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Ethical Obligations and Decision Making in Accounting Text and Cases 4th Edition Mintz

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Chapter 6 Discussion Questions

Extended Discussion

Here is an outline of the reporting requirements under Section 10A.

Section 10A of the Securities Exchange Act of 1934, 15 U.S.C.§ 78j-1. Audit requirements.

(a) In general

Each audit required pursuant to this chapter of the financial statements of an issuer bya registered public accounting firm shall include, in accordance with generally accepted auditing standards, as may be modified or supplemented from time to time by the Commission

(1) procedures designed to provide reasonable assurance of detecting illegal acts that would have a direct and material effect on the determination of financial statement amounts;

(2) procedures designed to identify related party transactions that are material to the financial statements or otherwise require disclosure therein; and

(3) an evaluation of whether there is substantial doubt about the abilityof the issuer to continue as a going concern during the ensuing fiscal year.

(b) Required response to audit discoveries

(1) Investigation and report to management

If, in the course of conducting an audit pursuant to this chapter to which subsection (a) of this section applies, the registered public accounting firm detects or otherwise becomes aware of information indicating that an illegal act (whether or not perceived to have a material effect on the financial statements of the issuer) has or may have occurred, the

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firm shall, in accordance with generallyaccepted auditing standards, as maybe modified or supplemented from time to time bythe SEC

(A)(i) determine whether it is likelythat an illegal act has occurred; and

(ii) if so, determine and consider the possible effect of the illegal act on the financial statements of the issuer, including anycontingent monetaryeffects, such as fines, penalties, and damages; and

(B) as soon as practicable, inform the appropriate level of the management of the issuer and assure that the audit committee of the issuer, or the board of directors of the issuer in the absence of such a committee, is adequatelyinformed with respect to illegal acts that have been detected or have otherwise come to the attention of such firm in the course of the audit, unless the illegal act is clearly inconsequential.

(2) Response to failure to take remedial action

If, after determining that the audit committee of the board of directors of the issuer, or the board of directors of the issuer in the absence of an audit committee, is adequately informed with respect to illegal acts that have been detected or have otherwise come to the attention of the firm in the course of the audit of such firm, the registered public accounting firm concludes that

(A) the illegal act has a material effect on the financial statements of the issuer;

(B) the senior management has not taken, and the board of directors has not caused senior management to take, timelyand appropriate remedial actions with respect to the illegal act; and

(C) the failure to take remedial action is reasonablyexpected to warrant departure from a standard report of the auditor, when made, or warrant resignation from the audit engagement;

the registered public accounting firm shall, as soon as practicable, directlyreport its conclusions to the board of directors.

(3) Notice to Commission; response to failure to notify

An issuer whose board of directors receives a report under paragraph (2) shall inform the Commission bynotice not later than 1 business day after the receipt of such report and shall furnish the registered public accounting firm making such report with a copyof the notice furnished to the Commission. If the registered public accounting firm fails to receive a copyof the notice before the expiration of the required 1-business-dayperiod, the registered public accounting firm shall

(A) resign from the engagement; or

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(B) furnish to the Commission a copyof its report (or the documentation of any oral report given) not later than 1 business day following such failure to receive notice.

(4) Report after resignation

If a registered public accounting firm resigns from an engagement under paragraph (3)(A), the firm shall, not later than 1 business dayfollowing the failure bythe issuer to notify the Commission under paragraph (3), furnish to the Commission a copyof the report of the firm (or the documentation of any oral report given).

8. What are the legal requirements for a third party to sue an auditor under Section 10 and Rule 10b-5 of the Securities Exchange Act of 1934? How do these requirements relate to the Hochfelder decision?

A plaintiff must prove the following under Rule 10b-5 of the Securities Act of 1934: 1) loss or damages; 2) financial statements were misleading; 3) reliance on the misleading statement; 4) misleading statements are the direct cause of loss; 5) accountant knew about the scheme to defraud (scienter). In the Hochfelder decision, the plaintiff could not prove scienter in that there was no showing that the auditors’ action was intentional or willful or designed to deceive investors.

9. Valley View Manufacturing Inc., sought a $500,000 loan from First National Bank. First National insisted that audited financial statements be submitted before it would extend credit. Valley View agreed to do so and an audit was performed by an independent CPA who submitted her report to Valley View. First National, upon reviewing the audited financial statements decided to extend the credit desired. Certain ratios used by First National in reaching its decision were extremely positive indicating a strong cash flow. It was subsequently learned that the CPA, despite the exercise of reasonable care, had failed to discover a sophisticated embezzlement scheme by Valley View's chief accountant. Under these circumstances, what liability might the CPA have?

Under this kind of situation, if the CPA can show due care and competency in the performance of the audit, the CPA would not be liable. The CPA would need to show that the audit was planned and performed to detect material misstatements, but that it is not absolute assurance that all misstatements, and especially sophisticated embezzlement by the chief accountant, will be discovered. The CPA did perform an audit with reasonable care. Still, the CPA might be held legally liable to Valley View for ordinary negligence because the embezzlement scheme was not discovered A plaintiff would likely argue that even if due care was exercised, the auditor did not follow GAAS because a greater level of professional skepticism backed by a probing mind and suspension of belief would have led the auditor to discover the embezzlement. A plaintiff such as Valley View (the client) would assert that the CPA is liable for ordinary negligence because of the privity relationship. Valley View (third party creditor) would argue for liability for

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gross negligence or fraud. It appears the creditor may not have been a foreseen or reasonable foreseeable third party but would be considered the foreseeable user. Therefore, under the liberal Rosenblum ruling the creditor would be viewed as a reasonably foreseeable third-party user since Valley View did obtain a loan from First National Bank.

10. Nixon and Co., CPAs, issued an unmodified opinion on the 2015 financial statements of Madison Corp. These financial statements were included in Madison’s annual report and Form 10-K filed with the SEC. Nixon did not detect material misstatements in the financial statements as a result of negligence in the performance of the audit. Based upon the financial statements, Harry purchased stock in Madison. Shortly thereafter, Madison became insolvent, causing the price of the stock to decline drastically. Harry has commenced legal action against Nixon for damages based upon Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934. What would be Nixon’s best defense to such an action? Explain.

Harry must show that he suffered a loss, that the financial statements were misleading, and that he relied on the financial statements to make his investment in Madison. Nixon’s defense against the legal action would be evidence of the audit performed with in accordance with GAAS and the exercise of due care, non-negligent performance and absence of causation or proximate cause. Nixon would need to show that it did not intentionally fail to detect the material misstatement and was not trying to induce Harry to purchase the stock of Madison and, but for the material misstatement, the audit was conducted with the degree of professionalism expected in the circumstances. In other words, the firm may have been guilty of ordinary negligence but took no overt action to fall into the gross negligence or fraud categories of legal liability.

11. The following pertains to auditor legal liability standards under the PSLRA:

a. The Reform Act requires that, in any private securities fraud action in which the plaintiff is alleging a misleading statement or omission on the part of the defendant, “the complaint shall specify each statement alleged to have been misleading, the reason or reasons why the statement is misleading, and, if an allegation regarding the statement or omission is made on information and belief, the complaint shall state with particularity all facts on which that belief is formed.”

Do you believe this standard better protects auditors from legal liability than the standards which existed before the PSLRA? Explain.

b. Do you believe the change in standards for auditors’ liability under the PSLRA from joint-and-several to proportional liability was a good thing? Explain.

a. The PSLRA requires that a complaint specify each statement alleged to have been misleading, the reason or reasons why the statement is misleading, and, if an allegation regarding the statement or omission is made on information and belief, the complaint shall state with particularity all facts on which the belief is formed.

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The PSLRA also requires that a complaint, with respect to each act or omission:

State with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind [i.e., scienter]. “With particularity” means that a plaintiff must provide “in great detail, all the relevant facts forming the basis of her belief.” [Rule 9(b) further requires that in alleging fraud, a plaintiff must “state with particularity” the circumstances constituting fraud or mistake.]

The particularity standard does better protect auditors from legal liability than the standards which existed before the PSLRA because it heightens the pleading requirements. The best way to illustrate its effect is by citing a court ruling on the matter.

Extended Discussion

The Sixth Circuit addressed the liability of an outside auditor named as a primary violator in a securities fraud action in Louisiana School Employees' Retirement System v. Ernst & Young, LLP, No. 08-6194 (6th Cir. Decided Sept. 22, 2010) There, the Circuit Court held that a plaintiff "may survive a motion to dismiss only by pleading with particularity facts that give rise to a strong inference that the defendant acted with knowledge or conscious disregard of the fraud being committed . . ." as to a defendant. However, "[t]he standard of recklessness is more stringent when the defendant is an outside auditor."

The case is based on the acquisition by Accredo Health, Inc., of a division of Gentiva Health Services, Inc. The deal closed in June 2002. EY issued an unqualified audit opinion on Accredo's 2002 fiscal year financial results.

Prior to closing, EY participated in due diligence. According to the complaint, the audit firm learned that nearly $58.5 million of the receivables in one division were uncollectible. EY also recognized that the allowance for doubtful accounts was understated resulting in revenue being materially overstated.

In May 2003, Accredo issued a press release stating that it was writing off the $58.5 million of accounts receivable acquired from Gentiva. In its Form 10-Q for the third quarter of 2003, the company noted that if the collection rates had been evaluated based on data as of January 1, 2003, the charge would have been recorded as of that date. Plaintiffs claim this statement was made to avoid a restatement. The company terminated EY and filed a malpractice suit against the firm. The next year, a securities class action was filed against the company and two officers. It was settled.

Subsequently, this separate suit was brought against EY alleging violations of the antifraud provisions of the federal securities laws. The district court dismissed the complaint, finding that scienter had not been adequately pleaded as required by the PSLRA and the Supreme Court's decision in Tellabs, Inc. v. Makor Issuers & Rights, Ltd., 551 U.S. 308 (2007).1

1 http://www.supremecourt.gov/opinions/06pdf/06-484.pdf.

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The Sixth Circuit affirmed. The Court began by noting that the PSLRA requires a securities law plaintiff to state with particularity both the facts constituting the alleged violation of Section 10(b) and those establishing scienter. As Tellabs holds, the "strong inference" standard of the PSLRA was intended to "raise the bar" for pleading scienter. While reckless conduct will suffice, when the case is against an outside auditor, more is required. In that instance "the complaint must identify specific, highly suspicious facts and circumstances available to the auditor at the time of the audit and allege that these facts were ignored, either deliberately or recklessly." Those well pleaded facts must give rise to a strong inference of scienter. In addition, a comparative analysis must be done regarding possible competing inferences.

Here, plaintiffs failed to adequately plead scienter. Pleading accounting irregularities or a failure to comply with GAAP is, by itself, insufficient. Central to plaintiffs' allegations is a claim that EY failed to adhere to proper professional standards. This keyed to a claim that its testing of the receivables was deficient because the firm used "old and stale" data. Even if true, this type of allegation does not constitute securities fraud, the Court noted.

Plaintiffs' claim is not bolstered by its assertion that the audit firm missed "red flags." To create a strong inference of scienter from such a claim, the factual allegations must demonstrate an "egregious refusal to see the obvious, or to investigate the doubtful." Typically, courts look for multiple, obvious red flags before drawing an inference of scienter. In this regard, plaintiff points only to a series of facts which support conflicting inferences or that are not supported by facts demonstrating that the audit firm was aware of it.

Likewise, the magnitude of the error does not support a finding of scienter, as plaintiffs claim. In this regard the court held "[w]e decline to follow the cases that hold that the magnitude of the financial fraud contributes to an inference of scienter on the part of the defendant . . . Allowing such an inference would eviscerate the principle that accounting errors alone cannot support a finding of scienter." Indeed, such a claim is little more that hindsight, speculation and conjecture the Court noted.

Finally, the allegations regarding motive do not save the complaint. Here, plaintiffs accuse EY of committing fraud because of a promise of future professional fees. It is beyond dispute that the firm earned substantial fees from the company. There is no allegation, however, that the fees from Accredo were more significant than those from other clients. There are no facts in the complaint demonstrating that EY's motive to retain Accredo as a client was any different than its general desire to retain business. Overall, plaintiffs' claims are little more that the classic fraud by hindsight case

Background

On December 22, 1995, the U.S. Senate voted to override President Clinton's December 19, 1995 veto of the Private Securities Litigation Reform Act of 1995. With the House of Representatives having similarly voted on December 20, 1995 to override the veto, the Reform Act, which affects dramatically the ability of companies to defend themselves

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against class actions brought under the Federal securities laws, became law on December 22, 1995; its provisions do not apply, however, to any private action commenced before that date.

The bill adopts proportionate liability for all non-knowing securities violations under the Exchange Act. (It adopts the same rule for non-officer directors under Section 11 of the Securities Act.) This provision is particularly important for underwriters, venture capital firms, outside directors, accounting firms and others pulled into securities cases as socalled "deep pocket" defendants. Plaintiffs will no longer have the hammer of joint and several liability to coerce peripheral defendants into settlements because the risk to those defendants of defending the action is unacceptable. Only those whom the trier of fact finds to have committed "knowing" securities fraud, i.e., had actual knowledge that (1) a statement was false and/or that an omission made a statement misleading, and (2) investors were reasonably likely to rely on the misrepresentation or omission, will suffer joint and several liability.

The Reform Act creates one exception to the new proportionate liability rule: where, within six months of judgment, the court determines that one defendant's share is uncollectible, then all other defendants will become jointly and severally liable for that share if the plaintiff (including any class member) (1) is an individual whose recoverable damages equal more than 10 percent of such plaintiff's net worth and (2) the plaintiff's net worth is less than $200,000. Under this exception, the amount paid by each of the remaining defendants to all other plaintiffs is capped at 150 percent of a defendant's proportionate share.

In a separate provision, the Reform Act provides that if one defendant settles, a court is required to issue an order barring all future claims for contribution or indemnity by nonsettling persons against the settling defendant and by that defendant against all nonsettling defendants. Any verdict or judgment is then reduced by the amount paid to the plaintiff pursuant to the settlement or by an amount corresponding to the percentage of responsibility of the settling person, whichever is greater.2

12. Some auditors claim that increased exposure under Section 404 of the SOX creates a litigation environment that is unfairly risky for auditors. Do you think that the inability of auditors to detect a financial statement misstatement due gross deficiencies in internal controls over financial reporting should expose auditors to litigation? Why or why not? Include reference to appropriate ethical standards in your response.

An ethical person wants to perform honest work for an honest dollar. Auditors have an obligation of due care and competency, or another way to say that is the auditors have an obligation not to be negligent. Auditors should be held to such a standard and should be liable for degrees of negligence and fraud. While a financial statement audit does not

2 http://corporate.findlaw.com/finance/the-private-securities-litigation-reform-act-of1995.html#sthash.z8xr6jfH.dpuf

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mean internal controls have been audited, it is understood that auditors will detect material problems with internal controls that lead to materially misstated financial statements. Whether or not an auditor should be held legally liable for failing to detect a misstatement due to gross deficiencies in internal controls depends on the facts and circumstances of each situation. Section 404 of SOX attempts to deal with the problem by requiring auditors to review management’s assessment of internal controls so that if the auditor fails to uncover the material misstatement because of an inadequate evaluation, then it would seem logical to hold the auditor liable for such negligence.

13. Assume a U.S. company operates overseas and is approached by foreign government officials with a request to provide family members with student internships with the company. The company does business in that country with foreign customers and is negotiating for a contract with one such customer to provide services. Under what circumstances might such a request violate the FCPA?

This is an actual case. On August 18, 2015, the SEC announced that BNY Mellon had agreed to pay $14.8 million to settle charges that it violated the Foreign Corrupt Practices Act (FCPA) by providing valuable student internships to family members of foreign government officials affiliated with a Middle Eastern sovereign wealth fund.3

An SEC investigation found that BNY Mellon did not evaluate or hire the family members through its existing, highly competitive internship programs that have stringent hiring standards and require a minimum grade point average and multiple interviews. The family members did not meet the rigorous criteria yet were hired with the knowledge and approval of senior BNY Mellon employees in order to corruptly influence foreign officials and win or retain contracts to manage and service the assets of the sovereign wealth fund.

According to the SEC’s order instituting a settled administrative proceeding, the sovereign wealth fund officials requested that BNY Mellon provide their family members with internships, and they made numerous follow-up requests about the status, timing, and other details of the internships for their relatives. BNY Mellon employees viewed the internships as important to keep the sovereign wealth fund’s business.

“The FCPA prohibits companies from improperly influencing foreign officials with ‘anything of value,’ and therefore cash payments, gifts, internships, or anything else used in corrupt attempts to win business can expose companies to an SEC enforcement action,” said Andrew J. Ceresney, Director of the SEC Enforcement Division. “BNY Mellon deserved significant sanction for providing valuable student internships to family members of foreign officials to influence their actions.”

3 http://www.sec.gov/news/pressrelease/2015-170.html.

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The SEC’s order finds that BNY Mellon lacked sufficient internal controls to prevent and detect the improper hiring practices. The company did have an FCPA compliance policy, but maintained few specific controls around the hiring of customers and relatives of customers, including foreign government officials. Sales staff and client relationship managers were permitted wide discretion in their initial hiring decisions, and human resources personnel were not trained to flag potentially problematic hires. Senior managers were able to approve hires requested by foreign officials with no mechanism for review by legal or compliance staff. BNY Mellon’s system of internal accounting controls was insufficiently tailored to the corruption risks inherent in the hiring of client referrals, and therefore was inadequate to fully effectuate BNY Mellon’s stated policy against bribery of foreign officials.

The SEC’s order found that in 2010 and 2011, BNY Mellon violated the anti-bribery and internal controls provisions of the Securities Exchange Act of 1934. Without admitting or denying the findings, the company agreed to pay $8.3 million in disgorgement, $1.5 million in prejudgment interest, and a $5 million penalty.

14. Has the accounting profession created a situation in which the auditors’ ethical behavior is impaired by their professional obligations? How does the profession’s view of such obligations relate to how courts tend to view the legal liability of auditors?

An example would be client confidentiality. Auditors do have not have auditor-client privilege in federal courts. It is only available in a small number of state courts. Auditors are not prohibited from reporting fraud and other violations externally. Under DoddFrank they are called upon to make an ethical choice about what to do when they identify possible violations of federal securities laws. The proper approach is first to report the securities violations to their employers or clients in accordance with relevant rules and regulations, and then work together to uncover the extent of wrongdoing and ensure that those responsible are held accountable.

The confidentiality obligation in the AICPA Code should not be used to mask a CPA’s duties to the public and investors. An ethical perspective requires that CPAs should question whether complete confidentiality is essential to the accountant-client relationship. Given the public reporting responsibilities of auditors and the audit report, the accountant’s primary duty is to protect the public from improper reporting rather than to protect the client from disclosure of wrongdoing.

Extended Discussion

The audit profession has come under significant criticism during the past decade over the ethical conduct of auditors and their roles in abetting (or, at least, failing to prevent) a variety of financial scandals, such as Enron, Tyco and WorldCom. The heightened attention led to the creation of SOX and revised professional standards, such as AU-C 240 which provides better guidance for the consideration of fraud during an audit. However, at the same time that legislators and the audit profession are attempting to

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guide auditors’ behavior, the profession’s standards of client confidentiality might be working to limit the ethical choices of accountants.

The restricted nature of audit opinions, together with the American Institute of Certified Public Accountants’ (AICPA) client confidentiality rule, places the auditor in the position of having to choose between earning a livelihood and making a proper ethical choice. The concept of accountant-client privilege has never been supported by the federal courts including a number of U.S. Supreme Court decisions, which failed to find such a (ethical) right. Changes in professional standards regarding confidentiality are necessary to better serve the public and the investors whose interests are unprotected by current statements of responsibility.

This is not to say that client confidentiality should be abolished. On the contrary, pledges of confidentiality are critical when gathering full disclosures of company information, which can be sensitive and/or proprietary. However, disclosure in limited circumstances, such as when a fraud is discovered, might help to prevent future harm without compromising the quality of financial audits.

Accountants have traditionally asserted the right of confidentiality, which is articulated most plainly in Section 1.700 of the AICPA Code (Confidential Client Information): A member in public practice shall not disclose any confidential client information without the specific consent of the client.

The same principle of confidentiality is invoked by auditors when fraud is uncovered during an audit. SAS No. 99 states that disclosure of fraud to parties other than the client and its audit committee “… would be precluded by the auditor’s ethical and legal obligations of confidentiality.” Although the protection of a client’s private disclosures is an important tenet of the profession, the assertion of a privileged accountant-client relationship is difficult to justify, particularly in the audit function. Moreover, even if we assume such a privileged relationship exists between accountants and their clients when a financial crime is uncovered, but not reported, it is difficult to justify the protection of confidentiality – either in the broader context of privileged information or, more specifically, in the context of accounting.

Normally, courts use four criteria – the so-called “Wigmore test” – to determine whether claims of privilege apply to persons in a given relation. According to J. Wigmore’s “A Treatise on the System of Evidence in Trials at Common Law, including the Statutes and Judicial Decisions of All Jurisdictions of the United States, England, and Canada,” the four criteria are: 1) the communications must originate in a confidence that they will not be disclosed 2) this element of confidentiality must be essential to the full and satisfactory maintenance of the relation between the parties 3) the relation must be one that, in the opinion of the community, ought to be sedulously fostered 4) the injury that would inure to the relation by the disclosure must be greater than the benefit thereby

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gained for the correct disposal of litigation. In general, the situation must address all four criteria for privilege to apply.4

Using such criteria, the federal government has failed consistently to recognize any privilege between accountants and their clients. The U.S. Supreme Court has made compelling arguments against accountant-client privilege in both Couch v. United States (1973) and United States v. Arthur Young & Co. (1984), noting in the latter that an accountant’s “public watchdog” function demands that the accountant maintain total independence from the client at all times and requires complete fidelity to the public trust. Following the second criterion set forth in Wigmore’s test, there’s reason to question whether complete confidentiality is essential to the accountant-client relationship. Indeed, given the public reporting nature of public accountancy, the accountant’s primary duty is to protect the public from improper reporting rather than to protect the client from disclosure of wrongdoing.

Even assuming that accountant-client privilege has merit, it’s difficult to assert that it would preclude an auditor from reporting an instance of financial crime to proper, outside authorities.

The fourth criterion in Wigmore’s test notes that there are balancing interests in society between confidentiality and societal harm. Thus, the law recognizes cases in which the damage to members of society outweighs client confidentiality. Physicians and other health-care workers, for example, are required to report cases of suspected child abuse. Similarly, mental health professionals have an obligation to report client information to law enforcement personnel if they have reason to believe the client will engage in actions that could result in injury – either to the client or others.

This isn’t to suggest that fraud is as heinous a crime to society as child abuse or murder. However, the willful misstatement of public financial statements is probably the most serious breach of trust within the context of the accounting practice. Given the seriousness of the crime in this context and the “ultimate allegiance” to investors and creditors asserted by the court, accountants would be hard-pressed to demonstrate that greater damage results from breaching client confidentiality than from reporting a suspected fraud to outside parties.

It’s common, however, to hear strong protests from practitioners against changing client confidentiality standards, even in cases of client fraud. Proponents of complete confidentiality normally assert one or more of the following arguments:

1. Breaching client confidentiality in matters of fraud will undermine the willingness of clients to cooperate.

2. Faced with the possibility of exposure, clients will engage in yet more devious methods to hide the fraud, which the auditors will be unable to find.

4 http://www.fraud-magazine.com/article.aspx?id=4294968847.

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3. The damage to firms that are suspected of fraud, but later found not to be responsible, will be significant and unwarranted either as a result of the accusation.

The seriousness of financial crimes and confidentiality breaches requires us to consider these objections in some detail.

There is no question that an audit requires the examination of large amounts of material that the client provides willingly. Lacking subpoena power, there is no other way an auditor could obtain this material. However, to suggest that clients would fail to cooperate if confidentiality was not required ignores the reality of the audit process. Publicly traded companies by law must be audited and CPAs are the only professional group allowed by law to conduct audits. Companies have no option but to comply with auditors’ requests; otherwise, no opinion would be issued. Moreover, because most clients are honest and auditors will still be strongly constrained concerning the information they can release, the majority of audits should be unaffected.

This professional monopoly protects the accounting profession and obligates it to consider the well-being of society while exercising its duties. Indeed, the granting of a professional monopoly is a recognition of the profession’s expertise in a given arena, but in return society expects a pledge of ethical behavior.

15. Consider the following statement and explain the relationship between legal compliance on a global level and ethical responsibilities of accountants and auditors: “Ethical values and legal principles are usually closely related, but ethical obligations typically exceed legal duties.”

A relationship exists between law and ethics. In some instances, law and ethics overlap and what is perceived as unethical is also illegal. In other situations, they do not overlap. In some cases, what is perceived as unethical is still legal, and in others, what is illegal is perceived as ethical. A behavior may be perceived as ethical to one person or group but might not be perceived as ethical by another. Further complicating this dichotomy of behavior, laws may have been legislated, effectively stating the government’s position, and presumably the majority opinion, on the behavior. As a result, in today’s diverse business environment, one must consider that law and ethics are not necessarily the same thing. This is where cultural values and legal compliance on a global level might lead to a different mix between what is legal and what is ethical as could be the case with the legal/ethical acceptance of facilitating (“grease”) payments. In the U.S., they are legal under the FCPA. In the UK, they are illegal under the UK Bribery Act.

Laws and rules describe the ways in which people are required to act in their relationships with others in a society. They are requirements to act in a given way, not just expectations or suggestions to act in that way. Since the government establishes law, the government can use police powers to enforce laws.

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The word ethics is derived from the Greek word ethos (character), and from the Latin word mores (customs). Together they combine to define how individuals choose to interact with one another. In philosophy, ethics defines what is good for the individual and for society and establishes the nature of duties that people owe themselves and one another. The following items are characteristics of ethics:

 Ethics involves learning what is right and wrong, and then doing the right thing.

 Most ethical decisions have extended consequences.

 Most ethical decisions have multiple alternatives.

 Most ethical decisions have mixed outcomes.

 Most ethical decisions have uncertain consequences.

 Most ethical decisions have personal implications.

[It is important to note that there is also a difference between ethics and morality. Morality refers both to the standards of behavior by which individuals are judged, and to the standards of behavior by which people in general are judged in their relationships with others. Ethics, on the other hand, encompasses the system of beliefs that supports a particular view of morality.]

Ethical values and legal principles are usually closely related, but ethical obligations typically exceed legal duties. In some cases, the law mandates ethical conduct. Examples of the application of law or policy to ethics include employment law, federal regulations, and codes of ethics.

Though law often embodies ethical principles, law and ethics are far from co-extensive. The law does not prohibit many acts that would be widely condemned as unethical. And the contrary is true as well. The law also prohibits acts that some groups would perceive as ethical. For example lying or betraying the confidence of a friend is not illegal, but most people would consider it unethical. Yet, speeding is illegal, but many people do not have an ethical conflict with exceeding the speed limit. Law is more than simply codifying ethical norms.

The following diagram shows the relationship between law and ethics.5 5 http://ansteadsue.tripod.com/ethics.htm

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Extended Discussion

Establishing a set of ethical guidelines for detecting, resolving, and forestalling ethical breaches often prevents a company from getting into subsequent legal conflicts. Having demonstrated a more positive approach to the problem may also ensure that punishment for legal violations will be less severe. Federal sentencing guidelines passed in 1991 permit judges to reduce fines and jail time for executives proportionate to the ethical measures a company has taken.

Numerous laws have been enacted to protect employees against what society perceives as unethical behavior in the workplace. These laws are administered by the United States Department of Labor. Generally, these laws reflect the ethical standards of the majority of society. An example is the Americans with Disabilities Act of 1990 (ADA). According to the ADA:

"No covered entity shall discriminate against a qualified individual with a disability because of the disability of such individual in regard to job application procedures, the hiring, advancement, or discharge of employees, employee compensation, job training, and other terms, conditions, and privileges of employment."

Most citizens would agree that it would be unethical to deny employment or promotion to a disabled applicant, solely on the basis of that disability, especially when that disability would not affect their work performance. Legislators reacted and have enacted the ADA in order to make it illegal to engage in such discrimination. Yet even with this legislation, the Supreme Court continues to evaluate provisions of the ADA and its definition of disability.

16. Business ethics is about managing ethics in an organizational context and involves applying principles and standards that guide behavior in business conduct. According to IFAC, “The decisions and behaviors of accountants should reinforce good governance and ethical practices, develop and promote an ethical culture, foster trust and transparency, bring credibility and value to decision making, and present a faithful picture of organizational health to stakeholders.” Explain how

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accountants and auditors can meet these expectations in a global environment and protect the public interest.

Every individual has unique personal principles and values, and every organization has its own set of values, rules, and organizational ethical culture. Business ethics must consider the organizational culture and interdependent relationships between the individual and other significant persons involved in organizational decision making. Employees cannot make the best, most ethical decisions in a vacuum devoid of the influence of organizational codes, policies, and culture. Most employees and all managers are responsible not only for their own ethical conduct, but for the conduct of coworkers and those who they supervise. Without effective guidance, those in a business cannot make ethical decisions while facing a short-term orientation, as often exists in financial reporting goals, and seeing rewards based on outcomes in a challenging competitive environment. In the global arena, these influences become even more challenging as cultural differences, such as those identified by Hofstede and Gray, create additional considerations in organizational behavior that conforms to ethical standards.

The application of business ethics differs depending on the country, culture, and traditions, as well as the level of maturity in terms of regulation and enforcement of organizations’ legal responsibility and the expectations and duties of directors. However, the nature of ethical issues is generally similar across organization types, sizes, and geographies. For finance and accounting activities, typical ethical issues include conflicts of interest, providing truthful information and reports, and facilitating payments and bribes. The main safeguards are also universal and include ethical leadership, effective governance, a values-based code of conduct reinforced by a responsible business culture, and effective stakeholder engagement, transparency, and accountability.

According to the International Federation of Accountants (IFAC), “A growing number of organizations go far beyond viewing ethical practices as a means to avoid penalties or fines; they believe that corporate responsibility and ethical practices lead to sustainable value creation. Many organizations view corporate responsibility as a core part of corporate culture, which can bring an array of benefits to both the organization and society. Business ethics can have a measurable impact on corporate and brand reputation and, ultimately, license to operate. In addition, organizations can suffer damage from actions that are legal but perceived by customers and society as unethical or not in the spirit of the law.”

The decisions and behaviors of accountants should reinforce good governance and ethical practices through diligent application of the rules and professional standards in accounting and auditing and adherence to ethical standards such as those in the AICPA Code and the Global Code of Ethics of IFAC. Moreover, enforcement of internal controls; working with internal auditors; and communications with audit committees are all steps that accountants can take to reinforce good governance and ethical practices. The auditors’ review of the control environment establishes the basis to assess organizational culture. The challenge in a global environment is the interaction of cultural variables with

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these governance procedures. For example, in Asian cultures the emphasis on protecting the group, putting a positive spin on the financial results, and secrecy of financial information (i.e., Chinese companies) together may lead to difficulties for international accountants in carrying out ethical and legal requirements in accordance with good governance standards.

A distinguishing characteristic of the accountancy profession is the responsibility to act in the public interest. The decisions and behaviors of accountants should reinforce good governance and ethical practices, develop and promote an ethical culture, foster trust and transparency, bring credibility and value to decision making, and present a faithful picture of organizational health to stakeholders.

Accountants appointed to senior management positions, both in business and practice, have a particular responsibility to provide ethical and trusted leadership. They are not only expected to be technically competent but to also use their position of influence to encourage ethical behavior and decision making throughout their organization.

Ethical behaviors by accountants are critical to enhance the trust placed by the end user in the professional services offered by accounting firms. In the absence of trust, such services will be perceived to have little or no value. The independence of professional accountants in practice, both in fact and appearance, is the key to securing trust. Hence, professional accountants in practice comply with independence requirements related to everything from investments to business and employment relationships to services delivered to clients.

Extended Discussion

In some jurisdictions, particularly in Europe and the U.S., aspects of business ethics are typically reinforced by regulation, laws, and stock exchange listing rules. Examples of regulatory and legislative approaches to business ethics and conduct include the US Federal Sentencing Guidelines (1991), Section 406 of the Sarbanes Oxley Act of 2002, UK Bribery Act (2010), and Clause 49 of the listing agreement of India’s stock exchange.

Significant progress has been made toward the global convergence of ethical standards by professional accountants. The International Ethics Standards Board for Accountants (IESBA) develops and issues, under its own authority, the Code of Ethics for Professional Accountants (the Code). The IESBA’s objective is to serve the public interest by setting high-quality ethics standards for professional accountants. Its longterm objective is convergence of the Code's ethical standards for professional accountants, including auditor independence standards, with those issued by regulators and national standard setters.

In addition, for accountants, business ethics requires the application of professional ethics. IFAC’s member organizations are required to apply ethical standards at least as stringent as the Code. Convergence to a single set of standards can enhance the quality and consistency of services provided by professional accountants throughout the world

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and can improve the efficiency of global capital markets. The Code requires professional accountants to comply with five fundamental principles: integrity; objectivity; professional competence and due care; confidentiality; and professional behavior.

The profession has developed a range of resources including reports, guidance, and support helplines to help accountants and their employers apply the Code (and local adaptations) and resolve ethical dilemmas.

17. How do Gray’s accounting values establish a basis for financial reporting in countries with different cultural systems?

Gray uses Hofstede’s values to identify four widely recognized accounting values that can be used to define a country’s cultural foundation with respect to financial reporting:

1. Professionalism (preference for professional judgment) versus statutorycontrol (compliance driven prescriptive legal requirements)

2. Uniformity (consistency across companies in the use of accounting practices) versus flexibility(choiceofaccountingpracticeinaccordancewiththeperceived circumstances of individual companies)

3. Conservatism (a cautious approach to measurement to deal better with the uncertainty of future events) versus optimism (following a more hands-off, risktaking approach)

4. Secrecy (preference for confidentiality and restrictions on disclosures) versus transparency (open and public accountability).

From an accounting perspective, high conservatism implies a tendency to defer the recognition of assets and items that increase net income while reserving for possible future declines in earnings. Within Hofstede’s framework, higher levels of conservatism are most closely linked with countries that have higher uncertainty avoidance and lower individualism. High secrecy implies a tendency to restrict the disclosure of relevant information to outside parties as is done in China. Higher levels of secrecy within a culture are associated with higher uncertainty avoidance and power distance and with lower individualism. A real life example is the difficulty the PCAOB has been having obtaining access to the audit documents of U.S. accounting firms operating in China through Chinese affiliates in order to carry out its inspections of the audits of Chinese companies listing shares on the NYSE and NASDAQ.

18. What are the costs and benefits of establishing one set of accounting standards (i.e., IFRS) around the world? How do cultural factors, legal systems, and ethics influence your answer? Apply a utilitarian approach in making the analysis.

The advantages of one set of accounting standards to be followed by all companies around the world include the comparability of financial statements, irrespective of the location of the company’s headquarters; global cost of capital; and its ability to raise

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capital in world-wide markets, not just the home country. The disadvantages of one set of accounting standards is the failure of one set of standards to be 100% compatible with the unique legal, regulatory, litigious, social, economic, religious, and cultural environments of each country. There are some concerns about the enforcement of IFRS. The SEC is the main regulatory body for U.S. companies. As the standard setting has moved to IFRS in so many countries (about 120) except the U.S., the fragmented, country-to-country regulatory environment has proven to be a challenge.

As the U.S. has effective enforcement, it's very difficult to implement stringent enforcement outside the U.S. because of the variations in economic (state-owned enterprises vs. public ownership); legal and regulatory (government versus market controls); and corporate governance differences (government oversight and control versus board of directors, audit committee, internal controls and an external audit).

Extended Discussion

Here is a more extensive list of advantages and disadvantages of adopting IFRS in the U.S. Any utilitarian analysis starts with identifying these factors (benefits/harms) and weighing each one’s importance (hard to do) – and then making a decision about the overall net benefits of adoption.

Advantages

 Improved transparency. Investors, executives, and managers in different countries should be able to better understand a foreign company’s or multinational’s reports and statements.

 Uniformity across international boundaries.

 Better management information, with more visibility into foreign subsidiaries and more transparency.

 Improved communication among subsidiaries, as their accounting converges in IFRS.

 Possible cash management advantages.

 Lowered costs of accounting services due to standardization; one example would be an entity located in a low-tax jurisdiction that can meet the needs of all subsidiaries of a multinational because all will rely on a single accounting and taxation method under IFRS.

Disadvantages

 Systems will need to be modified to accommodate new charts of accounts. There will likely be a period for US companies of tracking and reporting in both GAAP and IFRS, while also clarifying the variances between the two methods.

 Education of accounting students in IFRS is lacking; burden placed on firm training creates excessive costs

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 There will be changes to tax, technology, and valuation and these will vary from country to country.

 Differences in IFRS rules and accommodating for them in the GAAP system

 IFRS treats employee compensation and stock options differently, which could trigger major company policy shifts.

19. The Institute of Chartered Accountants in England and Wales (ICAEW) has adopted a code of ethics based on the IFAC Code. In commenting on the principlesbased approach used in these codes, the ICAEW states that a principles approach “focuses on the spirit of the guidance and encourage responsibility and the exercise of professional judgment, which are key elements of professions.”Explain how factors underlying professional judgment that were discussed in Chapter 4 come into play in the global environment.

In chapters 1 and 4 we noted that the principles in the AICPA Code are aspirational statements and guide members in the performance of their professional duties; they call for an unyielding commitment to honor the public interest, even at the sacrifice of personal benefits. The principles represent the expectations of the accountants on the part of the public in the performance of professional services. In this regard, the principles are based on values of the professions and virtues or traits of character that enable the accountant to meet their obligations to the public. Principles help accountants and auditors internalize the ethics of the accounting profession as virtues. Principles call for the exercise of professional judgment in conflicting cases by asking: Am I doing what a person of integrity would do?

The IFAC Code sets out five fundamental principles, which guide members’ behavior:

 Integrity

 Objectivity

 Professional competence and due care

 Confidentiality

 Professional behavior

Members are responsible for assessing threats to complying with those principles and for implementing safeguards where those threats are significant.

The ethics code relies on professional judgment. The rules can never be expected to cover all situations encountered by accounting professionals. When the rules are unclear, judgment must be used based on the principles in the code, basic ethical values such as honesty, integrity, trust, and responsibility, and ethical reasoning used to think through what should be done in a particular situation.

Professional judgment is influenced by personal behavioral traits (i.e., attitudes and ethical values) as well as one's knowledge of the accounting and auditing issues in

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question. Theoretical models of ethical decision-making, such as that of Hunt and Vitell, include personal values in their theory as one of several personal characteristics that potentially influence all ethical decision processes. The role of personal values (i.e., virtues) in auditor ethical decision making was discussed in Chapters 1 and 2.

Personal values link to ethical sensitivity and judgment. Ethical awareness of an ethical dilemma is a mediator on the personal factors and ethical judgment relationship, as recognized by Rest in his model of ethical decision making. It is unlikely that an accountant making a judgment on an employer's application of generally accepted accounting principles (GAAP) would make the best choice without realizing that that the decision will affect others through its consequences. Likewise, objectivity and due care are attitudes and behaviors that enable that choice to be made. For an auditor, professional skepticism is essential in making professional judgments. It helps to frame auditors' mindset of independent thought.

In Chapter 4 we discussed the KPMG Professional Judgment Framework. It starts with a common definition of judgment: Judgment is the process of reaching a decision or drawing a conclusion where there are a number of possible alternative solutions. Judgment occurs in a setting of uncertainty, risk, and often conflicts of interest. These factors are especially pronounced in the global environment where legal, environmental, and cultural variables provide the foundation for making judgments. For example, in many European countries a “true and fair view” criterion provides the foundation for making audit judgments while in the U.S. it is “present fairly.”

The KPMG framework identifies five components of professional judgment that revolve around one's mindset. The components are: (1) clarify issues and objectives; (2) consider alternatives; (3) gather and evaluate information; (4) reach conclusion; and (5) articulate and document rationale. The framework recognizes that influences and biases might affect the process as could one's knowledge of professional standards. Judgments are made in the context of ethical evaluations and the application of professional standards that differ from country to country, although the adoption of IFRS by about 120 countries has reduced the need for individualized judgment in each country at least to some extent. Each country is still permitted to apply IFRS standards within its legal and statutory framework.

At the very center of the KPMG framework is "mindset." Auditors should approach matters objectively and independently, with inquiring and incisive minds. Professional skepticism is required by auditing standards. It requires an objective attitude that includes a questioning mind and critical assessment of audit evidence. In the previous example, professional skepticism was sacrificed for expedience.

Professional skepticism is not the same as professional judgment, but it is an important component of professional judgment. It is a frame of reference to guide audit decisions and enhances ethical decision making.

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Our intuitive judgments can fall prey to cognitive traps and biases that negatively influence our judgments. Three common judgment traps are "group-think," a rush to solve a problems, and "judgment triggers." Group-think finds a home in stage 3 of Kohlberg's model. We become influenced by the expectations of the group and, consequently, we subjugate our own beliefs and thought process. We may do so to avoid conflicts or save time. In an audit, this means the team might accept copies of documents if the majority of members convince the others that the client can be trusted and the group doesn't want to bust the budget. Cultural variables influence judgments at this stage; emphasis on what is in the best interests of the group may influence judgments more than what is “right” or “wrong” in the context of professional and ethical standards.

The audit of financial statements has always required auditors to exercise their professional judgment, but the use and importance of these judgments continues to grow as the overall complexity and estimation uncertainty inherent in financial statements increases and business becomes more global with cultural influences playing a more important role than ever before. In an effort to facilitate auditors' use of sound professional judgment, audit firms have turned to developing professional judgment frameworks, such as the one provided by KPMG, to promote a rigorous, thoughtful, and deliberate judgment process to guide making reasonable accounting judgments.

20. Consider the practice of making “facilitating payments” to foreign officials and others as part of doing business abroad in the context of the following statement: International companies are confronted with a variety of decisions that create ethical dilemmas for the decision makers. “Right-wrong” and “just-unjust” derive their meaning and true value from the attitudes of a given culture. Some ethical standards are culture-specific, and we should not be surprised to find that an act that is considered quite ethical in one culture may be looked upon with disregard in another. Explain how culture interacts with the acceptability of making facilitating payments in a country. Use rights theory and justice reasoning to analyze the ethics of allowing facilitating payments such as under the FCPA in the United States and prohibiting them as under the U.K. Bribery Act.

For legal purposes, a facilitating payment is distinguished from bribery; however, the distinction is often blurred. Determining whether a payment is a facilitating one may be difficult and depend on the circumstances. The value of the payment is not immediately relevant; however, the greater the value, the higher are chances that it will be a red flag for law enforcement. Small unofficial payments are customary and even legal in some countries; nevertheless they may present a risk of liability according to the laws of the host country. There also exists a slippery slope danger of evolving into bribery payments.

As of 2006, the United Kingdom does not recognize the legality of facilitating payments and does not draw any distinction from bribes. However, the UK is unlikely to prosecute for minor facilitating payments in the areas where it is a common practice. Within the U.S. federal legislation, a facilitating payment or "grease payment", as defined by FCPA is a payment to a foreign official, political party or party official for "routine

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governmental action," such as processing papers, issuing permits, and other actions of an official, in order to expedite performance of duties of non-discretionary nature, i.e., which they are already bound to perform. The payment is not intended to influence the outcome of the official's action, only its timing. Facilitation payments are one of the few exceptions from anti-bribery prohibitions of the law.

Using Rights Theory, the categorical imperative would imply that if a bribe or facilitating payment is wrong in one culture, then it is wrong in all cultures. The imperative would also imply that if a facilitating payment is just an immaterial bribe, then it is a bribe also. The U.K. Bribery law is using reasoning in accordance with rights theory. Using Justice Theory, a just act respects your rights and treats you fairly. The most fundamental principle of justice is that “equals should be treated equally and unequals unequally.” The U.S. FCPA uses justice theory in recognizing that facilitating payments are not the same as bribes so that the penalties should be measured to reflect these differences. One might argue whether it is right or fair to characterize a payment as facilitating and not disclose it as a bribe given that it is ethically wrong but permitted by the law because it simply induces an official to do what that person should do in the normal course of carrying out their obligations. Where is the transparency?

21. One provision of the U.K. Bribery Act is that it applies to bribes that occur anywhere in the world by non-U.K. companies that conduct any part of their business in the United Kingdom. For example, the Bribery Act would cover a company that has a few employees working in the United Kingdom or that simply sells its goods or services in the United Kingdom. Evaluate this policy from an ethical perspective using ethical reasoning. In particular, do you think the policy is fair? Is it right?

The U.K. Bribery Law is using rights theory and the categorical imperative to determine that if a bribe or facilitating payments is wrong in one culture, then it is wrong in all cultures. Is this fair? Is it ethical to not act consistently with one’s values based on justifications for different actions in different situations? Being fair means treating like situations alike and unlike situations differently. The fairness argument may be used to support allowing facilitating payments in some countries while prohibiting them in others because of cultural differences that establish the basis for fairness. On the other hand, we might argue there is no meaningful difference between allowing facilitating payments in one country versus another because the parties that receive such payments operate in a similar capacity (i.e., ministerial duties such as a customs agent) and the purpose of the payment is the same in each instance (i.e., off-load goods).

The Rights Theory is stricter and it would be difficult to justify the U.S. distinction between a facilitating payment and bribe under this theory. If it is wrong to make payments to influence behavior, regardless of the nature of the behavior, then it is wrong whether the behavior is to induce someone to do what she should be doing otherwise (facilitating payment) as opposed to bribing someone to receive favored treatment. In other words, the ends do not justify the means.

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22. What is the purpose of having a two-tier system of boards of directors in countries such as Germany? How does the dual-board approach ameliorate the potential conflicts in the principal-agent relationship between investor and manager?

The two-tier structure for board directors consists of a Management Board and the Supervisory Board. The Management Board generally performs the duties and responsibilities of senior management of a corporation. The group is charged with the day-to-day managing of the corporation to benefit the various stakeholder groups. The Supervisory Board appoints, supervises, and advises the members of the Management Board on polices but does not participate in the day-to-day management. Shareholders at the annual meeting elect members of the Supervisory Board. Members are nonmanagement, and may include employee representatives. Other members include: shareholders holding 25% or more of the company’s stock; other block-holders of stock, including other business enterprises; wealthy families; and large commercial banks.

A major issue for corporate governance in Germany is that ownership structures are complex, and hybrid ownership groups and insider controls create challenges for effective transparency in corporate control. Emphasis on bank financing does not provide traditional protection for investors. Stock financing has been expanded to resolve some of these concerns. The German system allows for the management board to act as the agent of the shareholder/principals whereas in the U.S. it is the top managers who have that responsibility. One could argue that the dual board approach provides a better mechanism to deal with conflicts between these interests because the management board is not directly influenced by issues such as promotion, bonuses, and stock option values.

23. In discussing the benefits of the Global Code of Ethics, Richard George, chairperson of the International Ethics Standards Board for Accountants, said, “Strong and clear independence standards are vital to investor trust in financial reporting. The increase in trust and certainty that flow from familiarity with standards, including a common understanding of what it means to be independent when providing assurance services, will contribute immeasurably to a reduction in barriers to international capital flows.”Explain the link between auditor independence and facilitating international capital flows from the public interest perspective.

Auditor independence is the foundation of trust that the public places in financial reporting. Users of financial reports trust that auditors will act independently of management and make objective judgments when evaluating the accuracy and reliability of the financial reports; assessing the competency and sufficiency of audit evidence; assessing the risk of material misstatements due to fraud; and evaluating management’s report on internal controls. When international investors can trust that auditors will meet their professional obligations stated above, it is more likely that

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cross-border investments will be made with the confidence that audits of these investments will be made in accordance with prescribed ethical and professional standards.

A common understanding of independence is important because it is not 100 percent clear in all instances whether independence standards have been met. Independence is a factual determination but difficult to assess. Therefore, the appearance of independence is most important. This includes avoiding certain relationships with clients and client management that might lead an observer to conclude that independent thought cannot be exercised and objective judgment may be clouded.

Both the AICPA Code of Professional Conduct and IFAC Global Code of Ethics establish a conceptual framework approach to independence that calls for assessing threats to independence that may arise due to relationships with the client and whether any safeguards exist to mitigate such threats. The conceptual framework is designed to assist users in analyzing relationships and circumstances that the codes do not specifically address.

This is a good opportunity to review with students the threats and safeguards approach first discussed in Chapter 4.

Threats to independence include a self-review threat, advocacy threat, adverse interest threat, familiarity threat, intimidation threat, financial self-interest threat, and management participation threat. A brief description of each threat is given below, and Exhibit 4.2 provides examples of each threat.

Exhibit 4.2

Examples of Threats to Independence Threat Example

Self-Review Threat Preparing source documents used to generate the client’s financial statements.

Advocacy Threat Promoting the client’s securities as part of an initial public offering or representing a client in U.S. tax court.

Adverse Interest Threat Commencing, or the expressed intention to commence, litigation by either the client or the CPA against the other.

Familiarity Threat A CPA on the attest engagement team whose spouse is the client’s CEO.

Undue Influence Threat A threat to replace the CPA or CPA firm because of a disagreement with the client over the application of an accounting principle.

Financial SelfInterest Threat Having a loan from the client, from an officer or director of the client, or from an individual who owns 10 percent or more of the client’s outstanding equity securities.

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Management Participation Threat Establishing and maintaining internal controls for the client.

Self-Review Threat

A self-review threat occurs when a CPA reviews evidence during an attest engagement that is based on her own or her firm’s nonattest work. An example would be preparing source documents used to generate the client’s financial statements.

Advocacy Threat

An advocacy threat occurs when a CPA promotes an attest client’s interests or position in such a way that objectivity may be, or may be perceived to be, compromised. These are of particular concern when performing tax services.

Adverse Interest Threat

An adverse interest threat occurs when a CPA takes actions that are in opposition to an attest client’s interests or positions.

Familiarity Threat

A familiarity threat occurs when a close relationship is formed between the CPA and an attest client or its employees, members of top management, or directors of the client entity, including individuals or entities that performed nonattest work for the client (i.e., tax or consulting services).

Undue Influence Threat

An undue influence threat results from an attempt by the management of an attest client or other interested parties to coerce the CPA or exercise excessive influence over the CPA.

Financial Self-Interest Threat

A financial self-interest threat occurs when there is a potential benefit to a CPA from a financial interest in, or from some other financial relationship with, an attest client. It goes beyond simple situations where independence would be impaired, such as directly owning shares of stock of the client or having material indirect financial interest. Financial self-interest threats can also arise from business relationships with a client or a member of management that creates a mutual selfinterest.

Management Participation Threat

A management participation threat occurs when a CPA takes on the role of client management or otherwise performs management functions on behalf of an attest client.

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Safeguards to Counteract Threats

Safeguards are controls that eliminate or reduce threats to independence. These range from partial to complete prohibitions of the threatening circumstance to procedures that counteract the potential influence of a threat. The nature and extent of the safeguards to be applied depend on many factors, including the size of the firm and whether the client is a public interest entity. To be effective, safeguards should eliminate the threat or reduce to an acceptable level the threat’s potential to impair independence.

There are three broad categories of safeguards. The relative importance of a safeguard depends on its appropriateness in light of the facts and circumstances.

1. Safeguards created by the profession, legislation, or regulation. For example, continuing education requirements on independence and ethics and external review of a firm’s quality control system.

2. Safeguards implemented by the attest client, such as a tone at the top that emphasizes the attest client’s commitment to fair financial reporting and a governance structure, such as an active audit committee, that is designed to ensure appropriate decision making, oversight, and communications regarding a firm’s services.

3. Safeguards implemented by the firm, including policies and procedures to implement professional and regulatory requirements.

24. What

are the unique challenges to the global internal audit function?

Ever since the Sarbanes-Oxley Act was passed the internal audit function has increased in importance. The Treadway Commission had already established that the internal audit function should be independent of management and the internal auditors should have direct and unrestricted access to the audit committee of the board of directors. SOX calls for the internal auditors to meet periodically with the audit committee to discuss and resolve any differences with management. Internal auditors also serve as the “eyes” and “ears” for the external auditors and help the external auditors to meet their ethical and professional obligations.

The internal audit department plays a critical role in corporate governance. Given that corporate governance systems vary on a global level, the role of internal auditors may be different in different systems and cultures. For example, many European countries have a two-tier system of boards of directors so that the management board would work with the internal auditors in the former’s evaluation of the financial statements and carrying out their role in ensuring the statements are accurate and reliable.

A document prepared by Ernst & Young on the challenges of the global internal audit function provides useful information on this issue.6

6http://www.ey.com/Publication/vwLUAssets/ViewPoints:_Challenges_of_global_internal_audit/$FILE/ACLS_Vie wPoints-Challenges_of_global_internal_audit_May%202013_AU1630.pdf.

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EY points out that the role of internal audit has changed with the evolving global business environment including:

 Internal audit must recruit, train, and manage staff that can operate across a variety of cultures and deal with multiple regulatory regimes.

 Internal audit departments must secure a strong position within their companies, underpinned by trust and close relationships with staff in other business units and across multiple countries.

 Audit committee interactions influence the internal audit function as well as the department’s relations with management and the external auditor, which must be careful in how it uses the work of internal audit.

The internal audit function plays a number of key roles in large global companies through financial and operational audits, audits of compliance activities, involvement in risk management, and support for the external auditor. In some companies, internal audit provides feedback and recommendations on operational efficiency, focusing not just on whether a given process achieves its objective but also on how cost-effectively it does so.

To carry out its responsibilities on a global level, internal audit departments must be cognizant of cultural influences in different countries as well as the role of regulatory bodies. In China, for example, it may be more difficult to provide the kind of oversight and evaluations of financial reports and management of Chinese companies because so many are state-owned.

The basis for the relationship between the internal audit department and management typically revolves around the trust that exists between the chief audit executive and the CEO. There must be candid conversations and transparency in the disclosure of information needed by the internal auditors to meet their ethical and professional responsibilities. Trust can be an elusive concept when dealing with different cultures but is the basis for an effective corporate governance system that incorporates a strong global internal audit function.

25. In this chapter, we discuss problems encountered by the PCAOB in gaining access to inspect workpapers of auditors in U.S. international accounting firms that have Chinese company clients that list their stock in the United States. Explain why these problems exist from a cultural and legal perspective. How might shareholder interests be compromised by the arrangement between the PCAOB and CSRC that was struck in the Longtop Financial case discussed in this chapter?

Gray uses Hofstede’s values to identify accounting values of professional, uniformity, conservatism, and secrecy. China shows a preference for statutory control and compliance driven prescriptive legal requirements versus a preference for professional judgment; uniformity and consistency across companies in the use of accounting practices versus choice of accounting practice with perceived circumstances of individual companies; high conservatism, a tendency to defer the recognition of assets and items that increase net income while reserving for possible future declines in earnings; and high

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secrecy or preference for confidentiality and restrictions on disclosures. Information is tantamount to state secrets. In China the government is the main stockholder in many state-owned enterprises and, even in private concerns, it weald’s a great deal of power and influence over decisions made by top management. These cultural and accounting values seem to go a long way in explaining the difficulty in receiving adequate disclosures in Chinese company financial reports and cooperation from China’s government.

In the text we point out that Chinese companies listing shares in the U.S. have largely fallen through a regulatory loophole, partly because U.S. audit inspectors at the PCAOB have not been allowed inside China where the audits are done. The SEC has to work through the China Securities Regulatory Commission (CSRC). In the Longtop Financial case, the PCAOB had asked Deloitte to turn over its working papers because Longtop had allegedly committed fraud. After months of discussion, the SEC received a substantial volume of documents called for by its subpoena, including Deloitte audit workpapers and certain other documents related to Longtop. The production was made by the CSRC in January 2014, in response to the SEC’s request for assistance in August 2012. The CSRC produced the documents to the SEC after obtaining them from Deloitte thereby eliminating any claims that it had violated confidentiality in regards to its Chinese client.

The SEC began investigating Longtop Financial Technologies of China for accounting fraud in 2011 after Deloitte’s Chinese affiliate resigned as its auditor because of significant problems in verifying its financial statement. Deloitte had served as Longtop’s auditor since the company went public in the United States in 2007 through an initial public offering and listed its shares on the NYSE.

Deloitte issued a clean opinion on Longtop’s financial statements through 2010 and only withdrew its audit opinions in May 2011 when it resigned. In its letter to the company, Deloitte said it found “very serious defects” that included significant differences in deposit balances at banks from what the company reported and loans to it that had not been previously disclosed.

The first step in any corporate financial fraud investigation is to obtain the work papers of the auditors, so the SEC issued a broad subpoena to Deloitte’s Chinese affiliate for those records within days of its resignation. The misconduct disclosed in the resignation letter raises questions not only about Longtop’s management but also how the outside auditors did not learn about it for so long. The SEC is likely to look into whether anyone at Deloitte’s Chinese affiliate participated with management in the accounting problems that were eventually uncovered, and whether the firm was as thorough as it should have been in verifying the financial statements in prior years.

The firm has resisted complying with the subpoena because it asserted that turning over its work papers could violate Chinese law prohibiting the disclosure of “state secrets,” which it says includes information about the “national economy and social development.” Anyone convicted of a violation could be sentenced to a long prison term.

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In September 2011, the SEC filed a subpoena enforcement action in Federal District Court in Washington to force Deloitte’s Chinese affiliate to turn over the documents from its Longtop audits. The SEC argued that it should be permitted to serve the subpoena on Deloitte’s American lawyers along with an order requiring the firm to respond to its demand for documents without having to use a more cumbersome treaty procedure that requires working through the Chinese government, which would add months to the process.

The issue of whether Chinese accounting firms meet the standards set in the U.S. is a growing concern. The PCAOB has been working with its Chinese counterparts to come up with standards for inspecting auditing firms in China, but a planned meeting between the regulators have been delayed a number of times.

Auditors have resisted handing over records for fear of violating China’s state secrets law. Dozens of Chinese companies have raised billions of dollars in the past decade listing their shares on U.S. and foreign exchanges. Accuracy, reliability, and transparency concerns have led to share price reductions in some of those companies amid questions about their bookkeeping and financial disclosures. From an ethical perspective, it is an issue of trust and representational faithfulness in the financial reporting. Can foreign investors trust the financial reports produced by accountants in China and audited by the Big Four CPA firms to faithfully represent what it purports to represent thereby enhancing the usefulness of such reports? Can we really trust that the CSRC turns over all relevant information?

The bottom line issue in the Deloitte – Longtop case is legal and cultural considerations can and do influence the relationship between foreign entities doing business in the U.S.

Recent Agreement between SEC and CSRC

On April 4, 2015, a legal settlement was reached between the SEC and the China affiliates of the Big Four firms resolving the long-running dispute over access to audit working papers related to U.S.-listed Chinese companies.7

It seems that each party obtained what they wanted: the SEC Commission will be able to check audit working papers, the Big Four firms in China keep their clients, and shareholders should gain more transparency in evaluating the companies’ performance. Legal experts have described the settlement as a balanced outcome that benefits all major parties.

Under the terms of the agreement, the SEC will make requests for documentation to the China Securities Regulatory Commission, which will provide the papers. “There is a mechanism now for attempting to resolve disputes,” says Jacob Frenkel, who is a former senior counsel in the SEC’s enforcement division.

7 http://www.gaaaccounting.com/reaching-a-deal-on-china-audits/.

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According to the SEC order following the agreement, the China-based affiliates of the Big Four firms will submit the documents requested by SEC to the CSRC, but it is not specified in the order how audit documents deemed to be containing state secrets will be dealt with thereafter.

For their part, the Big Four firms concerned

Deloitte Touche Tohmatsu, Ernst & Young Hua Ming, KPMG Huazhen and PricewaterhouseCoopers Zhong Tian – issued a joint statement welcoming the settlement.

“We are pleased to have reached a settlement in the proceeding related to the production of Chinese audit work papers to the U.S. SEC,” the firms said in their statement. “The firms’ ability to continue to serve all their respective clients is not affected by this settlement.”

Chinese non-Big-Four firms watched the proceedings with interest, cautioning that the settlement is a relief but it appears to be a temporary solution until the U.S. and Chinese regulators can find a meaningful permanent reconciliation of the differences between Chinese laws and U.S. listed entity rules and regulations.

Roy Lo, Hong Kong Managing Partner of ShineWing (HK) CPA and a member of the Hong Kong Institute of CPAs. “I believe the settlement is positive in encouraging the access to audit work papers in China [towards] achieving the completion of audit work with a good balance of investors’ interests and confidentiality asserted by listed companies.”

Differences among regulators about aspects of an investigation could also contribute to miscommunication. “What the CSRC deems to be relevant could be less than the PCAOB’s to meet its mission to protect the interests of investors,” argues Steven M. Mintz, Professor of Accounting at the California Polytechnic State University, San Luis Obispo’s Orfalea College of Business.

One possible solution would be an international agreement to create uniform regulations for disclosure. “The only hope for a better solution would be if the international auditing community would come together and issue guidelines for inspections of global firms that audit companies listed on foreign exchanges,” suggests Mintz.

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