 22).

Evolution of Professional Standards

  • Development of Independence Rules: Addressed by the AICPA Code of Professional Conduct, establishing strict criteria for independence in accounting practices (Duska et al., 2018, p. 23-25).

Sarbanes-Oxley Act of 2002 (SOX)

  • Purpose: Enacted in response to major corporate scandals including Enron and WorldCom, aimed at promoting ethical conduct and preventing fraudulent reporting.

  • Scope: Mandates accountability from company executives, audit committees, and corporate boards, affecting those with influence over financial report accuracy.

Key Provisions of SOX

  • Public Company Accounting Oversight Board (PCAOB): Established oversight authority over accounting firms.

  • Auditor Independence: Tightened rules regarding auditor relationships and services (Sections 201 & 404).

  • Corporate Responsibility Requirements: Mandated that executives certify the accuracy of financial reports and the effectiveness of internal controls (Titles III & IV).

  • Penalties for White-Collar Crimes: Increased penalties for fraudulent activities and noncompliance (Titles IX & XI).

Conclusion

  • Significance of SOX: Strengthened frameworks for ethical behavior and thorough oversight within corporations, aiming to restore public trust in financial reporting practices.

References

  • American Institute of Certified Public Accountants (2025). Code of professional conduct. AICPA. https://pub.aicpa.org/codeofconduct/Ethics.aspx

  • Brooks, L., & Dunn, P. (2024). Business and Professional Ethics for Directors, Executives, & Accountants (9th ed.). Cengage.

  • Duska, R. F., Duska, B. S., & Kury, K. W. (2018). Accounting Ethics (3rd ed.). Wiley.

  • International Banker (2025). “The Enron Scandal,” History of Financial Crises, https://internationalbanker.com/history-of-financial-crises/the-enron-scandal-2001/

  • Schroeder, R. G., Clark, M.W., & Cathey, J. M. (2022). Financial accounting theory and analysis: Text and cases (14th ed.). Wiley.