Ethics in Accounting | Managerial Accounting Q1 | | | Instructor: Nikolaos Kourkoumelis, Ph.D. | Student: Marija Lukic | 11/14/2012 | |

Table of Contents The Ethics in Accounting case and the plan…………………………………………….4Incidentals of Authorization and Submittal…….………………………………………………………………..4Objective………………………………………………………………………………………………………………………..4 Use of Observational Techniques…………………………………………………………………………………….4 An overview of the Report……………………………………...……………………………………………………….4Introduction………………………………………………...…………………………………………5The importance of Ethics in Accounting…….……………………………………………………………………..6 Creative Accounting…………………………………………………………………………….…7 Accounting Scandals..……………………………………………………………………………………………………10 The Enron Scandal……………………………………………………………………………………..10 The WorldCom Scandal………………………………………………………………….…………..12The consequences of Creative Accounting……………………..…………………………………13Measures of Prevention……………………………………………………………………………………15Conclusion……………………………………………………………………….…………………..17Bibliography……………………………………………………………...…………………………18 |

Table of Figures

Figure1. A proposed framework for understanding accounting manipulation practices…….……...9

The Ethics in Accounting case and the plan

Incidentals of Authorization and Submittal
This report is submitted to Dr. Nikolaos Kourkoumelis , professor of “Managerial Accounting” , on November 14th 2012, as authorized on the second Week of Q1 classes, 2012. The research and report was conducted under the direction of Dr. Kourkoumelis. The project was written by Marija Lukic.

Objective
The objective of this report is to analyze the Ethics in accounting profession under the perspective of Managerial Accounting. My primary goal is to describe the meaning and importance of ethics in accounting, explain creative accounting term, then through the real life examples of violation the ethics show how people can manipulate figures and misuse theirs position in achieving their aims and its consequences, and finally present some of the prevention measures in order to pro-actively fight back against these events.

Use of Observational Techniques
In order to produce the current report, data was gathered via Internet sources, mainly newspapers articles and Google Scholar materials, as well as the textbook required for the class of Managerial Accounting. All of these helped me develop a frame and evidence to support my claims considering the topic.

An overview of the Report
The current report is structured as follows: Brief description of Ethics in Accounting Profession, the very beginnings and the term itself and it is followed by explanation of its importance overall, then description of creative accounting term, Enron and WorldCom scandals, its consequences, and finally recommending sets of measures which can help in prevention of these happenings and my final opinion of the topic as a whole.

Introduction

Accounting ethics would best be described as a set to of guidelines (consisting of judgments and moral values) that a professional has to follow while performing accounting. With no difference to any other profession (law, medicine, engineering, etc), an accounting professional also needs to strictly comply with the ethics that have become a norm in accounting. The individuals who receive the services of an accounting professional not only rely on his skill and ability, but also on his professional integrity. People using these services heavily rely on their professional competency to make decisions and in the process also relies on the ethics followed by them. As stated from the side of The Institute of Management Accountants the ethics “deals with human conduct in relation what is morally good and bad, right and wrong. It is the application of values to decision making. These values include honesty, fairness, responsibility, respect and compassion.” To put it simply, it is doing what is right.
It is worth to mention that this is not a “new age” dogma, because the ethics have been incorporated into accounting profession long time ago. Actually, to be precise it is the Luca Pacioli who had introduced it in his first book “Summa de arithmetica, geometria, proportioni, et proportionalita”, published in the far 15th Century. Numerous tiny details of bookkeeping technique set forth by Pacioli were followed in texts and the profession for at least the next four centuries, as accounting historian Henry Rand Hatfield put it, "persisting like buttons on our coat sleeves, long after their significance had disappeared." Perhaps the best proof that Pacioli's work was considered potentially significant even at the time of publication was the very fact that it was printed on November 10, 1494. Guttenberg had just a quarter-century earlier invented metal type, and it was still an extremely expensive proposition to print a book.
Since, “The Father of Accounting” the times have changed, but it is undoubtedly true that accounting practitioners in public accounting, industry, and not-for-profit organizations, as well as investors, lending institutions, business firms, and all other users for financial information are owing a lot to Luca Pacioli for his monumental role in the development of accounting.

The importance of Ethics in Accounting

The nature of the work carried out by accountants and auditors requires a high level of ethics. Shareholders, potential shareholders, and other users of the financial statements rely heavily on the yearly financial statements of a company as they can use this information to make critical decision about investment. They rely on the opinion of the accountants who prepared the statements, as well as the auditors that verified it, to present a true and fair view of the company. Knowledge of ethics can help accountants and auditors to overcome ethical dilemmas, allowing for the right choice that, although it may not benefit the company, will benefit the public who relies on the accountant/auditor's reporting.
The biggest question that the accounting profession faces is whether it is possible to teach ethics or not. Well, it has to be inculcated at some of time in one’s life because there is nobody in this world who comes with an inbuilt ethics mind and soul. So, it is the family, society, schools, colleges and professional organizations that carries on the continuous process of embedding ethics in a person. Same is applicable in the case of all accounting professionals. The codes of conduct that the professional organization expects their members build a sense of ethics in a professional.
Ethical conduct and education are critical to modern society, the business world and the accounting profession. When lapses in ethical behavior occur, the profession’s credibility is at stake. Yet while great effort is expanded teaching accounting students the technical aspects of accounting, the development of ethical values generally seems to be left to chance. Accounting students’ exposure to ethical issues is often limited to a discussion of the profession’s ethics code in the auditing course. The role of the accounting professors is crucial in shaping those values. Given the importance of ethics education many accounting professors are beginning to incorporate unique approaches to enhance the presentation of ethical issues in the classroom. This includes wide variety of methods like use of textbooks, case problems, videotape presentations, educational novels, and articles from various publications.
Ethics is the need of the day for the profession of accounting. When the world is passing through a turbulent economic time as these days it is even more essential.

Creative accounting

After we have concluded what is the meaning of ethics in accounting profession and its importance, let’s come back to reality. And reality has proved to be totally opposite from what we have learned so far. The newspapers are swamped every day with scandals in accounting worldwide. The reason for that is in the hands of professional accounts that sometimes get carried away with pretty little numbers. This is “phenomenon” is broadly known as creative accounting. When and why exactly this concept first appeared and what influenced its development – these are questions that come up when opening true Pandora’s Box: creative accounting. With hindsight a few favorable circumstances to this concept can be identified, circumstances first related to the economical advent of world states but at the same time to the need of economic entities to create for them a good reputation in an increasingly competitive and tough economic environment. The term of creative accounting is usually used to describe the process through which the accounting professionals use their knowledge in order to manipulate the figures included in the annual accounts. Testimonies like it is the “the art of faking a balance sheet” (Bertolus J.), “the art of calculating the benefits” (Lignon M.), “the art of presenting a balance sheet” (Gounin L.), or “the art of saving money” (Ledouble D.) are best describing the nature of creative accounting. This form of accounting actually can be found in the Anglo-Saxon literature in the 1970s, most often in the papers about the bankruptcy of enterprises and those written by Watts and Zimmerman (1978, 1986, 1990) which, to anyone’s surprise, represent the foundation of the positive accounting theory.
In the environment of the world economic crisis nowadays, creative accounting will be referred to more often as a field from where it is expected either to offer live-saving solutions or be blamed for all the negative evolutions. On this aspect, experts such as Salustro and Leburn (2000) would say: „Crisis periods are actually trials for enterprises; affecting their cash flow and generating risks, that accounting doesn’t deal with in a flawless manner. Therefore, managers are tempted to resort to ingenious, more often questionable procedures, for refining accounts presentation.”
Experts like Stolowy and Breton are ones of the few interested in the subject of creative accounting, brave enough to suggest a theoretical framework for the understanding of the accounting manipulation practices. The fundamental principle which their theoretical framework is based on is the following: the goal of publishing financial information is to reduce the costs of the enterprise projects financing. But this reduction depends on the risks to transfer the riches as they are perceived by the agents on the market. The practical means to operate these transfers are based on the results and the balance between the debts and share capital. Consequently, the purpose of accounting data management is to change these two measures: the variation of the result per share and the relation liabilities/assets. The result per share can be changed in two ways: either adding or subtracting certain profits or expenses (which represents the change of the net result) or transferring a column from the upstream or the downstream of the results serving as a computation base of the result per share (which is the management through classification). Regarding the relation between liabilities and assets, this can be modified by increasing the benefit or hiding certain financings with the help of engagements generating devices, off the balance sheet. Figure 1 represents the theoretical framework proposed by Stolowy and Breton for the understanding of the accounting data management.
The shareholders invest their capitals and give the top managers the freedom of finding and implementing the very best way of running the organization, putting all efforts to maximize the performance of the enterprise. This division in the responsibility can lead to conflicts generating costs. Manipulating accounting data is an activity reserved to company managers, even though the other players in the field influence them in their decision to perform such unethical activity. If it were possible to build a theory of the accounting data management, it would not have started from the techniques used for manipulation, but based on the needs, the occasions arising and of the relations between players and investors. The investors can be divided in four subgroups, according to Stolowy and Breton: real and potential shareholders and the real and potential stockholders. Their interests are more than often very opposite and the transfers of riches can be operated between these subgroups. The result of this can be their reaction in different streams to manipulating accounting data. Also, the selection and application of generally accepted accounting principles (GAAP) is flexible, leaving enough room for judgment in certain areas.

Figure1. A proposed framework for understanding accounting manipulation practices
Source: H. Stolowy, G. Breton, Accounts Manipulation: A Literature Review and Proposed Conceptual Framework

Accounting Scandals

"Creative accounting" is at the root of a number of accounting scandals, and many proposals for accounting reform - usually centering on an updated analysis of capital and factors of production that would correctly reflect how value is added. Newspaper and television journalists have hypothesized that the stock market downturn of 2002 was precipitated by reports of accounting irregularities at Enron, WorldCom and many other firms in the United States. “The origin of creative accounting scandals, besides their moral and ethical no-no's, is the monstrous greed and hubris exhibited by their perpetrators. Enron, Adelphia, Tyco- these are just a few companies rocked by scandals that at their heart were about money and power”. If we go into details of some of the world’s most famous scandals we can see the picture more clearly. The two cases selected for this study are both well-known accounting scandals at US clients of the international firm Arthur Andersen, namely Enron and WorldCom.
The Enron scandal

There is an interesting statement considering the Enron topic in the book „The Smartest Guys in the Room”, saying that "the Enron scandal grew out of a steady accumulation of habits and values and actions that began years before and finally spiraled out of control” (McLean and Elkid, p. 132-133). The company has been formed in year 1985 as a merger of Houston Natural Gas and Internorth, making the Enron be the first nationwide natural gas pipeline network. Prior to filing Chapter 11 bankruptcy on December 2, 2001, Enron, by then a conglomerate pursuing unrelated diversification with purely financial incentives, had expanded beyond the energy field to include newsprint, broadband, and cable. Revenues of $101 billion made Enron the seventh largest company of 2000’s Fortune 500. At the time Enron and its subsidiaries filed bankruptcy, Enron’s acting CEO, Stephen F. Cooper, estimated the company faced liability claims of $60 to $100 billion. The afterwards investigation showed that Enron’s dramatic collapse actually resulted from a series of illegal business practices, which has caused a national reexamination of not only Enron’s fraudulent actions but also business ethics in general.
So, how did they manage to do this, who to blame and who got the short end of the stick? One of the reasons many mentioned was that Enron's complex financial statements were confusing to shareholders and analysts. In addition, its complex business model and unethical practices required that the company use accounting limitations to misrepresent earnings and modify the balance sheet to indicate favorable performance. In one article by James Bodurtha, Jr., he argues that from 1997 until its demise, "the primary motivations for Enron's accounting and financial transactions seem to have been to keep reported income and reported cash flow up, asset values inflated, and liabilities off the books." The combination of these issues later resulted in the total bankruptcy of the company, and the majority of them were perpetuated by the indirect knowledge or direct actions of Lay, Jeffrey Skilling, Andrew Fastow, and other executives. It is known that Lay served as the chairman of the company in its last few years, and gave the “go ahead” to the actions of Skilling and Fastow although he did not always inquire about the details. Skilling, all the time emphasized meeting Wall Street expectations, advocated the use of mark-to-market accounting (accounting based on market value, which was then inflated) and pressured Enron top management to find new methods to hide its debt. Fastow and other executives "...created off-balance-sheet vehicles, complex financing structures, and deals so bewildering that few people could understand them."
Enron’s downfall, and the after expected imprisonment of several of its leadership group, was one of the most shocking and widely reported ethics violations of all time. It not only bankrupted the company but also destroyed Arthur Andersen, one of the largest audit firms in the world. The Securities and Exchange Commission (SEC) announced in 2001 that it was investigating the accounting practices of Enron after several years of questions raised by analysts and shareholders. The resulting disclosures and write-downs by the company reduced investor confidence and the company’s credit rating, leading to the bankruptcy in December 2001. The SEC announced that it would pursue charges against Lay, former CEO Jeffrey Skilling, CFO Andrew Fastow and other high-ranking employees. The charges related to knowingly manipulating accounting rules and masking the enormous losses and liabilities of the company. Lay and Skilling were tried together on 46 counts, including money laundering, bank fraud, insider trading and conspiracy. Skilling was convicted on 19 counts and sentenced to over 24 years in prison. Lay was convicted on six counts of fraud and faced up to 45 years in jail. Lay died in 2006, three months prior to his sentencing hearing. The result of investigation of the Enron event was Congress passing the Sarbanes-Oxley Act to improve corporate accountability.
As we can see, the consequences were large, for instance Low M., (2008) illustrates the role that accountants have played in these “achievements”:accounting/off balance sheet contrivances; chief financial officer indicted; company bankrupt; billions of equity value lost. The spectacular collapse of Enron Company provides a vivid image of the fact that some companies may use the legal form of transactions to hide the underlying economic substance of these transactions.
The WorldCom scandal The history of the WorldCom Inc. begins in Mississippi, as a small provider of long distance telephone service. During the 1990s, the company has made number of acquisitions of other telecommunications firms that boosted its reported revenues from $154 million in 1990 to $39.2 billion in 2001, placing it 42nd among Fortune 500 companies. One of the most valuable to mention acquisitions included the 1998 takeover of MCI, which made it the second largest U.S. long distance carrier, and the purchases of UUNet, CompuServe, and America Online’s data network, which put WorldCom among the leading operators of Internet infrastructure. Then, on June 25, 2002, WorldCom, the Nation’s second largest long distance telecommunications company, announced that it had overstated earnings in 2001 and the first quarter of 2002 by more than $3.8 billion. That dreadful announcement surprised financial analysts and, coming on top of accounting problems at other corporations, had a noticeable effect on the financial markets. The accounting maneuver responsible for the overstatement – classifying payments for using other companies’ communications networks as capital expenditures – was characterized by the press as scandalous, and it was immediately asked why Arthur Andersen, the company’s outside auditor at the time, had not detected it. WorldCom filed for bankruptcy protection on July 21st. On August 8th, the company announced that it had also manipulated its reserve accounts in recent years, affecting an additional $3.8 billion. How did they make it? Easy, as it is found out afterwards, by transferring part of a current expense to a capital account, WorldCom increased both its net income (since expenses were understated) and its assets (since capitalized costs are treated as an investment). There is a possibility, that if it had not been detected, the maneuver would have resulted in lower net income in subsequent years as the capitalized asset was depreciated (depreciation is an expense that reduces net income). Essentially, capitalizing line costs would have enabled the company to spread its current expenses into the future, perhaps for 10 years or even longer, as many experts think. The consequences were that a federal grand jury indicted Scott Sullivan (CFO at WorldCom) for securities fraud, conspiracy to commit securities fraud, and making false filings with the SEC. The indictment replaces the criminal complaint filed on August 1st. Also indicted was Buford Yates, WorldCom’s former director of general accounting. Betty Vinson (former director of management reporting) and Troy Normand (former director of legal entity reporting) were named as unindicted co-conspirators. These are some comments from press at the time when WorldCom scandal was revealed:
"This is just another nail in the coffin of confidence," said Paul Marsch, a London-based Morgan Stanley telecoms analyst. Stock markets reeled from Asia to Europe to the U.S., with already beleaguered telecoms stocks touching new, historic lows. "You walk into the kitchen, and you see a cockroach, you are pretty confident that it is not the only one around," said John Hendricks, vice president, trading and strategy group at State Street Global Markets. All in all, these scandals are just the peak of the iceberg and their consequences have long-term impact on the corporate image, trust of all stakeholders and of course on public.
The consequences of creative accounting

$400 billion dollars a year is believe it or not the costs that business frauds have incredibly reached. For instance, in 2002, the Institute for America’s Future reported that the corporate scandals have caused the public more than $200 billion in lost investment savings, lost jobs (over one million workers lost their jobs as their looted companies tumbled into bankruptcy), losses of private and public retirement savings (individual retirement account “401(K)” savings lost $178 billion, and public pension funds lost at least $6.4 billion), and lost tax revenues of nearly $13 billion from companies with questionable accounting practices underreporting their taxable profits. And what is even more critical, the direct and indirect financial consequences of frauds are staggering. On the line with damaging employee and stockholders morale, fraud can threaten an organization’s prized reputation and existence, not only for ethical standards, but also as a trusted fiduciary of stakeholders. Board of Directors and top management should be on the look for red flags that indicate a possibility of fraud, and should encourage management to conduct regular fraud risk assessment and seminars, as well as compliance with the entity’s code of ethical conduct. With the entity’s integrity at stake, preventing fraud –or, at least, promptly addressing it to minimize damage- is of the utmost importance.
Though the accounting profession has accepted a fair share of the blame for the nation’s crisis of confidence in the financial markets, Wall Street investment bankers, financial analysts, underwriters and brokerage dealers, and lawyers, are also to be blamed for the nation’s shaken faith in business and the accounting profession. These professions have been under eye-watch of SEC and the department of justice. Finally, one of the major concerns of the American Institute of CPAs is that the new legislation by Congress could become a template for parallel state legislation or rule changes that directly affect both non-publicly held companies and the CPAs who provide services to them.
A variety of press and academic commentators have tried to make sense of the scandals and the events that ensued. What caused them? Why did they occur then? What were the consequences? Was more regulation the optimal response? Will they happen again? Not surprisingly, these questions have been addressed from many diverse views. The future holds all the answers and the proper measures of preventing these misbehaviors.

Measures of prevention Most countries have differing focuses on enforcing accounting laws. In Germany for instance, accounting legislation is governed by "tax law"; in Sweden, by "accounting law"; and in the United Kingdom, by the "company law". Besides that, countries also have their own organizations which regulate accounting activity. For example, Sweden has the Bokföringsnämden (BFN - Accounting Standards Board), Spain the Instituto de Comtabilidad y Auditoria de Cuentas (ICAC), and the United States the Financial Accounting Standards Board (FASB). Most of the companies these days have their own Code of Ethics, but all these efforts are not enough if things do not start changing in practice, not just to stay on the paper. So, what are the tips for finding and stopping fraud within the organization? Or even more challenging how can you prevent those? Vast amount of studies have tried to answer these questions. I will name some of the recommendations which I find the most efficient. One of them is introducing hotlines within the companies so that people can “voice”. The reasons and steps in achieving that are mentioned below. First of all, change the current perception. An interesting, common problem with hotlines is their stigma and negativity. Employees are worried about being labeled tattletales or snitches. So why not expand the hotline’s purpose? A recent article in Fraud Magazine suggests having them encompass process improvements, safety issues, quality control enhancements, human resource suggestions, vendor comments, general complaints, and general employee suggestions. Remove the stigma and make the hotline more appealing. Next step, attach a reward to it. If you are truly devoted to change the perception of a hotline, put your money where your mouth is, as it is said. Seriously think of offering cash rewards for tips that save money through process improvement, as well as for tips that identify fraud, waste, and abuse. Monetary rewards can be a percentage of the savings, but companies can get creative with other reward ideas, also, such as non monetary once (extra days of vacation, tickets to sporting/recreational events), or even donations to the charity of the employee’s choice. And at the end, do not forget that it starts at the very top. It all raises a question: If the CEO can’t be a respected whistleblower, who can? It starts at the top. If the board of directors and chairman are not interested in legal and ethical practices, hotlines and whistleblowers serve no purpose. It is only when there is commitment to integrity from the highest possible places that a company will be effective in its implementation and use of hotlines. It is clear from the research that hotlines can help many more companies protect themselves from fraud. The real question is: Is your business willing and able to make the changes that allow a hotline to be effective? Also, I would like to mention the rising role of Forensic Accountants and the Credible instead of Creative accounting. No theory of accounting standards or related regulatory mechanism can ensure true and fair accounts unless the accountants and the management of the company are committed and sincere on the issue. Further, the management of the company of which accounts are true, fair and transparent is in a better position to take suitable managerial decision for remedy of past errors as well as future growth. The parties who are associated with accounts of a company either directly or indirectly like - accountants, management, investors, banks, financial institutions, stock exchanges, SEBI etc. can offer a reasonable level of confidence about the fidelity and transparency of accounts and efficiency of operation that serves for Credible Accounting. Also, the accounting performance can be measured and checked by investigation that is conducted by Forensic Accountants and Audit Firms. But, as always their ethics are also on the line, meaning how credible is their investigation (since we know what happened with Enron and WorldCom). Related to that, it is stated that the impact of creative and fraudulent accounting can be reduced by streamlining the accounting and auditing system and more effective corporate governance. Creative and fraudulent accounting can be reduced by:
1. Introducing forensic accounting for white collar fraud detection and fraud prevention;
2. Reducing the alternative choices of accounting treatment in accounting standards;
3. Enhancing the quality of corporate governance;
4. Amending Companies Act;
5. Enforcing strong regulation, and
6. Increasing the effectiveness of audit. I strongly believe that the introduction and implementation of international accounting standards will help to prevent the formation of creative accounting and so for forming a fully functioning system of comparable financial statements, an also increase the trust in enterprises, improving the ability to raise funds and mutual competitors comparability. Furthermore, I believe that honesty and ethical behavior in business is largely dependent on fiscal policy of each country. If the government does not create adequate environment for entrepreneurship, the level of taxation ever moves upwards or companies’ inaccessibility of loans increases, more activity in creative accounting could be always expected. Of course, the ideal situation for banks and financial authorities is to reach the complete truth about the situation of the company and all of its transactions. It is, however, a pity if any country's fiscal policy directs not against business but in opposite direction. At this point the entrepreneurs would also cease to go abroad and stay its residence in the home country. However, creativity in the accounting and falsifying financial statements is the primary responsibility which always lies on shoulders of company owners or management.

Conclusion In the World we live in today majority of us can agree on one thing, being ethical and righteous is questionable. The circumstances as they are, lead us to what I like to call the fall of human values. So, I would not spend time on theoritizing my view on this matter because it is not the topic, but I still want to point out the connection with global crisis and deteriorating effect on everything we do, how we feel, how we think, how we act. That is why it is no surprise that people have lost themselves in big Blue Ocean of money, money, money. The greed and small, personal self-centered interests gave the incentives to so many frauds and scandals. As stated in this report the need for incorporating ethical values in accounting profession is a must. Nowadays, since in the past the World has experienced and suffered from consequences of breaking the ethics in this field, the penalties and regulations are much more developed and stricter. Although this is all done in practice, rules are harsh, not much space for fraud, everyone is obeying incorporated rules of Code of Ethics in mostly every company, and the importance of Ethics is surely put to higher level, I still feel the need to stress one thing that no one can influence and that one thing is in many ways determinating creative accounting activities. It is our personal self-concept that makes the final decision, “to be or not to be”. The best way to conclude this topic is by using famous Aristotle’s quote:
“We do not act rightly because we have virtue or excellence, but we rather have those because we have acted rightly”. I think that a truly professional and ethical accountant has to have this on his mind all the time.

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http://www.essentiallifeskills.net/aristotlequotes.html

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[ 10 ]. http://link.springer.com/article/10.1007%2FBF00872114?LI=true#page-2, Journal of Business Ethics
December 1995, Volume 14, Issue 12, pp 987-995
“Importance of and approaches to incorporating ethics into the accounting classroom” by
David S. Kerr, L. Murphy Smith
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