Ethical Analysis Notes

Enabling Competencies: Ethical Analysis

Chapter 17: Ethical Analysis

• Figure 17a: The CPA Way — Ethical analysis
• Sample Case Situation: Yeager Industries
  • You, CPA, were hired last year as a financial accountant at Yeager Industries.
  • The company’s controller told the accounting staff to record a new lease as a financing lease.
  • Your analysis classified the lease as an operating lease because no bargain purchase exists and other capitalization criteria are not met.
  • The controller assures you that Yeager plans to purchase the asset at lease end and is comfortable that it should stay classified as a financing lease.
  • The lease is significant and could mislead financial statement users if not correctly recorded.
  • Managers receive an annual bonus if earnings exceed a set amount, and you are concerned that the requested entry might be intended to reduce expenses and achieve the bonus because the financing lease results in lower expenses each year.
  • Yeager is a privately held company but the owner has indicated a desire to go public a few years from now.
  • The company currently has a line of credit with the bank to cover working capital needs.
  • Yeager has been profitable for many years and the owner rarely takes a distribution, so most of the company’s growth has been financed with internal cash flows.
  • Yeager does not have a formal code of conduct, but its values statement includes the following paragraph: At Yeager Industries, we know that ethics means having the courage to say and do the right thing. Our employees and business partners have integrity and treat others with respect.

17.1 Assess the situation

17.1.1 Identifying an ethical issue

• An ethical issue is a situation or problem in which your actions, the actions of people you advise, or the actions of an organization you help to shape, might harm one or more people or stakeholder groups, or might violate ethical values.
• Ethical issues can be easy or difficult to detect.
• Practicing looking for them is the best way to improve recognition.
• Examples of accounting ethical issues:
  • Lying or intentionally misleading others
  • Disobeying technical or professional standards
  • Violating laws or regulations
  • Violating the Codes of Professional Conduct
  • Intentionally misstating/biasing financial or non-financial information for purposes such as:
    • Influencing market values
    • Achieving compensation or other performance goals
    • Complying with debt covenants
    • Manipulating contractual compliance and/or payments
  • Hiding information from auditors or regulators
  • Allowing an external client or internal customer to influence a CPA’s professional judgment
  • Engaging in business practices that are socially or environmentally harmful
  • Failing to ensure privacy and confidentiality of information
  • Proceeding with insufficient expertise
  • Tolerating theft, inefficiencies, or other waste of organizational resources
  • Ignoring any of the above practices by others within your realm of influence
• Hint: Stay alert to scenarios where individuals act counter to the values of the accounting profession, company values, policies or rules, or laws. Consider, for example, scenarios where management wants to hide information from other stakeholders or make decisions that increase profit while violating other key values.
• This may be done through manipulative accounting practices or unethical business practices such as sweatshop labor.

17.1.2 Planning work on ethical and other issues

• Ethical issues are often related to other major issues, so choice the order for addressing issues and determine whether or how one issue might affect another.
• In the Yeager Industries case, you have at least two issues to address:
  • The ethical issue
  • The correct accounting treatment
• It might be efficient to address the accounting issue first.
• If the accounting entry is appropriate, the ethical issue is irrelevant.
• If the accounting entry is inappropriate, then you will need to fully analyze the ethical issue and choose an appropriate ethical course of action.

17.1.3 Identifying alternatives

• As part of assessing the situation, you should create a list of potentially viable alternatives.
• You might not identify all possible alternatives at this time.
• However, you can use your initial list to help guide your analysis.
• For the Yeager Industries case, you are likely to identify the following alternatives:
  1. Record the entry as requested by the controller and do nothing else.
  2. Record the entry as requested and report the matter to the company owner.
  3. Refuse to record the entry and do nothing else.
  4. Refuse to record the entry and report the matter to the company owner.

17.2 Analyze an ethical issue

• Once you have identified a potential ethical issue and have gathered key situational information, the next step is to thoroughly analyze the issue.

17.2.1 Ethical criteria

• Your analysis of an ethical issue should first determine whether the alternatives are ethically permitted.
• Ethically permitted actions are viable because they are allowed by all relevant ethical constraints, as shown in Figure 17b.
• In the Yeager Industries case, recording an incorrect accounting entry would be evaluated as follows against the ethical criteria:
  • Codes of Professional Conduct: Yes, violation because you would not be complying with professional standards if the entry means that the statements are not presented fairly in accordance with generally accepted accounting principles.
  • Laws and regulations: No, there are no specific laws requiring compliance with accounting rules by a private company. However, companies with bank loans often require financial statements to be prepared by a public accountant, and, as such, the bank would require the financial statements to follow accounting standards.
  • Society norms: Probably, in general, society would expect correct accounting.
  • Organizational policies, procedures, and values: No, Yeager Industries does not appear to have any specific policies and procedures that would be violated. However, recording an incorrect accounting entry would probably violate the “right thing” and “integrity” aspects of the company’s Values Statement.
  • Individual ethics: Yes, making an accounting entry that you know to be incorrect would probably violate your own personal ethics.
• When writing a case analysis, do not include all of the preceding analysis details. Instead, ask yourself what the most important criteria are for the situation and summarize your analysis for only those criteria.
• For example, you might state: “Recording the entry would be inappropriate because [provide reason here]. Thus, it would be a violation of my personal and professional ethics to record it. In addition, recording the entry would violate the company’s values, which include having integrity and doing the right thing. It would probably also be viewed as inappropriate by the owner and the company’s bank.”

17.2.2 Stakeholder effects

• Ethical issues often arise because decision-maker goals and objectives conflict with the CPA’s ethical principles or with the interests of other stakeholders.
• Your analysis should clarify which stakeholders are likely to benefit and which stakeholders are likely to be harmed by potential alternatives.
• This analysis might be performed qualitatively or quantitatively if data are available to calculate or estimate the size of stakeholder effects.
• In the Yeager Industries case, you do not have sufficient data to calculate the impact of the accounting entry, but you are told that the impact is significant, so you can assume that the entry, as proposed, will mislead financial statement users.
• In a different scenario, you might be able to calculate the effect on bonuses (that is, to compare the bonus with and without the entry).
• Regardless of whether quantitative data are available, you can analyze the qualitative impact on stakeholders.
• For example:
  • The managers receiving the bonus would receive a larger bonus that was not earned.
  • The company and, indirectly, the owner would pay for the larger bonus.
  • The company’s bank would receive financial statements that are misleading, potentially causing an inappropriate lending decision (loan dollar amount and/or interest rate). However, this risk appears to be fairly low given the company’s reliance on past profits for most of its growth.

17.2.3 Underlying cause(s)

• When analyzing an ethical issue, you can increase your value as a CPA by discovering and providing possible remedies for underlying causes.
• Within an organization, unethical behavior can be reduced or eliminated if the entity has processes in place to help guide employees to making ethical decisions.
• The following weaknesses may encourage unethical behavior:
  • Inadequate corporate governance
  • No code of ethics/conduct, or inadequate compliance
  • Poor internal control
  • An organizational culture that discourages good character
  • Negative operating or financial trends
  • Performance-based pay
  • Personal relationships (for example, family, friends, and peers)
  • Conflicts of interest
• Your analysis should identify any organizational factors that lead to the potential ethical issues.
• You will want to address this in your response and look for ways that the entity’s operating environment can be improved.
• In the Yeager Industries case, little information is provided about possible underlying causes, and the company’s values statement appears to encourage ethical behavior.
• However, the company does not have a formal code of conduct.
• This fact, combined with the controller’s request to record an incorrect entry, suggests that a code of conduct and other controls might be needed.
• Hint: Not all of your analyses should be presented in the “analysis” section of a written response to a case. For example, you may see throughout your accounting analysis that managers make decisions based on improving profits, which are tied to their bonuses. When providing advice at the end of your written document, you should identify for the reader the pattern of behavior, explain why it occurred, and recommend how to address it going forward.

17.2.4 Viable alternative(s)

• If there is more than one viable alternative, then you will need to weigh the pros and cons of each viable alternative.
• Sometimes this means using bullet points or a table to summarize the pros and cons.
• However, you will need to decide on the best approach for communicating your analysis and conclusions for the situation.
• In the Yeager Industries case, assume that you have concluded that the entry to record the lease as a financing lease is inappropriate.
• Your technical accounting analysis is sufficient to explain why recording the entry would be ethically prohibited.
• However, your accounting technical analysis does not fully address the ethical issue.
• What is your best course of action?
• Recall from above that the alternatives must not violate ethical principles.
• Should you simply refuse to make the entry as requested by the controller?
• Should you also inform the owner about this matter?
• You need to consider all aspects of your decision before reaching a conclusion.

17.3 Conclude and advise

• When decisions involve more than one viable ethical alternative, your conclusion should select the alternative that best meets the ethical decision criteria for the scenario.

17.3.1 Ethical decision criteria

• Sometimes ethical decision criteria are obvious. For example, when selecting an accounting policy, you must select the choice that best matches the accounting standards and meets the needs of the users.
• When multiple alternatives meet the ethical constraints, then you can use other decision criteria to select amongst them.
• For example, you might need to consider which alternative best benefits key stakeholders or causes no harm.
• The table below summarizes the most common decision criteria for ethical decisions.
  • Satisfy all ethical constraints.
  • Cause no unjustified harm to people or stakeholder groups.
  • Act consistently with what individuals, the CPA profession, relevant stakeholders, and society typically view as good or right.
• There may be times when none of the alternatives satisfy all of the preceding decision criteria.
• In these scenarios, you need to select the option that provides a reasonable trade-off.
• For example, you might select the alternative that causes the least harm or that is most likely to be viewed as good or right.
• In the Yeager Industries case, perhaps you have already decided to not record the entry as requested by the controller (based on your analysis of the ethical constraints).
• However, you still need to decide whether to report the situation to the company’s owner.
• Reporting the incident might cause harm to the controller or other managers.
• However, this option would provide the owner with better information about the company’s culture and would generally be viewed by individuals, society, and the CPA profession as “good or right.”
• The benefit to the owner and consistency with what is viewed as good or right is probably more important than the potential harm to the controller or other managers.
• Accordingly, the best alternative is to (1) not record the entry and (2) report the incident to the owner.

17.3.2 Additional advice

• When responding to an ethical scenario, you can often add value by providing advice about how to avoid or address ethical concerns in the future.
• For example, creating ethical safeguards is likely to reduce the threat of unethical behavior or to mitigate harm.
• Examples of ethical safeguards include the following:
  • Education and training on ethical behavior, policies, and procedures
  • Strong internal control and risk management
  • Adequate corporate governance
  • Requirements to adhere to professional and ethical standards, policies, and procedures
  • External monitoring of compliance with ethical policies and procedures
  • Disciplinary processes
  • Explicit requirements and procedures to report breaches of ethical policies and procedures
  • Access to consultation about ethical matters with an independent advisor (a whistleblower hotline)
• In the Yeager Industries case, appropriate advice would include recommending that the owner create a code of ethics.
• Depending on whether this issue seems pervasive or not, you may also recommend strengthening internal controls so that there is less opportunity for this type of manipulation in the future.
• Hint: In a case, you may find that the person you are reporting to is the person who is making the decisions you are questioning. It is important to consider your audience in communications. Where information is sensitive, it may be necessary to write a separate memo to the board of directors or another party (such as the owner in the Yeager Industries case) to raise concerns about ethical issues.